As institutional real estate platforms - both private and public - scale up, portfolio managers begin making investment decisions consistent with diversification goals. While small funds generally ignore concentration risk since there’s not much they can do to diversify, larger platforms face critical questions about product type diversification, geographic diversification and tenant diversification. What they prioritize and the decisions they make have significant impacts on returns.

Is there a right approach? Do you think we’d be writing this if there wasn’t? Research is here to help from Professor Chacon at the University of Denver.¹ The question: Which diversification lever matters most for REIT returns? Product type, geography or tenant base? The answer: Tenant diversification. Studying REIT returns and using “horse-race” analytical techniques, when it comes to a REIT’s profitability, operating efficiency, risk, and the cost of debt, “tenant mix is the most critical dimension of portfolio concentration.”

You might think optimal tenant concentration is a low tenant concentration, but there is a “positive and significant relation between tenant concentration and profitability.” In plain terms, REITs with more concentrated tenant bases make more money. Profitability obviously comes from either more rent or greater operating efficiency (or both), and the research pinpointed operating efficiency—not rent increases—as the source of profitability for REITs with high tenant concentration. They had higher profit margins and lower expense ratios. The research found no correlation between tenant concentration and higher rents.

Specifically, for every one standard deviation increase in tenant concentration, a REIT’s return on assets (ROA) goes up 0.59 percentage points, which is a lot considering the average ROA is 2.49%. In other words, tenant concentration drives ROA up about 24% on average and is “a significant determinant of profitability.” That same REIT’s profit margin increases nearly 4%.

REITs that have high tenant concentration AND high-quality tenants (a concept we talk about below) see even stronger results: a one-standard-deviation increase in concentration doubles their ROA relative to the average. Sweet.

Driving these improvements, the research speculates that deeper tenant relationships create mutual dependence and trust, and tenants are more “likely to produce longer term leases and a higher probability of renewing leases.” For context, REITs have more tenant concentration than we thought. Across office, retail, healthcare, industrial and diversified portfolios (2000-2017), analyzing their tenant bases and “REIT-year” performance, the average REIT had a 23% exposure to its top five tenants. Healthcare REITs were the most concentrated, with the top five tenants representing 50% of their revenue. Industrial was the least concentrated at 15%.

But there’s a shadow side to this: Concentration comes with risk. There’s risk the tenant and landlord relationship could end abruptly, the tenant could shrink or default on its leases or even go bankrupt. One way to measure risk is in the volatility of operating results and the REIT’s stock price. That relationship turns out to be positive, volatility in those metrics is higher for REITs with higher tenant concentrations. Also the paper took a different, clever approach to looking at risk: the cost of debt. Because banks are in the business of assessing risk in borrowers, the hypothesis was that if tenant concentration led to higher risk, mortgage spreads for high-concentration REITs should be higher, and that’s what they found.

So high-tenant-concentration REITs are more risky and pay more for debt but are also more profitable. As the paper notes, “this is somewhat puzzling,” as higher profitability usually is negatively correlated with risk. That puzzlement is resolved by a closer examination of the tenant base and an assessment of tenant quality.

The research analyzed tenant quality by scoring each “concentrated” tenant on size, maturity, profitability, leverage, and interest coverage ratio. Each tenant earned a score of zero through five, with zero, one and two being low quality, three, four and five being high. Results clearly showed that the quality of the concentrated tenant base determined if the REIT enjoyed the benefits of enhanced profitability or suffered from higher risk and cost of debt.

In fact REITs with concentrations of high-quality tenants emerged as the true heroes of this story. They exhibited firm-level risk no different or even lower than average-diversification REITs and saw costs of debt at or below average, and still delivered the highest profitability. This is where you want to be.

So what should practitioners take away? Two things: First, tenant concentration has a disproportional impact on performance vs. geographic or property type diversification, so time spent focused on the portfolio rent roll is time well spent. Second, and counter-intuitively, less tenant diversification drives higher profitability and can do so adding no measurable downside, if done thoughtfully. You can actually be more profitable without taking risk - sometimes there really is a free lunch.

Who: Pali Adventures Summer Camp; Pali Institute

What: Occupying a mountain west of Los Angeles, the platonic ideal of a summer camp. Also an institute and massive outdoor educational facility.

The Sparkle: Pali’s real estate, infrastructure and programming go well beyond what you imagine. Paintball and ATV dirt courses get you started, but programs in street art, Hollywood stunts, aviation, and a trapeze program modeled on Cirque du Soleil are a step beyond. The insurance must be brutal. And Pali isn’t just summer camp, it hosts school-year partnerships with educational institutions focused on science and outdoor learning.

Ever wonder how astronauts get fresh water? On the International Space Station, there’s no faucet marked “fresh.” Water is water—sweat, breath vapor, even urine—all captured and recycled into drinkable supply. The closed-loop system recovers about 93% of all water that enters it.

The ISS system isn’t just efficient—it’s a feat of engineering. In an environment where nothing is disposable, everything is accounted for, and design must plan for permanence because resupply is rocket-launched.

It’s not hard to imagine terrestrial analogues: off-grid communities, desert cities, island economies, etc.

Link: https://theconversation.com/water-recycling-is-paramount-for-space-stations-and-long-duration-missions-an-environmental-engineer-explains-how-the-iss-does-it-260171

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