The Leverage Paradox

Data shows that over the long term, real estate benefits from a rising market more often than it suffers in a falling one. Yet extreme dislocations, often triggered by external shocks, can occur as unexpectedly as a fire or a flood, driving down the long-term performance of institutional real estate portfolios. Owing to its illiquidity, property can be especially vulnerable to periods of severe market dislocation, leading some pension funds and insurance companies to question the asset class’s place in their permanent allocations.

Defensively minded investors have traditionally responded to this challenge by concentrating their portfolios on core assets (i.e. high-quality, well-located properties) held without leverage. The logic is straightforward: by owning the best assets and avoiding debt, investors reduce the risk of permanent capital loss and eliminate the possibility that leverage will amplify losses in percentage terms.

As intuitive as this approach may seem, the drawback is that performance of such strategies has repeatedly disappointed. Historically, according to the MSCI UK Annual Property Index, core un-levered assets despite their apparent conservatism, have proven far more vulnerable to market downturns than their role in investment portfolios implies¹. They avoid the amplification of leverage, but they do absorb the full force of every valuation decline.

While this performance vulnerability is widely accepted as the cost of preserving upside potential, we believe the industry has, over time, turned a habit into a principle, thus painting all leverage with the same brush. Instead, we view leverage as a tool. A blunt tool can be dangerous but as a sharp tool used with skill, within a coherent portfolio capital structure, and combined with genuinely defensive reinvestment of the proceeds, leverage can provide real downside protection in certain scenarios where protection is most needed.