THE CASE FOR REAL ESTATE

Diversification into commercial real estate has been shown to enhance overall investment returns. Successful investment strategies are often geared toward achieving what finance experts refer to as the “efficient frontier”, the highest possible return for a given level of risk and associated volatility. Portfolio diversification, through the addition of directly owned commercial real estate, has been shown to lower portfolio volatility at all return levels. Real estate has emerged as one of the most attractive options for asset diversification and reallocation.

TYPICAL INSTITUTIONAL ALLOCATIONS

It is not surprising that most institutional investors have added real estate to their asset allocation models. Many institutional portfolio models incorporate real estate as a core asset class comprising approximately 5.0% to 10.0% of a typical investment portfolio. CALPERS (the California Public Employees Retirement System), the largest public pension fund in the U.S. with assets in excess of $240 billion and a bellwether of asset allocation and investment strategy, currently allocates approximately 10.0% of its investment portfolio to the real estate sector.

MITIGATE THE DAMAGING EFFECTS OF INFLATION

The inclusion of direct real estate ownership into a diversified portfolio of investments has the further benefit of reducing a portfolio’s vulnerability to the wealth eroding effects of inflation. Given its positive correlation with changes in consumer prices, private real estate investment can provide a partial hedge against inflation. As consumer prices rise, so do real estate cash flows and, typically, associated property values. Moreover, many commercial lease contracts are inflation-indexed, providing property owners with an additional layer of inflation protection.

DEFENSE AGAINST RECESSION

While equity and fixed income markets typically move in tandem with economic cycles, income from real estate assets often benefits from multi-year leasing contracts. As a result, properties can generate steady and predictable revenue streams apart from the relative growth of the general economy. Experienced real estate investors assess the creditworthiness and predictability of a property’s income stream and adjust their pricing, return requirements, capital structure, and underwriting criteria accordingly.

MARKET INEFFICIENCIES CREATE OPPORTUNITIES

Because equity and debt markets are priced globally by millions of investors each minute of the day, they are widely considered to be efficient. Therefore, prices already reflect all known information and reflect the collective beliefs of all investors about future prospects. In contrast, real estate markets are considered to be inefficient which yields an abundance of value enhancement opportunities for private investors with the information, discipline, and expertise to identify and capitalize on them.

DIRECT REAL ESTATE INVESTMENT VS. REITS

Publicly traded REIT shares fail to accomplish the goal of maximizing return and reducing risk through portfolio diversification into the real estate sector. The performance of publicly traded real estate instruments is closely correlated to that of other equities and thus does not markedly improve the risk-adjusted return of an otherwise equity focused portfolio. Since the late 1970s, the performance of REIT shares has closely tracked overall equity market performance. During the same period, the comparable equity market correlation for private real estate has been close to zero. This low correlation further reflects the counter-cyclicality of real estate and its demonstrated potential for performing well when equity markets are in decline. Furthermore, REITs are required to distribute 90% of their operating profits in the form of current income, a requirement which may compromise longer term operating strategies. Direct investment in real estate allows private investors to achieve both diversification and tax efficiency.