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By Karl Mergenthaler, CFA and Eva Wei Real estate has been the subject of considerable debate and analysis among institutional investors. As an asset class, real estate is large and complex. As of September 2010, the European Public Real Estate Association valued the global real estate market at an estimated $21.15 trillion for underlying properties, with $6.15 trillion in the U.S.1 Real estate may provide advantages to institutional portfolios by acting as a hedge against inflation and offering diversification benefits. In participating in real estate, investors must grapple with a multitude of economic and financial issues. Historically, investment in real estate by pension funds has been in the form of either private equity real estate funds or direct ownership of physical brick and mortar properties. Other available options include real estate funds of funds, which are usually comprised of around 20-30 unlisted funds, or investment in shares in listed real estate companies, such as Real Estate Investment Trusts (REITs). Overall, typical pension funds generally allocate 0% to 15% of the portfolio to real estate. Institutional Investors Based on our proprietary analysis, public and corporate pension funds have an average allocation of approximately 4% to real estate, with individually weighted averages of 1.3% to public real estate and 3.1% to private real estate. Exhibit 1 depicts the allocation of 335 U.S. pension funds in the Preqin data universe. The chart indicates that the majority of investors allocate less than 10% to real estate, with approximately 85% of funds allocating that amount or less for U.S. funds. This percentage decreases to around 74% on a global basis. Exhibit 1 — U.S. Pension Fund Allocation to Real Estate
Public Real Estate Investors interested in public real estate investment may consider REITs, which offer benefits such as greater transparency and liquidity. Most public REITs are priced daily and listed on regulated exchanges, providing investors with a more standardized measure of asset value. REITs are able to invest in a spectrum of assets ranging from mortgages and debt instruments to hotels and equity in real estate companies. Income is usually derived from rents from leasers or from interest payments from refinancing. Public real estate as an asset class has its share of drawbacks. REIT investments tend to experience higher volatility than private real estate investments. Consequently, it is easier for investors to be affected by euphoria and panic in the broader stock market. As a result, asset pricing can more easily diverge from underlying property value, and downturns in the public real estate realm tend to happen more quickly.3 Table 1 — The Pros and Cons of Investing in REITs
Exhibit 2 — Performance in Different Rate Environments Source: reit.com
Private real estate funds usually have direct ownership of assets, providing the potential for active improvements and more control over the properties. As well, private funds tend to be less correlated with the broader equity markets. This may be tied to the fact that physical properties are more illiquid and time consuming, so valuations of such assets are less reactive to short term trends or news. Similar to the private equity J-curve, the private real estate J-curve also exists, where investor contributions tend to exceed fund distributions for the first several years in the life of a fund. Private real estate funds also have their portion of shortcomings; investors are hesitant to invest because of liquidity and fee concerns. Physical properties are rather illiquid, potentially taking months to sell. As a result, investments are usually locked for long periods of time, and thus downturns can be more prolonged.5 In addition, investors also face a significant investment hurdle, since initial investment requirements are usually above $1 million. After investment, investors also incur high performance and maintenance fees, ranging up to 12-15%. Table 2 — The Pros and Cons of Investing in Private Real Estate Funds
Exhibit 3 — Historical Private Real Estate Fundraising Source: Preqin
Investors view real estate as an asset class that could protect against inflation, where owners will pay back properties with fixed debt payments using cheaper dollars. Average real estate prices exhibit an upward drift in the long term and, in recent decades, have risen faster than the rate of inflation. Real estate positively correlates with inflation and potentially serves as an inflation hedge in preserving the real rate of return. This view has been weakened in recent years due to high vacancy rates and too much supply. Real estate may better serve as an inflation hedge when supply and demand are back in line and new construction picks back up. In recent times, correlations among all asset classes have embarked on an upward trend. Fund managers who turn to real estate for diversification purposes should note that real estate is no exception. Exhibit 4 depicts the rolling one year correlations among public real estate and other asset classes and relevant macroeconomic data. There is a noticeable tightening range and upward drift. Exhibit 4 — Public Real Estate Correlations with Broader Market
Active management in real estate can run the spectrum from repositioning properties to extensive redevelopment. Real estate is a very local market, so a significant amount of information asymmetry results. Returns in real estate are primarily driven by local and regional economic and real estate conditions. As a result of this informational inefficiency, managers need greater levels of specialized local market expertise. A number of active real estate funds advertise specialist managers with market-specific expertise. These managers proclaim their ability to identify and invest in real estate that is underappreciated. They claim to target companies with higher than average growth rates and strong balance sheets that can be purchased at reasonable prices. Countless real estate managers aim to diversify across sectors, geographic locations and tenant exposure in order to protect capital. They combine top-down regional allocation and bottom-up property selection in the formation of their portfolios of assets. This necessitates that managers thoroughly research and analyze macroeconomic and local conditions. Many managers also advertise hands-on due diligence, including site visits to examine hard assets in person and meetings with property managements. Because of the local nature of much of real estate investing, investing in private real estate funds is somewhat analogous to betting on the fund managers’ ability to allocate capital to suitable investments. As a result, it is very important for managers to have accurate valuations, which can fluctuate depending on input variables and proprietary formulas. Investors can add significant value to their portfolios by selecting top-tier managers. Based on our analysis, there exists a large disparity of returns between the top and the next quartile managers. The large disparity in performance may highlight the importance of manager selection in this asset class. Exhibit 5 — Internal Rates of Return for Private Real Estate Managers
U.S. residential real estate benchmarks include: the daily Radar Logic Residential Property Index (RPX) and the monthly S&P/Case-Shiller Home Price Indices (SPCS). Benchmarks for commercial properties include: the quarterly market cap-weighted National Council of Real Estate Investment Fiduciaries (NCREIF) Property Index (NPNCRE), the daily Financial Times and the London Stock Exchange/the National Association of Real Estate Investment Trusts (FTSE NAREIT). Because real estate properties are not completely interchangeable, investors should note that indices are fundamentally unable to represent the real estate market as a whole. Risks and Current Issues Investors should be familiar with risk factors that exist across real estate as an asset class, regardless of whether public or private. Liquidity issues affect the inability of investors to withdraw funds quickly, for redemptions can often depend on the completion of asset sales. There is no sole industry-wide standard that valuations must adhere to, so investors may run into cases of differing valuations of the same underlying investments. In addition, investors should continue to be guarded about obsolete and fringe assets. Even in periods of recovery, such assets still retain considerable risk. Broader macroeconomic factors will also impact real estate performance, both domestically and abroad. Global unrest continues to unsettle international markets. The U.S. economy continues to face a subdued outlook, as citizens face high debt and unemployment levels and an ever competitive global marketplace. The thoughts of double-dip recessions continue to linger in the minds of some investors. Continued unemployment and stagnant wages will affect peoples’ ability to invest in real estate. As a result of the unease, a flight to quality has guided investors to better situated real estate markets encompassing metropolitan areas, potentially leaving some interior markets struggling. Conclusion After struggling through the global economic downturn, real estate has re-emerged as an attractive investment class to both help diversify portfolios and hedge against inflation risk. However, investors should keep in mind the risks of both liquidity and transparency that this alternative asset class carries. We believe both public and private real estate investment offer their share of pros and cons. Due to the different characteristics in risk and return, it may be appropriate for investors to invest with both types. For private real estate, investors should seek out managers that have demonstrated continued aptitude in investing in undervalued assets and have the ability to turn such properties around.
1 Philip Charls, “The Global Listed Real Estate Market,” September 2010 2 Joseph Dobrian, “REITs Offer a Remedy for Pension Fund Crisis,” Wall Street Journal, November 15, 2010 3 Philip Charls, “The Global Listed Real Estate Market,” September 2010 4 JPMAM, “The Best of Both Worlds: Why the strategic case for REITs endures,” Insights, September 2009 5 Philip Charls, “The Global Listed Real Estate Market,” September 2010 6 Preqin, “What Now for Private Equity Real Estate?,” November 2010 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||
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