Download Real estate has a place in a well-diversified investment

Real Estate Equity Inve
Real estate has a place in a well-diversified investment portfolio.
Along with many advantages, real estate investment vehicles and
strategies also carry risks that can be minimized.
C
ommercial real estate equity is a significant asset
class for institutional investors seeking to maximize risk-adjusted returns through well-diversified
portfolios. It is also a major source of job and
wealth creation in the U.S. economy.
At the end of 2011, U.S. defined benefit funds had an
average allocation of 6.5% to real estate equity.1 Real estate equity assets managed for U.S. tax-exempt investors
(including endowments and foundations) as of the end of
2011 totaled $293.4 billion, a 7.3% increase over the prior
year.2
With respect to its impact on the U.S. economy, according to the U.S. Bureau of Labor Statistics (BLS), real estate
and construction activity accounted for approximately $2.3
trillion of economic activity or 15% of economic activity in
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2010. BLS further reported that 6.9 million Americans worked in real estate or construction in 2010.3
Given the range of investment vehicles and strategies
available, real estate has become an accepted and meaningful asset class for institutional investors. Public, multiemployer and corporate pension funds have become
significant owners of office towers, apartment complexes,
industrial parks and hotels across the nation. The cachet
of owning marquis properties is not, however, the appeal.
Based on their potential for appreciation and income, low
volatility relative to stocks and diversification benefits, real estate investments provide the opportunity to improve expected
risk-adjusted returns. Potential benefits of owning real estate
through commingled funds, limited partnerships, direct investments or real estate investment trusts (REITs) include:
sting for Benefit Funds
by | Julian M. Regan
• Projected cash yields from rental and lease payments
that may significantly exceed yields on traditional investments, especially in a low-interest-rate environment
• Total expected returns from two sources: potential
price appreciation and cash yields
• Lower projected volatility than equities when investing
through private vehicles
• A potential strategy for protecting assets from the impacts of high and rising inflation
• The potential collateral benefit of contributing to economic growth and jobs.
Like every asset class, real estate investments expose investors to risks. These include:
• Market risks that may be exacerbated by real estate’s
sensitivity to economic conditions
• Lower liquidity, especially for closed-end, limited partnership and direct investments
• Operational and credit risks that are higher than those
of traditional investments.
Real estate investors have the ability to minimize these risks
through an oversight framework that includes documentation
of managers’ responsibilities and reporting requirements, due
diligence processes to assess managers’ guidelines relative to
board risk tolerances, and reporting that provides transparency into diversification, leverage, occupancy rates and sources
of returns.
Definitions: Distinguishing Between
Real Estate Equity and Debt
Real estate investing can take two broad forms—equity
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investments
FIGURE 1
Real Estate Compared to S&P and Ten-Year Treasury Note
10%
8%
5.42%
6%
4%
2%
0%
2.20%
S&P
1.76%
Ten-Year Note
Real Estate
Source: Bloomberg, NCREIF, data as of December 31, 2012.
S&P is S&P 500 12-month trailing dividend yield; Ten-Year Note is ten-year U.S. Treasury yield to
maturity; Real Estate is NCREIF ODCE one-year income return.
investing and debt investing. In the
case of real estate equity, the investor typically pools its interests with
other like investors to acquire, develop
and operate portfolios of office, retail,
apartment, industrial and hotel properties. Returns are generated from operating income from rents and price
appreciation. In the case of real estate
debt, there are two primary methods of
investment: direct lending to other entities that are acquiring or developing
real estate (originating loans) and investing in debt securities backed by real
estate assets. While this article will focus on real estate equity investing, real
estate debt also provides benefit funds
with opportunities to further diversify
their portfolios.
Real Estate’s Place Within a
Diversified Asset Allocation
Structure
With the possible exception of daily
traded real estate investment trusts
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benefits magazine may 2013
(REITS), real estate investments are considered to be alternative investments.
Like many other alternatives, real estate
offers attractive correlation, diversification and risk/return benefits. Private core
real estate, for example, offers annualized
expected returns that are higher than
bonds, but lower than stocks. Moreover,
returns from real estate are expected to
be less volatile than equities, although
they generally have lower liquidity, less
frequent valuations and, in some cases,
more complex legal structures.
Potential Benefits of
Real Estate Investing
Real estate equity investing offers a
number of benefits to institutional investors. These include the potential for
cash yields that exceed those of fixed
income investments, a total return that
benefits from two underlying drivers,
lower projected volatility than equities,
diversification and a potential hedge
against inflation.
Cash Yields
British philosopher John Stuart Mill
once stated that “landlords grow rich in
their sleep.” Benefit fund investors can
in effect grow rich in their sleep by acting as landlords who accumulate wealth
from rents paid by occupants of office
buildings, apartment complexes, malls
and industrial parks. As of December
2012, the National Conference of Real
Estate Investment Fiduciaries OpenEnd Diversified Core Equity Index
(NCREIF ODCE) offered a yield of
5.4%, more than triple the yield on a tenyear U.S. Treasury note (see Figure 1).4
Total Return
The fact that real estate portfolios
have two sources of return, appreciation and income, provides the benefit
of smoothing out the return, particularly when appreciation is negative.
This is especially the case in more conservative core portfolios that invest in
fully developed properties. Real estate, like many asset classes, incurred
substantial losses during and after
the financial system crisis of 20082009. Notwithstanding this period
of volatility, the NCREIF ODCE and
NCREIF National Property Indexes
(NPI) generated annualized returns
of 6.7% and 8.4%, respectively, for the
ten years that ended December 2012.
(See Figure 2.)
Modest Volatility (Relative to Stocks)
In the aftermath of the financial system crisis, investors gained a greater
appreciation for the damaging impacts
of equity risk. Not surprisingly, they are
working as hard as ever to find asset
classes with smoother return streams.
Private real estate investments offered
in commingled fund and limited part-
investments
FIGURE 2
NCREIF ODCE Quarterly Returns
Income
Appreciation
Rate of Return
10%
5%
0%
-5%
-10%
4Q12
1Q12
2Q11
3Q10
4Q09
1Q09
2Q08
3Q07
4Q06
1Q06
2Q05
3Q04
4Q03
-20%
1Q03
-15%
Note: The National Council of Real Estate Investment Fiduciaries Open-End Diversified Core Equity Index (NCREIF ODCE) is an index of private real estate
investments that measures the aggregate results from core open-ended real estate funds. Data as of December 31, 2012.
nership structures offer the potential for a less volatile return
stream. This is evidenced by the fact that the annualized
volatility of the NCREIF ODCE Index (commingled openend fund index) for the 20 years that ended December 31,
2012 was 7.0%, a fraction of the volatility of the Standard
and Poor’s Index of large-cap stocks (the S&P 500) during
the same period, 18.1%.5
(in nominal terms) during inflation. Returns may be further
increased if landlords are able to increase rents at a rate that
exceeds increases in operating costs. There is no guarantee that
this will be the case in every inflationary environment, especially if the economy stalls, but real estate has had a positive
correlation to inflation, which means that it rises along with
increases in the inflation rate.
Diversification Benefits
Economic Impacts
In their quest for risk-adjusted returns, investors are seeking investments that have a tendency not to move in tandem
with equities. By most accounts, the majority of pension
funds have 40‒60% allocated to stocks, the riskiest asset class.
Any time a pension fund with high equity risk introduces a
less volatile asset class that has low correlations to equities, it
will improve diversification. Real estate historically has had
a low correlation to equities, as evidenced by the fact that its
returns do not move in tandem with stocks. This will improve portfolio diversification, all things being equal.
Although it is not an investment consideration, a discussion of real estate investing would not be complete without
acknowledging the potential economic impacts. Real estate
investments that involve development in particular may
increase revenues for union contractors, provide jobs for
unionized building trades and lead to increased contributions into multiemployer benefit funds.
Inflation Protection
Although no two inflationary environments are the same,
real estate generally provides investors with a better potential
hedge against losses during periods of high and rising inflation
than do stocks and bonds. The prices of real assets generally rise
Risks of Real Estate Investing
Real estate investments expose investors to market, liquidity, operational and credit risks that must be understood
in order for investors to formulate a plan for effective management.
Market Risk
Returns from real estate investments are strongly cormay 2013 benefits magazine
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takeaways >>
• U.S. defined benefit funds had an average allocation of 6.5% to real estate equity at the
end of 2011.
• Real estate investments have the potential for appreciation and income, low volatility
relative to stocks, and diversification benefits.
• Real estate portfolios have returns from both appreciation and income, providing the
benefit of smoothing out the return, particularly when appreciation is negative.
• Real estate historically has had a low correlation to equities, which may improve portfolio diversification.
• Real estate investments expose investors to market, liquidity, operational and credit
risks.
• When they involve development, these investments may increase revenues for union
contractors, provide jobs for unionized building trades and lead to increased contributions into multiemployer benefit funds.
related to economic conditions. The
great recession of 2008-2009 was an
exceptional period, but also instructive. Beginning in July 2008, the
NCREIF ODCE Index incurred six
straight quarters of negative returns as
write-downs due to excess supply and
sagging demand overwhelmed property income. This period also served
to illustrate commercial real estate’s
tendency to act as a lagging economic
indicator.
Core real estate managers are expected to minimize the probability
and severity of losses due to market
risks by diversifying assets across
multiple properties (sometimes hundreds), property types, regions and
tenants and by limiting the use of leverage.
Liquidity Risk
Liquidity risk is the risk of loss
when an investor does not receive its
money when expected. The fact that
this risk is higher for private real estate equity investments than for traditional investments should come as
no surprise. After all, it is impractical
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benefits magazine may 2013
to sell an apartment complex, office
building or hotel on short notice on
favorable terms to raise money to pay
benefits. While exchange-listed REITs
offer daily liquidity, more common institutional vehicles typically offer quarterly liquidity or they lock up investors’
money during multiple-year investing
periods prior to making distributions
in later years.
Commingled fund managers are
tasked with managing liquidity risk by
keeping enough cash on hand to pay
anticipated redemptions. As real estate investors experienced in 2009 and
2010, many commingled fund managers could not meet redemption requests
after the financial crisis, which led to
redemption queues.
Ironically, the environment for real
estate has now improved to the point
where some high-quality managers
have investment queues.
Operational Risk
Operational risk is higher for many
real estate investments than it is for
traditional asset classes due to a lower
frequency of valuations, more complex
legal structures and the number of parties involved in commercial real estate
transactions. Specific operational risks
for real estate include potential reporting inaccuracies and potential contractual and litigation issues.
Managers are tasked with managing these risks by, among other things,
conducting best-practice independent appraisals of properties, agreeing to act as ERISA fiduciaries and/or
as a qualified professional asset manager (QPAM) where appropriate, and
selecting high-quality service providers to administer and audit their portfolios.
Credit Risk
Commercial real estate investors are
exposed to credit risk to a greater or
lesser degree based on tenants’ collective ability to pay rents. If the economy
goes south, the ability of commercial
real estate tenants to pay rents puts the
cash yield of real estate investments at
risk.
Investment managers are tasked
with reducing the likelihood and severity of credit risk losses by making sure
their properties are occupied by companies with high credit ratings and tenants whose incomes are derived from
diverse sectors of the economy.
Investment Vehicles,
Strategies and Property Types
Institutional investors have the
ability to access real estate investment
opportunities through an array of vehicles, strategies and property types.
Determining the best route for an individual benefit fund will depend on
trustees’ risk tolerance and the size of
their portfolios. For larger funds, diversifying a real estate portfolio across
investments
FIGURE 3
Private Real Estate Equity Strategies
Opportunistic
Includes major redevelopment, development, emerging
sectors, distressed sellers, etc.
Lower
ReturnHigher
Value Added
Properties needing to be leased and typically require significant
repositioning, substantial redevelopment and/or development
Core Plus
Not quite fully leased properties that typically require repositioning
and/or moderate redevelopment. Can also be a core portfolio
containing some value-added properties.
Core
Fully leased, multitenant properties that generate cash flow,
allow for stable price appreciation and protect against inflation
Lower
Higher
Risk
multiple vehicles, strategies and property types will make
sense, while smaller funds may have fewer options and be
limited to a single vehicle or strategy that typically falls into
the core or lower risk category.
Institutional vehicles include REITs, open- and closedend commingled funds, limited partnerships and individual
properties. All of them have trade-offs. REITS offer daily liquidity but are also the most volatile, since their pricing is
subject to investor sentiment. Open-end commingled funds
have an infinite life, offer quarterly liquidity and are a common vehicle for similar investors to pool their interests in
lower risk core strategies. Closed-end commingled funds
have a finite life and may not make distributions until later
years when properties are sold. The same is true of limited
partnerships that typically invest clients’ assets over a multiple-year investing period before making distributions halfway through a ten-year life. Any of the established real estate
investment vehicles may be viable, provided that they are
managed by capable, responsive firms that understand their
fiduciary duty to the fund and its members.
Private real estate equity strategies include core (the
most common), core plus, value-added and opportunistic approaches. Core diversified funds have lower risk due
to their limited use of leverage and broad diversification
across multiple property types, geographic regions and income-generating assets (most properties in core portfolios
are fully leased and generating income). Further out on the
risk-and-return continuum, core plus, value-added and opportunistic funds have lower occupancy rates, utilize more
leverage and include properties in the development and/or
predevelopment stage. Because of their higher risk, these
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From the Bookstore
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39
investments
FIGURE 4
Diversification of NCREIF ODCE Index
U.S. Geographical Location
Property Type
Retail
17.3%
Apartment
24.0%
Other
2.6%
West
37.7%
East
34.3%
Hotel
2.5%
Industrial
15.2%
Office
38.3%
Midwest
9.6%
South
18.4%
Source: NCREIF ODCE, data as of September 30, 2012.
strategies are expected to generate
returns that exceed those of equities.
Figure 3 provides an illustration.
While all property types (office,
multifamily, industrial, retail, etc.)
exhibit sensitivity to broad economic
factors, each type is more heavily influenced by differing factors. For example, office space is heavily influenced by unemployment, while retail
properties are affected more by consumer spending and consumer confidence. Industrial property values may
be significantly influenced by the level
of business investment as well as by in-
ventory levels. Apartment complexes
have recently delivered some of the
best returns in the industry. Their returns have been driven in part by a key
demographic trend: declining homeownership in the wake of the financial
system crisis. Figure 4 shows the property type and geographic diversification of the NCREIF ODCE Index as of
September 30, 2012.
Real Estate Investing
and Risk Oversight
Institutional investors have a number of tools at their disposal to assess
TABLE
Key Performance and Risk Measures
Key Measures
Definition/Explanation
DiversificationDiversification across properties, markets, property types,
strategies and tenants
Occupancy
Percentage of property that is leased and generating income
Net-of-fee returnsNet-of-fee returns relative to benchmarks (e.g., NCREIF
ODCE); a measure of the value of active management
Capitalization rate (cap rate) Property’s net operating income divided by its purchase price
Life cycleDescribes stages of property development—predevelopment, development, leasing, operating and redevelopment
Loan-to-value ratio
40
The percentage of a property’s value that is mortgaged
benefits magazine may 2013
whether a future or current real estate
investment is within their risk tolerance. These include:
• Audits of a fund’s internal controls and financial statements
along with independent appraisals of property values
• Development of an investment
policy that documents acceptable
investment strategies and vehicles as well as investment manager reporting and compliance
requirements
• Investment guidelines that set
forth the manager’s thresholds
for diversification across properties and regions, credit quality
and occupancy
• Documentation of risk controls,
valuation processes, return objectives and, where applicable,
the manager’s role as an ERISA
fiduciary in legal agreements.
Additional tools for risk oversight
include ongoing monitoring that is
assisted by comprehensive reporting
from the investment consultant and
managers. Reports should inform fund
fiduciaries of the portfolio’s current
state relative to key measures including
capitalization rates, property life cycles,
leverage, diversification, occupancy
rates and, of course, net-of-fee returns.
(See the table.)
Conclusion
Real estate equity investing provides institutional investors with the
opportunity to add an uncorrelated
source of risk-adjusted returns to a
diversified portfolio with lower volatility and low correlations to equities.
It also provides the potential for protection from inflation and potential
economic benefits. Notwithstanding
the benefits, there are trade-offs associated with real estate
investing. These include market risk, liquidity, operational
and credit risks that can be exacerbated in a contracting
economy. Real estate investors, however, have the ability to
position themselves for long-term success by minimizing
these risks through a risk oversight approach that includes
audits and assessments, effective investment policy guidelines, contractual provisions and actionable reporting on
key performance and risk measures. Endnotes
1. U.S. Bureau of Economic Analysis; U.S. Bureau of Labor Statistics.
2.
Pensions & Investments, October 15, 2012.
3. U.S. Bureau of Labor Statistics.
4. Bloomberg, NCREIF, data as of December 31, 2012. S&P is S&P 500
12-month trailing dividend yield, Ten-Year Note is Ten-Year U.S. Treasury
yield to maturity, real estate is NCREIF ODCE preliminary one-year income
return.
5. Source: Morningstar, NCREIF. Annualized standard deviation derived from quarterly return data from 1Q 1993 to 4Q 2012.
<< bio
investments
Julian M. Regan is vice president
and senior consultant for the Marco
Consulting Group (MCG). He has
over 23 years of experience advising
executives and trustees of multiemployer and public benefit funds. Regan previously
served as chief executive for an $8 billion retirement board as well as in a series of senior management and regulatory roles. He is a member of
MCG’s Fiduciary Services Committee and is a
frequent author and speaker for leading labormanagement and public benefit plan organizations. Regan, a former member of HERE Local 26
and past appointee to the IRS Tax-Exempt and
Government Entities Committee, received M.B.A.
and B.S.B.A. degrees from Suffolk University.
may 2013 benefits magazine
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