Real estate plays an important role in investment portfolios. The risk-adjusted return properties of real estate related securities and their low correlation with equities and fixed income make real estate attractive as an alternative asset class. Real estate investment trusts (REITs) have long existed in the U.S., Australia and the Netherlands. With the rise of global connectivity, other countries have adopted REIT-type structures and the market for REITs and listed real estate equities have become global in nature. The free-float market capitalization of global REITs and listed real estate operating companies (REOCs) grew from $280 billion in 2001 to just under $700 billion in 2005.

Non-U.S. real estate securities exhibit characteristics sufficiently different from their U.S. counterparts and, therefore, should be considered as a separate asset class. In this article, we'll show you how global real estate holds the potential to occupy a unique role in a diversified investment portfolio. (Learn the basics to real estate investments in Investing In Real Estate and Exploring Real Estate Investments.)

The Real Estate Securities Market
Most people think of real estate in its most tangible form - direct investment in residential and commercial properties. However, in the context of portfolio management we are primarily concerned with securitized real estate structures - pooled vehicles that offer indirect investment interests in diversified holdings of commercial real estate properties. The two primary forms of such structures are REITs and REOCs.

An REOC is simply a listed, publicly traded company with its primary business is real estate investment and development. REITs are structures that qualify for special tax treatment in return for meeting certain conditions, such as paying out at least 90% of their taxable income annually in the form of dividends, investing at least 75% of total assets in qualifying real estate assets and earning at least 75% of gross income from rents or mortgage interest from real properties.

The chart below shows the annualized risk-return properties of REITs compared to other asset classes over 28 years from 1979-2007.

Source: Zephyr & Associates LLC StyleAdvisor

Over the long term, REITs tend to exhibit similar return properties to common equities with somewhat lower risk. This lower risk may be due, in part, to the tax-qualifying conditions imposed on REITs, such as higher payout ratios and limits on borrowing. REITs also exhibit very low correlation to both equities and fixed income.

Over this same time period of between 1979 and 2007, the cash-adjusted r-squared between the NAREIT All REITs Index and the S&P 500 was 0.25, and the r-squared between the NAREIT All REITs Index and the Lehman U.S. Aggregate Bond Index was 0.08.

The r-squared of 1 indicates perfect positive correlation; -1 represents perfect negative correlation. Their typically low correlation with the overall market makes REITs attractive as an alternative asset class in diversified investment portfolios. (To learn more about diversification, see Introduction To Diversification, The Importance Of Diversification and The Dangers Of Over-Diversification.)

Going Global
International equities are well established as a separate asset class for modern investment portfolios. However, the traditional benefit of low correlation between international and U.S. equities has waned over time with globalization. Most of the world's largest companies - the ones whose weightings are most influential in market cap-weighted stock indexes - are global leaders that derive revenues from all over the world, making U.S. and non-U.S. companies increasingly indistinguishable.

The same cannot be said of companies whose primary business is real estate. Real estate is a highly localized business. Even within a single country, the characteristics of property markets in different locales can be very dissimilar. Those dissimilarities are greater still when different countries are involved. Moreover, successful commercial real estate investing involves more than just the development and lease or rental of space to stable tenants; it also involves mastery of what can often be a cumbersome legal and regulatory process in different municipal jurisdictions. Thus, it is harder for a real estate company to, say, export its successful operating template from the U.S. to Germany, for example, where local laws and regulations are different and access to key decision makers can be difficult for non-locals.

This localization adds a further diversification benefit to portfolios, evidenced by performance data for global real estate securities. During a two-year time period from January 2005 to December 2006, the Dow Wilshire Global ex-U.S. REITs Index exhibited an r-squared of 0.24 with the S&P 500, 0.34 with the MSCI EAFE Index of developed international stocks, 0.12 with the Lehman U.S. Aggregate Index and 0.16 with the NAREIT All-REITs Index. (To learn more about r-squared, read Understanding Volatility Measurements.)

In other words, global REITs were even less correlated with U.S. REITs than they were with U.S. stocks. As the chart below shows, for this period global REITs also looked attractive from a risk-return standpoint:

Source: Zephyr & Associates LLC StyleAdvisor

What's German for REIT?
One of the considerations for investing in global real estate is the spread of REIT-type structures around the world. REITs have existed in the U.S. since 1960. Other early adopters of tax-advantaged pooled real estate structures were the Netherlands in 1969 and Australia and New Zealand in 1971. As of June 2007, there were 18 countries on four continents with REIT structures and another (Germany) with legislation pending according to the Deutsche Bank/RREEF Research article "Global Real Estate Securities" (January 2007).

There is ongoing debate over the extent to which the adoption of an REIT-type structure improves the risk-return profile of real estate securities in any given country, but there appears to be evidence that the REIT-qualifying conditions of payout ratios, debt limits, investment mix and other requirements do have the potential to make REITs relatively risk-efficient.

Approaches and Considerations for Investors
There are several alternative approaches through which you can gain exposure to global real estate securities. A growing number of mutual fund families and exchange-traded fund (ETF) sponsors offer funds dedicated to global real estate. For those with the stomach to test their own security selection abilities, there are a number of large international property development companies whose American Depositary Shares (ADSs) trade on U.S. securities exchanges.

Investors looking to take the latter route should bear in mind that the localized nature of real estate implies a potentially higher level of country risk for investors taking real estate exposure as opposed to common equity exposure in the same country. Other risks associated with global real estate securities are similar to those for international equities generally including exchange rate risk, country-specific economic and geopolitical factors and quality of management.

REITs involve additional considerations. Because REITs pay out the majority of their net income in the form of annual dividends, they can be attractive for income-oriented portfolios. According to a 2006 white paper by Ibbotson Associates, about 60% of the total return from an investment in equity REITs over the previous 20 years came from dividend payouts. On the other hand, because REITs also have limits on the percentage of the business mix derived from development, there may be less opportunity for higher growth-associated returns than for REOCs that do not have such restrictions.

Conclusions
Based on the portfolio management trinity of return, risk and correlation characteristics, global real estate appears to qualify as a distinct asset class by offering attractive risk-return positioning with a relatively low correlation to other U.S. and non-U.S. asset classes, including U.S. real estate. The adoption of REIT-type structures by a growing number of countries around the world will likely help this asset class to grow in volume and popularity over time.

by Katrina Lamb (Contact Author | Biography)

Katrina Lamb is an investment analyst based in Washington, DC, where she researches and advises on portfolio strategies employing a wide range of asset classes and means of investment exposure. Katrina has spent more than 15 years in the investment profession including a great deal time of living and working overseas in markets such as Japan, Southeast Asia, Central and Eastern Europe and the former Soviet Union. She is fluent in several languages including Russian and Japanese.