Historically used as a more tactical investment or for providing portfolio alpha, real estate has been used as part of a long-term core strategy due to increased market efficiency and increasing concerns about the future long-term variability of stock and bond returns. In fact, real estate is known for its ability to serve as a portfolio diversifier and inflation hedge.

If investors plan to make permanent real estate allocations in their investment portfolios, what return expectations should they have and what risks will they inevitably encounter? An investor considering the use of real estate as part of a long-term investment strategy should understand how to form return expectations and evaluate these investments in relation to more conventional investment options. We'll show you how it's done.

Historical Benefits and Risks
The following are four basic divisions in the possible collection of real estate investments:

  • Private equity
  • Private debt
  • Public equity
  • Public debt

These sectors take the form of direct real estate investments, real estate investment trusts (REITs) and public and private fixed income investments collateralized by equity real estate.

Historically, investor interest in real estate has been for diversification and its ability to maintain the purchasing power of capital. The National Council of Real Estate Investment Fiduciaries (NCREIF) states that market indexes for the real estate industry have continually shown low correlation with the returns of both stock and bond investments. This suggests that real estate investments can increase portfolio diversification. The continual introduction of new real estate products and global opportunities provides for additional diversification possibilities and risk mitigation potential, by providing investors with greater flexibility to customize the real estate portion of their asset allocation.

Hedging Inflation
The inflation hedging capacity of a real estate investment comes from the owner's ability to increase rental rates during periods of inflation. Unlike manufacturing concerns and service providers, real estate owners do not have to contend with demand elasticity in order to increase prices, but they do have to compete with rival properties in the marketplace; in theory, this should also raise rates in inflationary periods. Real estate tends to maintain the purchasing power of capital by passing on all or a portion of the inflationary pressure onto tenants. However, the ability of real estate to act as an inflationary hedge can only be accomplished as the opportunities for new leasing become available.

Risk Reduction
Real estate also has the unique ability to reduce risk in the way properties are leased. Portfolios that have followed a cash flow strategy and decided to lock in rates in long-term leases have less risk exposure to market movements, but they also have less inflation-hedging ability. Certain properties that are well-occupied and contain long-term leases will have very stable income streams and perform like annuity or low risk bond investments.

Although real estate debt instruments are heavily influenced by the movement of interest rates, their performance will also depend on the property markets, because their risk will often mirror that of the properties that collateralize them. Oftentimes, property returns are very stable, growing by small incremental amounts until they "pop" with some market adjustment that leads to their anticipated total return. This change in value can be significant and can explain a large portion of total return, which compels real estate investors to identify when those changes in value will occur, in order to make the correct buy, hold or sell decision.

With all of the risk-mitigation potential of real estate, the asset class still bears a considerable amount of market risk. Real estate has shown itself to be very cyclical, somewhat mirroring the ups and downs of the overall economy. In addition to employment and demographic changes, real estate is also influenced by changes in interest rates and the credit markets, which affect the demand and supply of capital and thus real estate values. Along with changes in market fundamentals, investors wishing to add real estate as part of their core investment portfolios need to look for property concentrations by area or by property type. Because property returns are directly affected by local market basics, real estate portfolios that are too heavily concentrated in one area or property type can lose their risk mitigation attributes and bear additional risk by being too influenced by local or sector market changes.

Historic Returns
Some real estate investments mimic the structure, income and risks provided by fixed-income securities, while others resemble equities. The belief is that long-term real estate returns should fall somewhere between those of stocks and bonds. Historic performance has borne this out, with all returns of all the real estate quadrants having underperformed those of stocks over the long run. However, having underperformed the stock market does not necessarily make real estate an inferior investment on a risk-adjusted basis.

A basic and systematically used measure of the risk-adjusted superiority of investments is the Sharpe ratio. Because risk is defined as the variation in return, the Sharpe ratio is calculated by dividing the investment risk premium for a given period by the standard deviation of return for that same time interval. The risk premium is calculated by subtracting the risk-free rate - such as the 10-year U.S. Treasury bond (T-bond) - from the rate of return for a portfolio.

By dividing the risk premium by the standard deviation, one obtains the amount of performance for a given unit of risk. Sharpe ratios will differ significantly depending on the time period used; however, using the NPI (NCRIEF Property Index for Real Estate) and the S&P 500 (as the equity market index) as guides for the long term, it appears that real estate has a greater risk-adjusted return than equities. Some critics do not believe the Sharpe ratio is an appropriate measure to compare real estate equity to other investment classes. The dissent comes about from the way that real estate values are determined and booked into fund financials. REIT stocks are marked to market daily, but due to the infrequency of real estate equity transactions, owners have to employ third party appraisers to derive property values.

The problem with the appraisal method of valuation is twofold. Appraisals are apt to lag the market in times of rapid market changes, undervaluing properties during market improvement and overvaluing during market decline. The other contention is that the lack of transactions and the periodic appraisal of properties (usually once a quarter), tends to artificially smooth returns, taking out the natural variability of returns, and increasing Sharpe ratios. Despite the fact that past returns have no impact on future performance, investors looking to use Sharpe ratios, or any other performance measure as a way to compare investments, should be well aware of what makes up the statistics and the portfolios that they are reviewing.

Portfolio Construction
It seems that the historic performance of real estate, combined with its ability to increase diversification and hedge inflation, and increase risk adjusted performance, makes the case for the inclusion of real estate in a diversified portfolio. However, those considering moving a portion of their portfolio into real estate should consider the impact of home ownership on their overall risk to real estate. For most retail investors, a home is one of their largest single asset investments. As such, investors should incorporate their residences as part of their overall portfolio strategy and capital allocation, because home ownership increases their investment exposure to real estate and will affect potential risk-mitigation strategies.

The continued increase in real estate market efficiency, as demonstrated by the continual offerings of new real estate investment products and global investment opportunities, provides greater motive for including real estate in one's overall capital allocation. In addition to the potential risk/return superiority of traditional real estate alternatives, the emergence of investments, such as real estate derivatives and 1031 tax-deferred exchanges helps investors craft specific, potentially high-performing, tax-efficient and diversified investment portfolios.

The Bottom Line
The four real estate quadrants fit neatly within bonds and equity, with products that act similarly to each, providing investors with great investment flexibility. Real estate investments can also act as an appropriate bridge from a greater reliance on equities to a larger exposure to fixed income, as one gets older and considers retirement. Investors who have not previously considered a long-term position in real estate should research the myriad of real estate opportunities and the expected correlation to their existing assets in the quest to build the most efficient portfolio possible.

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