Since late 2018, volatility returned to US equity markets after a long period of unusually low levels — and it remains a disruptive force to date. A broad measure of volatility in the US stock market — the CBOE Volatility Index, or VIX — spiked in March 2020 to levels unseen since the Global Financial Crisis, while the US 10-year yield touched a record low of 0.3%. Investors are bracing for continued volatility as several uncertainties loom prominently on the horizon, including most recently the global coronavirus pandemic.
If you’re among them, we’ll explore in this article why you may want to consider adding commercial real estate to your portfolio. We’ll also illustrate why an investment in private real estate may be a better option than publicly traded real estate, such as REITs.
Opportunity for attractive risk-adjusted returns
Source: NCREIF. Private Real Estate reflects the NCREIF Open-End Diversified Core (ODCE) Index
Smart investors continually strive to capture the most attractive risk-adjusted returns, especially in the face of volatile markets and changing conditions. When it comes to meeting this objective, real estate has historically played an important role in a diversified investment portfolio for individual and institutional investors alike, as shown below. Private real estate has generated higher annual returns over the past 20 years than both US stocks and bonds, yet it has experienced significantly less volatility than stocks. Given this historical performance, it’s not surprising that institutional investors — who are among the savviest market participants thanks to their deep resources and knowledge — typically target a real estate allocation of 10-20%. Research findings back up this allocation decision. A 2013 study found that adding real estate to a portfolio with the traditional mix of assets both increased return and reduced volatility.
Opportunity for diversification
Private real estate has a low correlation to listed REITs, US stocks and bonds, as illustrated below. A correlation of 1.0 means two assets move in lockstep; a correlation of -1.0 means they move in opposite directions; and a correlation close to 0.0 means they are uncorrelated. Adding a non-correlated asset class can bring stability to an investor’s overall portfolio — meaning private real estate can serve as a welcome counterbalance when public equities are volatile.
Source: NCREIF, Bloomberg. Indices represented: Private Real Estate (NCREIF Fund Index–Open End Diversified Core Equity (NFI–ODCE), REITs (FTSE NAREIT U.S. Real Estate Index), Stocks (S&P 500 Index), Bonds (Bloomberg Barclays US Aggregate Bond Index).
The short-term volatility in REITs
For investors keen to take advantage of the potential benefits of real estate, there are two primary ways to establish exposure. The first option is to invest in public real estate, namely real estate investment trusts (REITs), which use pooled capital from its shareholders to purchase, manage and develop income-producing properties. Shares of publicly listed REITs are traded on major stock exchanges and are sometimes called “listed” real estate. Because investors own shares of a corporation or trust, this is known as an indirect form of real estate investment. The second option is to purchase a property or an interest in a property directly, known as private or direct real estate investing.
In addition, correlations between REITs and the broader equity market can skyrocket at times — for example, during the 2008-09 financial crisis. Market participants lumped REITs in with banking and financial stocks, which sold off heavily. Ultimately, the ability to buy and sell REITs on a daily basis makes them more volatile over the short term than private real estate. As such, for investors seeking to use real estate as a shelter from stock market volatility, private real estate may be a better fit.
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Originally published 4 Nov 2019, updated 30 March 2020
Hodes Weill & Associates ↩︎
The Journal of Index Investing, “Using Index ETFs for Multi-Asset-Class Investing: Shifting the Efficient Frontier Up” By Pankaj Agrrawal, Fall 2013, https://www.academia.edu/38146628/Using_Index_ETFs_for_Multi-Asset-Class_Investing_Shifting_the_Efficient_Frontier_Up; as cited by The New York Times, “Real Estate Funds Have Been a Balm in a Stinging Market” By Tim Gray, January 11, 2019, https://www.nytimes.com/2019/01/11/business/real-estate-funds-balm-in-stinging-market.html ↩︎
Institutional Investor, “Despite REITs’ Virtues, Institutions Still Favor Private Real Estate Funds” By Julie Segal, April 30, 2013, https://www.institutionalinvestor.com/article/b14zbbvgmlhwkr/despite-reits-virtues-institutions-still-favor-private-real-estate-funds ↩︎
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