Seeking Stability in a Volatile Stock Market? Consider Commercial Real Estate
Since late 2018, volatility returned to US equity markets after a long period of unusually low levels — and it has remained a disruptive force throughout 2019. A broad measure of volatility in the US stock market — the Cboe Volatility Index, or VIX — has ticked up in recent months.1 Investors are bracing for higher levels of volatility as several events loom prominently on the horizon, including trade war developments, corporate earnings reports, Federal Reserve rate-setting meetings, and economic data releases.
If equity market moves aren’t enough to make investors uneasy, the bond market has also been sending up red flags. In August, the 10-year Treasury yield traded at its lowest level since 2016, while the 30-year yield dropped below 2% for the first time in history. In addition, the 10-year Treasury yielded less than both two-year and three-month bonds.2 And while stocks have recently begun to hit highs again,3 these swings can have investors looking for a safe haven in an unpredictable market.
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
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%.4 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.5
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.
Private real estate vs. listed REITs: Beware 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.
REITs and private real estate investments differ in several areas, including risk and volatility. Over the short term, REITs have traditionally exhibited more volatility than private real estate. Because they trade publicly, a significant portion of price movements in REITs can be attributed to general stock market sentiment and investment flows. On the other hand, private real estate valuations tend to more closely reflect true property market fundamentals — not indiscriminate market noise.
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.6 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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- Cboe, http://www.cboe.com/vix
- Barron’s, “Stocks Swing Wildly as Yield Curve Flips. Is There a Recession Out There?” By Ben Levisohn, August 16, 2019, https://www.barrons.com/articles/stocks-swing-wildly-as-yield-curve-flips-51566002682?mod=past_editions
- Barron’s, “Stocks Are Hitting New Highs. The Yield Curve Might Be the Reason.” By Nicholas Jasinski, October 31, 2019, https://www.barrons.com/articles/the-s-p-500-is-hitting-new-highs-maybe-thank-the-yield-curve-51572516901
- 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