Institutional investors have long recognized the advantages of including commercial real estate (CRE) in a balanced portfolio. But for some investors, exposure to real estate has been limited. This article will discuss four characteristics of CRE that merit attention.
Investments can produce two kinds of positive returns: income and capital gains. In the case of “core” commercial real estate such as retail, office and industrial properties, income returns generated from tenants’ rental payments have historically accounted for more than 90% of total returns, compared with 25% in the case of stocks, according to data from the National Council of Real Estate Investment Fiduciaries.
Income returns on commercial property may be particularly attractive today relative to other investment alternatives. Aggressive Federal Reserve policies aimed at promoting economic recovery have pushed cash and Treasury yields down to record low levels. Indeed, as of December 2011, the spread between yields on CRE (about 6% per NCREIF) and 10-year Treasuries (around 2% per the Federal Reserve) was near a historic high. Yields on corporate bonds (around 5% for BAA corporate, per the Federal Reserve) and the S&P 500 (2% per Moody’s Analytics) generally did not match those available from commercial real estate.
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Relatively higher income returns point to another attribute: the potential for capital gains. Attractive yields indicate that, on a relative basis, the income generated from CRE is high relative to its price. The corollary is that the price of commercial real estate is attractive relative to the income it commands, leaving room for appreciation.
Real estate’s stable income potential helps temper its volatility relative to asset classes whose performance hinge on daily price movements. CRE returns have historically been nearly as stable as bonds and far less volatile than equities, whose prices are more sensitive to market sentiment. This relative stability is alluring in today’s uncertain economic climate, when financial markets are experiencing extraordinary turbulence.