Commercial real estate (CRE) is a unique asset class that warrants consideration by investors given the many benefits. Five of the key benefits of CRE investment are:
(1) A large investable universe,
(2) Income returns,
(3) Lower volatility,
(4) Diversification, and
(5) Inflation hedging.
Large Investable Universe
After bonds (61.9%) and stocks (28.7%), CRE is the third largest asset class in the United States representing approximately $5.1 trillion, or 9.4%, of the $54.5 trillion investable universe, as shown in Figure 1.3. Accordingly, an investor that excludes it from a portfolio is significantly narrowing the universe of potential investment opportunities.
(CRE is defined to include multifamily, office, retail, warehouse, and hotel properties.)
Investments in general produce two kinds of returns: cash yields (income returns) and value changes (capital gains or losses). In the case of CRE, income returns (generated from tenants’ rental payments) have historically accounted for more than 90% of total returns (compared with 23% in the case of stocks). Real estate’s healthy income component is attractive to investors seeking stable cash flow. Stable income is also safer during periods of financial-market stress when liquidating assets may prove problematic.
Income returns on commercial property have been particularly attractive in recent times relative to other investment alternatives. Aggressive Federal Reserve policies aimed at promoting economic recovery (close to 0% short-term interest rates and several rounds of asset purchases) have pushed cash and Treasury bond yields down to near-record lows. Although corporate bond and equity dividend yields are attractive, they still do not match those available from CRE (see Figure 1.4).
Real estate’s substantial income component helps to temper its volatility relative to asset classes that derive a higher proportion of returns from price movement. Additionally, longer rental lease terms help to mitigate the impact economic fluctuations have on rental income. CRE as an investment has historically exhibited stability similar to bonds while being much less volatile than equities, whose prices are more sensitive to systematic risk factors and overall sentiment (see Figure 1.5). This relative stability may be especially alluring in today’s uncertain financial climate.
On a stand-alone basis, CRE may offer compelling value as a source of current income. Yet its capacity to reduce volatility is enhanced when it is included in a balanced portfolio. Like stocks and bonds, real estate is influenced by economic and financial drivers, such as economic output and interest rates. But it also has unique characteristics, including extended lease terms, sensitivity to development activity (currently near an all-time low), and other factors. Correlation coefficients are used to compare risk and the similarity of risks between asset classes. Accordingly, the return correlations of CRE with other asset classes have historically been low (see Figure 1.6).
The fact that CRE has a low correlation with stocks implies that a crisis in equity markets would not likely affect real estate proportionately, limiting the overall damage to a portfolio containing both investments. With correlations of less than 0.25 to all major asset classes, CRE has meaningful capacity to reduce portfolio volatility through diversification.