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Portfolio > Alternative Investments > Real Estate

5 ‘Whys’ for Commercial Real Estate Investing

By David Lynn, Ph.D

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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.)

 Figure 1.3. CRE Is Sizable Portion of US Investable Universe

Income Returns

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).

Figure 1.4. CRE Income Returns Relative to Other Asset Classes (2013 Q1)

Lower Volatility

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.

Figure 1.5. High Income of CRE Returns Equals Lower Volatility (1983 Q2 – 2013 Q1)

Diversification

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).

Figure 1.6. Low Correlations with Other Asset Classes (1983 Q2–2013 Q1)

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.

[Practice Pointer: If your clients are heavily weighted in a portfolio of publicly traded stocks or equities, investing in CRE will reduce their risk exposure and help reduce the volatility of the portfolio. As we will see later, this mixed approach will also maximize portfolio returns over the long run.]

Additional diversification can be found within the CRE market through exposure to a broad range of property types, geographies, and tenants.

  • Property types: The major CRE property types have unique economic drivers that can impact their performance, including job growth (office), demographics (multifamily), retail sales (retail), business and leisure travel (hotel), and manufacturing and international trade (industrial).
  • Geographies: Local CRE markets behave differently due to structural factors (e.g., physical or regulatory barriers to new supply) or economic drivers (e.g., a significant presence of specific industries, such as energy, technology, finance, or government).
  • Tenants: The selection of tenants making rental payments and the industries they compete in allow for additional diversification. Over economic cycles, government or healthcare tenants may prove more resilient in recessions, but they can be more vulnerable to policy risks. Finance, technology, and other companies may be sensitive to factors transcending the broader economy (e.g., global oil prices, financial regulation, and business capital spending).

Inflation Hedging

Inflation is currently modest, in line with the Federal Reserve’s implicit target of around 2%, and elevated levels of unemployment will likely keep inflation fears at bay for the time being. However, the Fed’s rampant money printing (its balance sheet has more than tripled since the financial crisis of 2008 to more than $3 trillion) has raised the possibility of a significant upturn in inflation once economic conditions firm.

CRE can help to mitigate inflation risks. Fundamentally, the value of real estate is supported by the rental payments it generates. In periods of high inflation, rising wages and profits increase the nominal amount tenants are willing to pay for any given amount of space. Meanwhile, higher construction costs (due to rising labor rates and commodity prices) restrict commercial development. The resulting increase in demand and decrease in supply lift rental rates and cash flows. Even if rents do not respond immediately, inflation-fearing investors typically price future rent increases into current values. Over the long term, CRE prices tend to rise with replacement costs, which are driven by inflation.

Several academic studies have confirmed CRE’s ability to hedge inflation. Although many of these studies are statistically complex, at the most basic level CRE has exhibited a strong correlation with inflation relative to other investments (Figure 1.7). It certainly proved its worth during the United States’ last major inflation scare, following the oil crisis of the 1970s. From 1979 to 1982, as consumer prices increased 10% per year, CRE delivered strong returns averaging 14%, while stocks (9%) and bonds (6%) lost ground on an inflation-adjusted basis.

Figure 1.7 CRE Offers Good Hedge against Inflation

 

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