Why real estate?
fall 2008
By Martha S. Peyton, Ph.D., Thomas Park and Fabiana Lotito
This is an update of a paper first written in Fall 2004 and updated in Spring
2006 in which we examined the benefits of investing in commercial real estate.
Real estate investing reached a milestone of sorts with the September 2003
special issue of The Journal of Portfolio Management (JPM), which was devoted
in its entirety to real estate. This lavish attention to the asset class followed
a prolonged absence of interest as captured by the Journal’s editor, Peter
Bernstein, who noted in his introduction that the JPM had published only six
articles on real estate since the end of the 1980s.
A second special real estate issue followed in September 2005, in which Peter
Bernstein called attention to the sophistication with which commercial real
estate was being evaluated: “we are now using all the tools of modern portfolio
theory to analyze real estate.”
In the third special real estate issue published September 2007, the lead article
was entitled “Real Estate Comes of Age,” in which the authors note recent
milestones in the maturation of commercial real estate including its wider
acceptance as a legitimate institutional investment, competition with alternative
investments like private equity, hedge funds, and infrastructure for investor
allocations, and most importantly, further integration with the broader capital
markets. Notwithstanding the recent capital markets turmoil, the authors observe
that while real estate has adopted many of the features of the broader capital
markets, they believe that “…real estate retains its distinct features as an asset
class; the case for real estate remains strong, especially over the long-term.”
Why REAL ESTATE?
As the September 2007 issue was being written and
published, the capital markets turmoil exemplified in the
collapse of the subprime residential mortgage market was
beginning to take hold. In subsequent months, the U.S.
housing market started to tank, structured securities’
values slid, and financial institutions endured mushrooming
writedowns and writeoffs. Economic fundamentals around
the globe weakened. Commercial real estate fundamentals
softened as well. Space demand weakened, and coupled
with moderate construction, caused vacancies to tick up. The
credit crunch has curtailed sales activity, and transactions
that have occurred indicate that property prices have fallen
modestly for top tier properties, and sometimes significantly
for properties in secondary markets and locations.
Given current economic and capital markets conditions
and the uncertain outlook, an especially cautious and well
thought out investment strategy is needed.1 Nonetheless,
TIAA-CREF believes that the benefits of commercial real
estate for investors with a long-term horizon remain as
strong as ever. In the first two JPM issues, the lead articles,
both entitled “Why Real Estate?” succinctly described the
benefits of commercial real estate investment, benefits
which transcend short-term economic and capital markets
weakness. In the article, co-authors Susan Hudson-Wilson,
Frank Fabozzi and Jacques Gordon (all notable names in the
investing and real estate worlds) identified and examined
the five comprehensive reasons listed below for investing
in commercial real estate, reasons which we believe
remain especially compelling during these turbulent times.
Specifically, real estate remains attractive as:
1.
2.
3.
4.
5.
a
a
a
a
a
source of diversification;
generator of attractive risk-adjusted return;
hedge against unexpected inflation or deflation;
component of the investment universe; and
strong cash flow generator.
While this list is complete, we would like to offer some
context and critique that might be obvious to the
cognoscente of real estate investors but enlightening
to potential investors less familiar with the asset class.
REAL ESTATE AS DIVERSIFIER
To demonstrate the diversification benefits of real estate,
Hudson-Wilson, Fabozzi and Gordon created a valueweighted real estate index consisting of the asset class’
“four quadrants”: (1) private equity, i.e., ownership of real
property (24% of index); (2) private debt, i.e., commercial
mortgages (50%); (3) public debt, i.e., CMBS (17%); and (4)
public equity, i.e., REIT stocks (9%). Using a value-weighted
index of returns, the authors calculated the optimal allocation
to real estate in a mixed asset class portfolio of stocks,
bonds, and cash. They determined that real estate warranted
inclusion in the optimal portfolio because of its relatively
high historical returns and low correlations with stock, bond
and cash returns. Optimal allocations for real estate varied
considerably, depending upon an investor’s risk/return profile.
With significant investments in each of the four quadrants,
TIAA-CREF is an advocate of a four quadrant approach with
regards to commercial real estate investment.2 However,
we believe that the composite index muddies the unique
diversification potential of private equity real estate. Not
surprisingly, both public and private debt returns are
historically highly correlated with corporate bond returns as
each are priced based on spreads to U.S. Treasuries; and
returns of equity REITs are strongly correlated with broader
stock market returns.3 By comparison, Exhibit 1 below
shows that total return on the National Council of Real
Estate Investment Fiduciaries (NCREIF) Property Index (the
“NPI”, which is the most widely used measure of private
real estate equity returns) is uncorrelated (0.06) with U.S.
See, for example, Martha Peyton, “Why Invest In U.S. Commercial Real Estate When Capital Markets Are In Turmoil?”, TIAACREF Asset Management, Summer 2008.
2
See, for example, Martha Peyton, Thomas Park and Fabiana Lotito, “REITs and Real Estate: A Perfect Pair,” TIAA-CREF Asset
Management, Summer 2007.
3
See, Martha Peyton, Thomas Park and Fabiana Badillo, “Why Real Estate?”, TIAA-CREF Asset Management, Spring 2006,
page 3, Exhibit 1.
4
More complicated measurements of real estate returns produce similarly weak correlations with stock and bond returns. For
instance, Feldman examines July 1987-June 2001 using corrections for transactions bias and variable liquidity and produces
correlations with the S&P of 0.32 and with the Lehman Aggregate of -0.14.
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2 REAL ESTATE WHITEPAPER
stock returns (S&P 500) and uncorrelated (-0.28) with bond
returns (Lehman Aggregate).4 Exhibit 1 also shows that
direct real estate investment returns compare favorably
with those of stocks and bonds over the 1978-2007 period,
both in terms of average return and return volatility, as
discussed in detail below.
Real estate returns have remained relatively attractive
through the first half of 2008 as well, at 2.2% as measured
by the NPI versus -11.9% for stocks and 1.1% for corporate
bonds, as measured by the S&P 500 and Lehman
Aggregate, respectively. Prospects for stocks, bonds and
real estate during the second half of 2008 all remain
uncertain, but one should not make allocation decisions
based on short term performance measures. To that point,
we believe that commercial real estate’s diversification
potential is best illustrated by the low correlations with
stock and bond returns over the longer term, as represented
by the data in Exhibit 1 for the 1978–2007 period.
The 2007 JPM issue contained several articles of
relevance to this topic. One of the articles examined recent
developments cited as evidence that real estate has “come
of age.” While long viewed as an alternative asset class, real
estate must now compete with hedge funds, infrastructure,
agriculture, timber and the like in the “alternative space.” If
comparative results are not favorable, “…real estate could
fall out of favor with institutional investors,” and potentially to
the benefit of private equity, hedge funds, infrastructure, and
commodity funds. While hedge funds’ recent performance
may call this assumption into question, co-authors Bond,
Hwang, Mitchell and Satchell evaluated historical return
data and concluded that real estate diversification potential
was unmatched by other alternative investments: “As to
whether these benefits could be derived by substituting other
alternative assets for real estate, the emphatic answer is that
no other asset class can deliver the same level of portfolio
diversification benefits as real estate.”With institutional
investors now looking to assemble portfolios with both
“classic” and alternative asset investments, real estate’s
unique risk diversification capabilities places it in good stead.5
REAL ESTATE AS RISK-ADJUSTED
RETURN GENERATOR
Not only are the diversification benefits of commercial real
estate well documented, but historic returns are attractive
vis-à-vis those of stocks and bonds, as indicated by the data
in Exhibit 1. However, to obtain a measure of the true value
to an investor, returns must be adjusted for fees because
real estate funds (a common vehicle utilized by institutional
investors) typically have higher fee structures than cash,
bond and stock funds. Currently, management fees on
actively managed investment funds range from a low of
20 basis points for cash accounts to 100 basis points or
more for real estate funds. Bond and stock funds, at 25
and 45 basis points, respectively, fall in between. Exhibit 2
on the following page shows hypothetical returns along the
efficient frontier for stock/bond/cash/real estate portfolios
EXHIBIT 1
CORRELATIONS
Avg.
Return
Std.
Deviation
Stocks
Bonds
Cash
Direct
Real Estate
Investments
13.0%
15.1%
1.00
0.25
0.15
0.06
Bonds
8.5%
7.3%
0.25
1.00
0.27
-0.28
Cash
6.0%
3.2%
0.15
0.27
1.00
0.31
10.3%
6.3%
0.06
-0.28
0.31
1.00
Stocks
Direct Real Estate
Investments
Data are based on average annual returns for the 1978 to 2007 period. Return indices are as follows: Stocks: S&P 500; Bonds: Lehman
Aggregate; Cash: 30-Day T-Bills; Real Estate: NCREIF NPI.
See also Martha Peyton and Fabiana Lotito, “Real Estate: The Classic Diversifying Asset,” TIAA-CREF Asset Management,
Second Quarter 2006.
5
REAL ESTATE WHITEPAPER
3
Why REAL ESTATE?
approach produces lower volatility than would returns based
on actual quarterly appraisals. The use of annual return data
assuages this problem somewhat but not completely.6 For
instance, the 6.3% standard deviation shown for direct real
estate in Exhibit 1 has been calculated based on annual
data; the standard deviation for the same period based on
quarterly data is 3.7%.
vs. stock/bond/cash portfolios. The shaded area represents
the incremental return associated with adding a direct real
estate component to a portfolio, and more importantly
represents the incremental return at similar levels of risk.
While prospective investors would tailor their real estate
allocations to their individual risk/return profiles, Exhibit 2
shows that direct real estate contributes measurable riskadjusted return benefits on an after-fee basis.
Not all of the low volatility in real estate return is illusory.
The long-duration nature of tenant leases does indeed
provide some degree of cash flow stability. This is especially
valuable and significant in the context of the large,
diversified NCREIF portfolio. As a result, NCREIF cash flows
do not gyrate in sync with swings in the stock and bond
markets or the local economy. Staggered lease expirations
also smooth cash flow volatility. In addition, since the
transaction costs of investing in direct real estate can be
high, investors typically have a relatively long investment
horizon. To accommodate such long horizons, investors
need to have the capacity to wait out periods of weak
performance. This option to wait has been evident in recent
months as the volume of direct real estate transactions
While NCREIF data suggest that direct real estate returns
have low volatility, as indicated by the 6.3% standard
deviation shown in Exhibit 1, seasoned investors know that
this is somewhat illusory and related to NCREIF measurement
methodology. NPI returns have low volatility partly because
of appraisal smoothing, which refers to the fact that property
appraisals are often available less frequently than the
quarterly NPI return calculations. This leaves some quarterly
return calculations to be based on appraisals that can be up
to three quarters or even more than a year old. As a result,
income returns are smoothed out, and property values
appear to be static for several quarters and then gyrate in
the quarter the property is re-appraised. Statistically, this
EXHIBIT 2: efficient frontiers (fee-adjusted returns)
13.0
12.0
Return (%)
11.0
10.0
9.0
8.0
7.0
6.0
5.0
2.0
4.0
With Real Estate*
6.0
8.0
Without Real Estate**
10.0
12.0
14.0
Risk (%)
Source: Ibbotson Associates and TIAA-CREF Asset Management.
*
Various combinations of stocks, bonds, cash and real estate.
**
Various combinations of stocks, bonds and cash.
Many NCREIF contributors are open-end funds that value investments quarterly and are thereby not subject to appraisal smoothing.
Closed-end NCREIF fund contributors value their investments annually or even less frequently. With the number of open-end funds
in NCREIF increasing each year, appraisal smoothing may become less of a concern in the future.
6
4 REAL ESTATE WHITEPAPER
16.0
has dropped sharply in the face of weaker performance
prospects and the capital markets crunch.
Individual investors should be aware that when making
asset allocation decisions they cannot replicate the size
and diversity of the NCREIF portfolio, and consequently,
their returns from private real estate will be more volatile
than those of the NPI. This can be mitigated by selecting
fund investments with relatively large and diverse property
portfolios, both in terms of geography and property type.
The appraisal smoothing problem requires that investors
make adjustments in volatility measurements. The
adjustment doesn’t need to be complicated. One approach
described by David Swensen, Yale’s Chief Investment Ofﬁcer
and author of Pioneering Portfolio Management, is based
on the observation that direct real estate has debt- and
equity-like characteristics. The debt-like aspect comes from
tenant leases wherein tenants are committed to paying
specified amounts over a specified period; the equity-like
piece comes from changes in real estate values separate
from tenant cash flow. Hence, Swensen suggests adjusting
for the impact of appraisal smoothing by assuming that the
volatility of equity real estate returns lies midway between
that of stocks and bonds. This assumption nearly doubles
the volatility of annual real estate returns, which we believe
may be an overly punitive adjustment. Nonetheless, the
shaded area in Exhibit 3 shows the incremental return
associated with direct real estate on a volatility-adjusted
and after-fee basis. As indicated, direct real estate does
indeed contribute measurable risk-adjusted return benefits
to a stock/bond/cash portfolio even on a volatility-adjusted
and after-fee basis.7
REAL ESTATE AS AN INFLATION
OR DEFLATION HEDGE
Real estate’s potential as an inflation-deflation hedge is
murkier than its potential as a diversifier and source of
attractive risk-adjusted return. Inflation-deflation hedging is
not our first choice motivation for investing in real estate.
The conventional wisdom is that the same long-duration
debt-like leases that temper cash flow volatility typically
EXHIBIT 3: efficient frontiers (fee- AND risk-adjusted returns)
13.0
12.0
Return (%)
11.0
10.0
9.0
8.0
7.0
6.0
5.0
2.0
4.0
With Real Estate*
6.0
8.0
Without Real Estate**
10.0
12.0
14.0
16.0
Risk (%)
Source: Ibbotson Associates and TIAA-CREF Asset Management.
*
Various combinations of Stocks, Bonds, Cash and Real Estate.
**
Various combinations of Stocks, Bonds and Cash.
See also Gianluca Marcato and Key, Tony, “Smoothing and Implications for Asset Allocation Choices,” September 2007, Special
Real Estate Issue, JPM, in which they conclude that “different unsmoothing techniques yield very similar asset allocation choices.”
7
REAL ESTATE WHITEPAPER
5
Why REAL ESTATE?
include annual or periodic rent increases over the terms
of the leases (many of which are linked to the rate of
inflation). Hence, cash flows move in step with overall price
inflation and are protected from deflation. This is generally
true when real estate markets are in equilibrium. However,
the mechanism comes under pressure when markets
become oversupplied as tenants quickly perceive their
negotiating power and either negotiate for lower rents when
leases roll over or renegotiate existing leases. In essence,
property market fundamentals are the driving force behind
rent inflation or deflation rather than movements in the
consumer or producer prices indexes.
Despite the deficiencies of the conventional view of
real estate inflation-deflation hedging capacity, we do
perceive some inflation-protecting features related to
other aspects of commercial property leases. Industrial
property, for example, is leased on a triple net basis in
which tenants, in addition to paying rent, are obligated
to pay all real estate taxes, property insurance and
operating expenses, which thereby limits a landlord’s
exposure to rising taxes and expenses. Similarly, retail
properties are leased on a triple net basis plus an
administrative surcharge producing landlord expense
recoveries that can occasionally exceed actual expenses.
Office space is also leased on a triple net basis in
many markets. In other markets, landlords are gradually
converting to net leases as leases roll over. However,
even gross leases offer some protection against tax
increases and rising expenses by passing along to
tenants increases above an established base expense
stop. These features offer a measure of protection
against inflation, though they are still subject to
weakening when markets become over-supplied.
While commercial real estate has been viewed as an
inflation hedge, hard evidence of this long-held assumption
was provided by an article in the September 2007 JPM
issue entitled “Private Commercial Real Estate Equity
Returns and Inflation.” In the article, co-authors Huang and
Hudson-Wilson note the inflation-hedging capacity due to
tenants’ typical lease obligations as previously described.
However, the more compelling evidence was an analysis of
historic NPI office, industrial, apartment, and retail returns
which demonstrated that office, industrial, and apartment
properties were all an effective hedge against inflation
over the 1987-2006 period. Only retail property fell short,
a finding which was described as “counter-intuitive” and
contradictory with several earlier academic studies.
REAL ESTATE AS A COMPONENT
OF THE INVESTMENT UNIVERSE
The lead article in the first two special JPM issues also
observed that “Real estate belongs in a balanced investment
portfolio because real estate is an important part of the
investment universe.” At that time, the authors estimated
that real estate accounted for roughly 8% of the current
investment universe and argued that pension funds, with
only a 4% allocation to real estate, were underweighted with
respect to the asset class. The recent fluctuation of stock,
bond and other asset values has significantly changed the
weights of the various classes as well as investors’ views as
to optimal allocations. However, the conclusion that many
institutional investors remain underweighted with respect
to direct real estate remains valid, as indicated by investor
surveys conducted by Pensions & Investments and Pension
Real Estate Association (PREA).8
While investing in real estate in an attempt to create
a “market-neutral” portfolio comprised of a mix of
investments approximating the full range of investment
alternatives may have intellectual appeal, it is typically
not a primary motivation voiced by investors. Yet those
who ascribe to the “market-neutral” concept and prefer
a more passive approach to direct real estate might
consider the recently introduced derivative instruments.
Pension & Investments’ most recent survey found that direct real estate represented 4.8% of the aggregate assets of the largest
200 employee benefits plans as of September 30, 2007. Preliminary results from PREA’s most recent member survey found that real
estate investments, which it defines as direct real estate investments and commercial mortgages, CMBS and REIT stock, accounted
for an estimated 7.5% of average total assets of its 500 member firms as of year-end 2007.
9
See David Geltner and Fisher, Jeffrey D., “Pricing and Index Considerations in Commercial Real Estate Derivatives,” September 2007,
Special Real Estate Issue, and Fisher, Jeffrey D., “New Strategies for Commercial Real Estate Investment and Risk Management,”
September 2005, Special Real Estate Issue, The Journal of Portfolio Management.
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6 REAL ESTATE WHITEPAPER
While the market for commercial real estate derivatives
is still very shallow, they might one day offer the raw
material for investing in the “generic” real estate market.9
Investors who appreciate the asset class’ nuanced risk
and return characteristics described herein will likely
consider real estate investments either directly, through
joint ventures, or through funds. Those that invest directly
or through joint ventures will experience the attributes
of real estate ownership and investing described by
editor Peter Bernstein in the September JPM 2007 issue,
including tangibility which provides owners “…with some
control over the performance of the asset they own.”
Real Estate as a Strong Cash Flow
Generator
The remaining reason for investing in real estate —
real estate as a strong generator of cash flow — is
a stronger motivator. But again, real estate’s cash
flow-generating qualities are more nuanced than they
appear. Cash flow generated by the properties in the
NCREIF index has represented 7.8% of the index’s 10.2%
historical annualized total return over the 1978–2Q2008
period. Cash flow has been lush and attractive not only
because of the large size and diversity of the portfolio
but also because the index is restricted to properties
that have achieved a “stabilized” level of occupancy. For
the prospective investor, some real estate investment
vehicles make strong cash flow generation a priority and
target stabilized properties in major markets and/or core
property types. Others are more opportunistic, focusing
on development or repositioning; these strategies offer
more potential for capital gains rather than immediate
cash flow. Investors can opt for either strategy depending
upon individual appetites for income return versus
capital appreciation over the longer term, though the two
strategies have different levels of associated risk.
TIAA-CREF REAL ESTATE INVESTMENT
STRATEGY
As a major participant in each of the four real estate
investment quadrants, the TIAA-CREF organization has a
unique perspective of the real estate investment universe.
As of June 30, 2008, our real estate-related investments
currently total over $70 billion, consisting of a $24 billion
real estate equity portfolio, a $20 billion commercial
mortgage portfolio, a $25 billion CMBS and REIT debt
portfolio, and $1 billion REIT equity portfolio. The scope
of our real estate investing activities provides us with
the capacity to search out and identify investments with
attractive relative value and potential to provide the
diversification, risk-adjusted return and cash flow benefits
of the asset class that are its major attractions. Our
holdings provide a wealth of property market information,
property-specific operating data, and industry contacts
to undertake the exhaustive and in-depth due diligence
needed for real property investments.
This material has been prepared by and represents the views of TIAA-CREF’s Global Real Estate Research Group, and does not reflect the
views of any TIAA-CREF affiliate. These views may change in response to changing economic and market conditions. Any projections included
in this material are for asset classes only, and do not reflect the experience of any product or service offered by TIAA-CREF. The material is
for informational purposes only and should not be regarded as a recommendation or an offer to buy or sell any product or service.
Real estate investing risks include fluctuations in property values, higher expenses or lower income than expected, higher interest rates
which affect leveraged investments, and potential environmental problems and liability.
REAL ESTATE WHITEPAPER
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