Real estate is the type of investment you never forget. You may be stuck with a speculative property in foreclosure, or you may have struck gold at the corner of Mink Mile and Bourse Boulevard. Perhaps you’ve discovered, in the real estate jungle, a resilient money tree. For good or ill, real estate investments stick with you.
More often than not, it’s because they are private transactions that are hard to get out of (in alpha-speak, they are called illiquid). If they are public investments, the net operating income can be addictive (in alpha-speak, cash flowing).
Where’s the alpha opportunity? There are three ways to get exposure: publicly traded real estate companies, the growing universe of Real Estate Investment Trusts, and finally private real estate. Are they related? At first sight, they seem to follow their own rhythms. REITs are closely linked to the performance of public equities, particularly high-yield equities. Private real estate seems akin to private equity, however.
In a recent paper, “Private and Public Real Estate — What’s the Link?,” Raghu Suryanarayanan and Dan Stefek at MSCI Barra suggest that different types of real estate investment are more closely correlated than the metrics have previously disclosed, at least in the U.S. and U.K.
It’s an important issue because money, particularly pension fund money, is beginning to flow into real estate again. And REITs, according to Bloomberg, are vying for a bigger piece of the pie.
The National Association of REITs is trying to entice institutional investors, who typically put only 10% of their real estate allocation into publicly traded stocks, as a complement to direct commercial real estate investing. According to NAREIT:
REITs are the spark plug to boost portfolio performance and a powerful diversifier to reduce volatility. [T]he REIT return cycle leads the private real estate return cycle going into both downturns and recoveries. In the last real estate market cycle, REIT returns peaked approximately one year ahead of those of private real estate funds.
That touches on the timing case for real estate.
Apart from that, REITs have a lower beta to the unlevered private real estate market as the chart below shows (click to enlarge images):
Blending private and public investments does diversify, but not in expected ways. It actually increases the volatility of a core real estate portfolio – unless value-added and opportunistic plays are stripped out – but at the same time increases the Sharpe ratio, as seen below.
NAREIT’s data is presented as smoothed on the private side. So, beware, that data may be misleading.
Private real estate holdings may actually be more volatile than current wisdom would have it. Suryanarayanan and Stefek noted that private real estate values are appraised quarterly in the U.K., and annually in the U.S. What looks good on paper may not provide an accurate measure of what is happening while the data is being committed to paper.
“Appraisal-based indices suffer from two well-known problems,” they noted. “They lag the market and understate volatility. These problems stem, in part, from the tendency of appraisers to smooth their valuations. Appraisers anchor their valuation of a property on its past appraisal and adjust it based on recent transactions of comparable properties. The ability to quickly incorporate new market information greatly depends on the availability of timely and comparable property sales.”
Appraisal is not an exact science, as property taxpayers who routinely appeal their “market value” assessments well know. Applied to capital properties, the inexactitude can overstate the investment case since appraisals are not quite the same as daily price discovery for publicly traded companies and typically lag behind them.
“As a result, property index returns do not accurately capture true private real estate returns,” write Suryanarayanan and Stefek . “Instead, given the nature of the property appraisal process, a quarterly index return reflects a fraction of the true return over the quarter as well as portions of the true returns for previous quarters.”
How to remedy this?:
We assume that true private real estate returns may be related to both current and past public real estate returns. We expect there to be a contemporaneous relationship between the two types of investments since both are exposed to the broad underlying U.K. real estate market.
Smoothed appraisals obscure this relationship. With returns left unsmoothed, the correlation between public and private real estate hovers between 40% and 45%.
That’s the U.K. deconstruction with quarterly appraisals included. The task is a little more difficult when applied to U.S. private real estate returns since appraisals are annual. But there is a stronger relationship between public and private real estate than what is normally reported.
A final task for the MSCI Barra researchers is to decompose liquidity. Privately held real estate seems to be less volatile because the holding periods are longer than for publicly traded equities. But by their analysis:
Real estate volatility is greater than one might think, especially at longer horizons. Second, private and public real estate investments behave more similarly at longer horizons. This further suggests that private real estate may also be considerably more correlated with traditional equities at longer horizons than is commonly assumed.
In real estate, there is correlation, correlation, correlation. So it’s really about diversification, diversification, diversification – and time, time, time until when correlations converge on 1. Then it’s through for this old house.
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