REITs: Effective exposure to commercial real estate?

Page created by Arnold Sandoval
 
CONTINUE READING
REITs: Effective exposure
to commercial real estate?

Vanguard research                                                                                                                   March 2011

Executive summary. The global commercial real estate market has been
estimated to be as large as $23 trillion.1 Historically, commercial real estate                                           Authors
has provided competitive real returns and diversification opportunities for                                               Christopher B. Philips, CFA
                                                                                                                          David J. Walker, CFA
traditional portfolios. Yet an important question remains: Can an investment
                                                                                                                          Yan Zilbering
in commercial real estate actually deliver the characteristics and benefits of
the broad real estate market? Indeed, investment vehicles such as real
estate investment trusts (REITs), partnerships, or private investment pools
can look quite different from the broad real estate market. The complexity of
this question is a possible reason why institutional investors on average
allocate only 6% of their portfolios to commercial equity real estate (Cerulli
Associates, 2011). In the United States, as of December 2010, private
commercial real estate holdings were estimated at $247 billion, according to
the National Council of Real Estate Investment Fiduciaries (NCREIF), and
public U.S. equity REITs at $358 billion.2 This analysis evaluates the
commercial real estate market and offers perspective regarding the various
investment options.

1 Estimated market size based on data provided by Prudential Real Estate Investors.
2 For this paper, we use real estate investment trust or REIT to refer to any form of equitized real estate investment.

Connect with Vanguard > vanguard.com
We contend that:

     • Commercial real estate is a unique and significant asset class.

     • An equitized real estate index serves as a long-term proxy for the commercial real
       estate market.

     • Because REITs represent exposure to the commercial real estate asset class, they may be
       evaluated for strategic inclusion in a portfolio using the same metrics employed for other
       asset classes.

     • However, because REITs are equities and are therefore part of broad-based global equity
       markets, investors must factor in the exposure already contained within the active and
       indexed portions of their portfolios.

     Commercial equity real estate basics                        Long-term returns for real estate are driven primarily
     Commercial equity real estate is a unique and               by a property’s net operating income (NOI) and to a
     significant asset class. It provides investors with the     lesser extent by property value appreciation.
     opportunity to own property, with the primary               Historically, commercial real estate prices and
     objective of leasing a structure to various tenants in      income (assuming properties are maintained
     return for income and the potential for capital gain        appropriately) have grown on par with to slightly
     upon the sale of the property.                              above inflation (Figure 1, page 4). Income-oriented
                                                                 properties may increase rents to compensate for
     Commercial real estate may be segmented by                  inflation’s erosion of value, and thus obtain some
     property type, geographic location, and development         hedge against inflation. However, for a property to
     stage. Core property types commonly include                 maintain its inflation-adjusted value, it must be well-
     multifamily residential (apartment buildings), retail,      located, have rents that can be adjusted periodically,
     office, and industrial. Other, less common property         and not be subject to sudden, sharp increases in
     types include health care facilities, public storage        operating costs. As an extreme example, if an
     buildings, golf courses, and hotels. Development            apartment had rent-control provisions, the proprietor
     stages include core (mature, income-producing               would not be able to increase rents, and the property
     properties), value-added (income-producing                  therefore would not provide an inflation hedge.
     properties with appreciation potential), and
     opportunistic or distressed (development properties
     with a focus on capital appreciation).

       Notes on risk: All investments are subject to risk. Funds that concentrate on a relatively narrow market sector
       face the risk of higher share-price volatility. Foreign investing involves additional risks, including currency
       fluctuations and political uncertainty. Past performance is not a guarantee of future results. The performance
       of an index is not an exact representation of any particular investment, as you cannot invest directly in an
       index. Diversification does not ensure a profit or protect against a loss in a declining market.

2
Public and private real estate investments
     A real estate investment trust is an operating                                  commingled funds represent large pools of
     company that offers ownership shares to the                                     capital, with the underlying properties managed
     public and, as a result, trades on a stock                                      by a specialist. Open-ended commingled funds
     exchange. Equity REITs own property directly                                    offer investors more freedom to add or withdraw
     and derive most of their earnings from property                                 capital—given proper notification and the approval
     income, with a smaller portion coming from                                      of the manager. By their very nature, private
     appreciation when an underlying holding is sold.                                partnerships are highly customizable. Without tax
     As a consequence of various tax and income                                      laws to govern their structure, private
     requirements,3 many equity REITs choose to                                      partnerships can focus on any combination of
     invest primarily in mature, income-generating                                   property types and development stages.
     properties. Mortgage REITs make loans to
     property developers, and hybrid REITs combine                                   The most popular benchmark used to measure
     the two strategies. In this report we use equity                                private investment holdings is the NCREIF
     REITs as a lens for the market, because the                                     Property Index. Because of well-documented
     other types do not explicitly focus on income-                                  concerns about the appraisal-based valuation
     producing properties. We thus employ the FTSE                                   methodology, which introduces serial correlation
     NAREIT Equity REIT Index as a proxy for U.S.                                    and return (volatility) smoothing, we elected to
     REIT investments.4                                                              use a transactions-based index that was
                                                                                     developed by the MIT Center for Real Estate
     Private real estate investment can take the form                                (Fisher, Geltner, and Pollakowski, 2006) and
     of direct investments, open- or closed-ended                                    endorsed by NCREIF. The transactions-based
     commingled funds, or private partnerships. In a                                 index corrects for smoothing, leading to standard
     direct investment, an investor purchases and                                    deviations significantly greater than reported in
     manages a property directly. Closed-ended                                       the standard index.

Sustainable NOI is used to calculate the current and                                 Investing in commercial real estate
future value of a property. Expectations of future                                   Traditionally, there are three primary means of
NOI (and hence property values) change with                                          investing in commercial real estate, as summarized
economic cycles, the supply and demand of                                            in Figure 2, page 4: direct investment and
properties and tenants, and the performance of the                                   management, participation in a private investment
financial markets (stocks and bonds compete with                                     pool, and purchases of REIT shares.
real estate for investor capital).

3 Tax laws mandate that a REIT must pay out 90% of its taxable profit in the form of dividends. In addition, a REIT must continually satisfy certain tests with
  respect to the sources of its income, the nature and diversification of its assets, the amount of its distributions to stockholders, and the ownership of its
  stock. Among other things, these restrictions may limit the company’s ability to acquire certain types of assets, limit its ability to dispose of assets that it
  has held for less than four years if the disposition would result in gains exceeding specified amounts, limit the ability to engage in hedging transactions,
  and require the company to make distributions to its stockholders at times when the company might deem it more advantageous to use those funds for
  other corporate purposes or when the company might not have funds readily available for distribution.
4 For analysis using the FTSE NAREIT Equity REIT Index, many choose to focus on the period starting in the early 1990s, because of the significant tax and
  structural changes that followed the 1986 Tax Reform Act. The act permitted REITs to operate and manage most types of income-producing commercial
  properties by providing “customary” services associated with real estate ownership. Between 1986 and 1992, real estate suffered a severe recession, and
  by 1992 many private real estate companies realized that the most efficient way to access capital was from the public marketplace through REITs (source:
  www.reit.com).

                                                                                                                                                                     3
Direct investment involves purchasing a property                                                            Figure 1.   Inflation-adjusted growth in national
     outright and assuming operating control over rent                                                                       nonresidential real estate prices and
     policy and collection, maintenance, and growth.                                                                         rental income, 1947–2009
     Although direct ownership allows the investor to
                                                                                                                  1.5%
     collect rents and the proceeds of any property sales
     without paying a management fee, it requires
     expertise in property management, or a willingness

                                                                                        Annualized real growth
     to hire a third-party manager. Direct ownership also                                                         1.0%
     limits the ability to create a multi-property portfolio
     because of the size of the required investments.
     Because of these challenges, few diversified real
     estate investors choose to own properties directly.                                                          0.5%

     Private real estate vehicles provide direct access to
     commercial real estate properties. However, for
                                                                                                                  0.0%
     many investors, private real estate can be difficult to
                                                                                                                               Real estate prices          Rental incomes
     include in a diversified portfolio because of high
     costs, illiquidity,5 limited transparency, and large                                   Source: Author’s calculations using data from the Bureau of Economic Analysis
     required minimum investments. And even an open-                                        and Moody’s Analytics. The BEA updates data in August of each year.

       Figure 2.         Characteristics of primary real estate vehicles

                                   Direct investment                          Private investment pool                                     REIT shares
     Form of investment            Purchase investment property               Invest in commingled trust or                               Purchase shares on stock
                                   directly                                   private partnership                                         exchange
     Management                    Direct management of property              Investment manager allocates                                Investment management
                                                                              funds and manages property                                  company (REIT) manages
                                                                              portfolio.                                                  property portfolio.
     Investor time and             High                                       Variable                                                    Low
     resource requirements
     Source of returns             Rents received; property value             Pooled rents; partnership share                              Dividends paid; share price
                                   appreciation                               appreciation                                                 appreciation
     Valuation                     Annual appraisal; income                   Pooled appraisals; pooled                                    Funds from operations (FFO)
                                   capitalization rate                        capitalization rates                                         multiples; NAV/market cap
     Return characteristics        Highly idiosyncratic                       Idiosyncratic—highly subject to                              Can range from idiosyncratic
                                                                              manager skill                                                (single REIT) to systematic
                                                                                                                                           (REIT index)
     Liquidity                     Highly illiquid                            Illiquid—subject to purchase                                 Highly liquid
                                                                              and redemption restrictions and
                                                                                          1.50
                                                                              transaction minimums
     Management fees               None                                       Higher                              1.25                     Lower
     Diversification?              No                                         Limited                                                      Yes
     Transparency                  Transparent (property owner)                             1.00
                                                                              Little portfolio transparency                                Transparency consistent with
                                                                                                                                           requirements for publicly
                                                                                                                  0.75                     traded companies

     Note: There may be other material differences between products that must be considered prior to investing.
                                                                                                                  0.50
     Source: Vanguard.
                                                                                                                  0.25
     5 Although illiquidity potentially leads to a return premium in most assets, whether or not such a premium exists for an investment pool is the subject of an
                                                                                             0.00
       ongoing debate in the investment industry.

4
ended commingled fund often requires early                   Figure 3.       Sector composition of FTSE NAREIT
notification and substantial waiting periods for                             Equity REIT Index
account transactions. Finally, to attain diversification
across property types and regions, the investor            As of December 31, 2010
needs to either buy a share in a vast portfolio or
                                                           Apartments                                                   16%
acquire shares in multiple portfolios.
                                                           Regional malls                                               15%
                                                           Offices                                                      14%
In terms of the underlying real estate exposure,
                                                           Health care                                                  12%
there is no substantive difference between holding
                                                           Shopping centers                                             9%
an interest in a private real estate partnership and
                                                           Lodging/resorts                                              6%
holding a REIT. However, ownership of REIT shares
                                                           Diversified                                                  6%
addresses many of the investment concerns
                                                           Specialty                                                    6%
associated with private real estate partnerships or
                                                           Self-storage                                                 6%
pools. REITs offer transparency and liquidity far
                                                           Industrial                                                   5%
exceeding that of most private real estate
                                                           Office/industrial mix                                        3%
investments. And regional and property-type
                                                           Free-standing retail                                         2%
diversification is achieved more easily in public real
                                                           Manufactured homes                                           1%
estate than in private real estate. For example, a
REIT index fund may hold more than 100 REITs,              Note: Percentages may not sum to 100% because of rounding.
each representing many underlying properties across        Source: FTSE/NAREIT.
geographic regions.

Are REITs an effective proxy                               and geographic regions suggests that a broad REIT
for the real estate market?                                index is more representative of the aggregate real
Public real estate options come with their own             estate market than any single REIT or private
unique concerns. Given the desirable investment            investment pool.
qualities of REITs, for many investors the primary
question is whether REITs can provide effective            It is also instructive to examine the performance of
exposure to real estate. Although REITs constitute a       REITs relative to that of private holdings. Given that
small portion of the real estate market and have           investment properties represent the underlying
performed quite differently from other real estate         holdings of both public and private investment
vehicles in the short term, we believe there are at        vehicles, returns should be more similar than
least two fundamental similarities leading to the          different, particularly over the long term. However,
conclusion that REITs are representative of the            because the primary public and private benchmarks
commercial real estate market. These are geographic        have modestly different constituents (the NCREIF
representation and long-term performance.                  Property Index includes office, retail, industrial, and
                                                           residential properties, along with a very small
Most important, REITs and private investments—             percentage of hotels, and includes properties
whether held directly or through a private investment      across the range of development stages), we would
pool—are invested similarly. Indeed, both private and      expect some differences in returns, particularly in
public investment pools derive returns from holding        the short term. To help illustrate this concept,
portfolios of commercial real estate. As Figure 3          Figure 4, page 6, shows that since 1984 (the
suggests, the REIT market is well-diversified across       inception of the NCREIF transaction index), the
property types, including a significant portion of the     cumulative returns of public and private real estate
property types that are likely to be included in a         have not been meaningfully different over longer
private investment pool. In addition, a REIT index is      periods when private real estate is adjusted for
geographically diversified, representing holdings from     differences in how benchmark returns are reported;
all areas of the country. The range of property types      see the note below Figure 4 for details. From this

                                                                                                                              5
Figure 4.                    Long-term returns are similar across real estate investment options

       Cumulative returns for December 1983–September 2010

                                       2,500
                                                                             NAREIT        NCREIF MIT          NCREIF MIT Index
                                                                               Index               Index    with 50% adjustment
                                                  Mean quarterly return       3.00%               1.93%                     2.90%
     indexed to 100 in December 1983

                                       2,000
                                                  Statistically different                            No:                       No:
         Cumulative performance

                                                  from REITs?                            t-stat = –1.045           t-stat = –0.094

                                       1,500

                                       1,000

                                        500

                                          0
                                          Dec. 1983         Dec. 1987        Dec. 1991          Dec. 1995          Dec. 1999         Dec. 2003            Dec. 2007       Sept. 2010

                                                   NCREIF MIT transactions-based index with 50% adjustment
                                                   Equity REITs

       Note: There are two adjustments to the traditional NCREIF Property Index. First, we use the transactions-based index developed by the MIT Center for Real Estate and
       provided by NCREIF. This eliminates the smoothing resulting from appraisal pricing. Second, we adjust the NCREIF returns to account for the discrepancy with which returns
       are reported. Because REIT returns are a function of capital structure, the return series accounts for any debt/equity ratio the firms employ. In contrast, private real estate
       returns assume that property investment is made without the use of debt financing. In fact, returns represent changes in property value only, not the returns realized by
       investors who may be partially financed with debt. Academic and industry analyses typically include adjustments to private real estate returns of anywhere from 30% to 70%.
       Our adjustment is an attempt to make the return series more comparable, with the acknowledgment that there are perhaps more complex and more accurate approaches.
       Source: Author’s calculations using data from FTSE/NAREIT and from NCREIF with MIT. Analysis is derived from the methodology employed by researchers such as Joseph
       Pagliari Jr. (2003). The transactions index data is released on a quarterly lag.

       perspective, investors in public or broad private real                                              Arguments against using REITs
       estate indexes would have ended up in essentially                                                   As a result of the potential for short-term
       the same place over longer periods of time, albeit                                                  performance disparity, the primary argument against
       by marginally different routes.                                                                     using REITs as a proxy for the commercial real
                                                                                                           estate market is the correlation of REIT performance
       Although the use of publicly held real estate vehicles                                              with the broad equity market—particularly in the
       as a proxy for the commercial real estate market                                                    small-cap value sector. Higher historical correlations
       seems reasonable, it is clear that returns for public                                               between REITs and small-cap value stocks do
       REITs and private pools may differ significantly in the                                             suggest that some return variation is related to the
       short term, as seen in Figure 5. Here we show that                                                  movements of the small-value sector. However, a
                         2500
       over three-year periods, the FTSE NAREIT and                                                        significant portion of REITs’ return variation
       NCREIF transaction indexes have performed quite                                                     (approximately 50%) is uncorrelated, indicating
                                                                                                                                                                                         N
       differently. This could be due to differences in                                                    substantial independence.
                         2000
       holdings or, more important, to a potentially                                                                                                                                     E
       significant short-term relationship between REITs                                                   The primary differences between REITs and traditional
       and public equity markets.
                         1500                                                                              equities are the core businesses and the primary
                                                                                                           drivers of earnings growth. REIT earnings are driven
                                                                                                           by the net operating income of the property holdings
                         1000                                                                              and, to a lesser degree, by appreciation in the value of
                                                                                                           properties. In contrast, traditional corporate earnings
                                                                                                           are driven by growth in sales revenue for products
                                       500                                                                 and services. As a result of this difference in business

6                                       0
                                       Dec. 1983
                                               Dec. 1987
                                                       Dec. 1991
                                                               Dec. 1995
                                                                       Dec. 1999
                                                                               Dec. 2003
                                                                                       Dec. 2007
                                                                                            Sept. 2010
Figure 5.        Shorter periods can result in significant performance differences

Total cumulative returns: Three-year nonoverlapping periods
120%

100%

  80%

  60%

  40%

  20%

   0%

–20%

–40%
              1984–1986         1987–1989         1990–1992         1993–1995        1996–1998         1999–2001         2002–2004        2005–2007        2008–9/2010

              FTSE NAREIT Equity REIT Index
              NCREIF MIT transactions-based index with 50% adjustment

Source: Author’s calculations using data from FTSE/NAREIT and from NCREIF with MIT. Transactions-based index data are released on a quarterly lag. The final bars reflect
data through September 30, 2010. See the note to Figure 4 for an explanation of the 50% adjustment.

  Figure 6.        REIT fundamentals differ from those for small-cap value stocks

                                                                                         Small-cap value                                                            REITs
Core business/earnings                                                      Traditional revenue sources                                   Real estate management
Balance-sheet assets                                                                          Depreciating                                                 Appreciating
Source of returns: Price                                                                              8.53%                                                        3.41%
Source of returns: Income                                                                             2.29%                                                        6.91%
Annualized volatility                                                                                 17.16%                                                       19.14%
    1.2 dividend yield
Average                                                                                               2.17%                                                        6.54%
                                                                                                                                                                            NCREIF MIT Tra
     1.0
Sources: Russell and FTSE/NAREIT. Data reflect the period from 1989 through 2010; 1989 represents the start of the Russell 2000 Value Index dividend yield data.            FTSE NAREIT U
     0.8

     0.6

fundamentals,
    0.4          there can be other significant contrasts                                focused on energy or mining firms can be used as
between traditional small-cap value stocks and REITs,                                    proxies for a commodity index itself. However,
    0.2
as illustrated in Figure 6.                                                              investing in real estate typically centers on a decision
     0.0                                                                                 about whether to obtain exposure through a publicly
A second argument commonly used against REITs is                                         listed REIT or a privately held partnership—that is, a
   -0.2
that equitization of real estate exposure may not                                        choice between public and private vehicles, not a
work
   -0.4 because it hasn’t worked with other asset                                        decision about whether to hold property outright or
          1984-1986 1987-1989 1990-1992 1993-1995 1996-1998                              1999-2001 2002-2004 2005-2007 2008-9/2010
classes—mainly commodities. The impact of                                                as a share in a managed portfolio of properties. The
equitization is often evaluated in the commodity                                         equitization of commodities involves deciding
markets, where equity sectors such as those                                              whether to invest in the commodity itself (say, a

                                                                                                                                                                               7
gold bar), in commodity futures (the gold component                                this option to the same degree. The derivatives
     of a commodity index), or in shares of companies                                   markets may eventually help investors to track
     whose primary business is the production of that                                   private real estate indexes, but for now such
     commodity (gold-mining companies).                                                 opportunities are limited. The importance of manager
                                                                                        selection therefore results in a potentially wide
     Commercial real estate market exposure                                             distribution of return possibilities. In fact, if investors
                                                                                        in private vehicles receive the return for the overall
     For investors in any asset class to obtain the risk and
                                                                                        real estate market, it is more likely to be because of
     return characteristics of the market, an investable
                                                                                        luck than because they found an investment pool
     market index is required. However, there are two
                                                                                        that is diversified enough to replicate the true
     primary concerns with commercial real estate indexes.
                                                                                        characteristics of the aggregate real estate market.
     First, existing benchmarks (such as the FTSE NAREIT
     and NCREIF indexes) represent only a small portion of
                                                                                       Figure 7 demonstrates the relationship between
     the total U.S. commercial real estate market. For
                                                                                       idiosyncratic risk and systematic risk. Here we plot
     example, the total value of U.S. commercial real estate
                                                                                       five-year annualized returns of individual REITs over
     is likely measured in trillions; since investment
                                                                                       time, with each dash representing the return for a
     holdings account for approximately $600 billion, it
                                                                                       specific REIT.6 For example, in 1993, 46 REITs had
     appears that the vast majority of the commercial real
                                                                                       five-year returns, while in 2009, 141 had five-year
     estate market is closely held by real estate developers,
                                                                                       returns. The dispersion of the returns simulates the
     brokers, and long-term investors and is therefore
                                                                                       risk inherent to selecting a concentrated real estate
     unavailable for transaction. This is somewhat different
                                                                                       portfolio. We also plot the index return as well as the
     from the equity and debt markets, where public
                                                                                       25th, 50th, and 75th percentile returns. By definition,
     holdings make up a much larger portion of the total
                                                                                       in any given period, 50% of firms will be above the
     market capitalization of each asset class.
                                                                                       median and 50% will be below the median, but it is
                                                                                       instructive to look at the range of returns as well as
     Second, only REIT indexes have historically been
                                                                                       where the index falls relative to the distributions. In
     investable, as the NCREIF Property Index represents
                                                                                       every five-year period, a percentage of firms posted
     an aggregation of private investor holdings. In fact,
                                                                                       returns well below “average.”
     outside of a REIT index mutual fund or ETF, any
     investment in commercial real estate is highly
                                                                                        It is also instructive to evaluate the spread between
     concentrated and consequently a bet on manager
                                                                                        the 25th and 75th percentiles. In most years this
     skill. Investment performance therefore entirely
                                                                                        spread was between 15 and 20 percentage points.
     depends on the selection of a manager and that
                                                                                        Such a wide spread sheds light on the challenges
     manager’s skill.
                                                                                        associated with using undiversified investment
                                                                                        vehicles to implement an asset allocation strategy.
     The difference between specialized exposure and
                                                                                        In this example, investors can own the REIT market,
     market exposure is important, because investors
                                                                                        which means that the decision to invest with a
     typically model asset allocation and expected
                                                                                        manager or through an index can be a part of the
     portfolio risks and returns on the basis of broad
                                                                                        investment process. However, no such investable
     market exposures. In other words, investors put the
                                                                                        index exists for the remainder of the commercial
     characteristics of a particular asset class into a model
                                                                                        real estate market. As a result, investors in private
     to determine an appropriate allocation. Many asset
                                                                                        partnerships must be able to believe that their
     classes, such as domestic and international stocks
                                                                                        managers can consistently deliver returns that are
     and bonds, can be replicated to capture the market
                                                                                        not only above the median return for all private
     exposure, but specialized investments such as
                                                                                        partnerships but also above the index return for
     privately held commercial real estate do not yet offer
                                                                                        public REITs.

     6 We use REIT returns here because, unlike return data for private partnerships, REIT data are accurate and free of biases. Further, a REIT can be thought of
       as a publicly traded version of a private partnership or private investment pool. The investment managers invest in similar properties, with similar goals,
       objectives, and risks.

8
Figure 7.       The dangers of concentrated investment in commercial real estate

The distribution of five-year annualized returns for individual REITs, 1988–2010
 60%

 40%

 20%

  0%

–20%

–40%

–60%
         1993     1994     1995     1996     1997    1998     1999     2000   2001    2002   2003     2004    2005     2006    2007    2008     2009    2010

              25th percentile
              50th percentile
              75th percentile
              FTSE NAREIT All REITs Index

Source: Author’s calculations using data from FTSE/NAREIT and Morningstar.

Portfolio impact of equitized real estate                                            equities—a case that is reasonably strong. For
To evaluate the potential impact of real estate                                      example, the returns of most equities may be almost
exposure on a portfolio, we used the FTSE NAREIT                                     entirely explained by three key variables—the returns
Equity REIT Index to approximate the real estate                                     of the broad equity market, a size factor (large or
market. This presents an obvious challenge: We                                       small), and a style factor (growth or value). These are
have provided evidence to support the idea that                                      commonly known as the Fama-French risk factors.
commercial real estate is a separate asset class,                                    However, returns for REITs are only partially explained
naturally subject to asset-allocation decisions similar                              by these fundamental factors. In fact, the underlying
to those made for stocks and bonds. Further, we                                      real estate holdings constitute the largest single
believe that REITs represent the best opportunity for                                influence on REIT returns.7 It can be contended,
many investors to gain access to this asset class.                                   therefore, that investors gain access to the previously
The waters are muddied, however, because while                                       unavailable real estate market through REITs.
REITs represent exposure to a unique asset class,
they are in fact equities.                                                           Of course, while arguments can be made regarding
                                                                                     the utility of adding a unique REIT allocation to a
Because REITs are equities, to justify their inclusion in                            portfolio, investors must account for the fact that
a financial model as a unique asset class, investors                                 REITs are equities and as such are often contained in
must believe that REITs offer an exposure                                            their broad equity allocations.8 In fact, for many
fundamentally different from that provided by other                                  investors, this may represent the only commercial
                                                                                     real estate exposure required.

7 Separately we find that the Fama-French factors explain only 50% of REIT returns, leaving a large error term, likely representative of the real estate asset.
8 Investors with heavy allocations to active equity managers will be less able to control the total allocation to REITs, as the underlying managers themselves
  may be overweighting or underweighting REITs within their specific portfolios. In fact, a given strategic allocation is known for certain only if the entire
  portfolio is indexed.

                                                                                                                                                                  9
Overall, to advocate a specific allocation to REITs, an                            At a high level, the rationale for including non-U.S.
       investor must first believe that a broad REIT index                                real estate in a portfolio that already contains a U.S.
       fund or ETF accurately represents systematic                                       allocation to this asset class is similar to the
       exposure to commercial real estate. If the investor                                argument for combining U.S. and non-U.S. equities—
       does not believe that but still desires exposure to                                namely, increased diversification and the potential for
       commercial real estate, then an allocation to private                              lower volatility. For example, global diversification
       real estate requires confidence that the private                                   permits exposure to multiple property markets,
       manager will consistently produce returns above                                    business cycles, and interest rate regimes. Imperfect
       those achieved by the median private manager as                                    correlations across these markets would theoretically
       well as by the REIT index.                                                         lead to lower overall portfolio volatility.

       If an investor does accept that an index vehicle                                   Figure 8 reveals that as of December 2010, U.S.
       provides systematic exposure to the commercial real                                REITs accounted for only one third of the global
       estate market, then the investor must also be                                      equitized real estate market. By focusing solely on
       comfortable with potentially significant deviations                                U.S. REITs, an investor is actively excluding two
       from other real estate indexes in the short term                                   thirds of the global market from the real estate
       (Figure 5). And the investor must be confident that                                portfolio. It would therefore make intuitive sense
       the portfolio will benefit from exposure above that                                that a U.S. investor could obtain a diversification
       provided by the inclusion of REITs in the public                                   benefit from expanding the portfolio to include non-
       equity market. Assuming that these conditions hold                                 U.S. REITs.
       for certain investors, then an independent strategic
       allocation to real estate may be warranted. Such                                   The left panel of Figure 9, page 12, shows that
       strategic allocations to REITs should be based on                                  historically the U.S. REIT market has been
       specific risk and return objectives and constraints,                               imperfectly correlated to the non-U.S. real estate
       and portfolios should be periodically rebalanced to                                market. While correlations have been trending up
       those allocations.                                                                 since the early 2000s, the potential for diversification
                                                                                          remains as long as correlations are less than 1.10
       Looking beyond the United States
                                                                                          The right panel of Figure 9 reveals that, while the
       So far in this analysis, we have made the case for
                                                                                          impact to portfolio volatility has cycled between
       commercial real estate using benchmarks focused
                                                                                          higher and lower volatility, portfolios including both
       on the U.S. market. This is primarily due to the
                                                                                          U.S. and non-U.S. real estate exposure would have
       abundance of data in the United States and the
                                                                                          experienced lower average volatility than a portfolio
       relative lack of data globally. That said, a case can be
                                                                                          solely invested in U.S. real estate. This can be seen
       made that, as with equities and fixed income,
                                                                                          wherever the line in the graph dips below the x-axis.
       investors thinking about including a real estate proxy
                                                                                          It is notable that, despite the increasing correlations,
       in a broadly diversified portfolio should not limit
                                                                                          for much of the 2000s a portfolio that incorporated
       themselves to a focus on one country or currency.
                                                                                          global real estate exposure would have experienced
       Indeed, to the extent that global investment options
                                                                                          lower average volatility, even during the financial
       are available, a portfolio’s diversification may be
                                                                                          crisis of 2008.
       enhanced by including exposure to both U.S. and
       non-U.S. components.9

       9 Outside the United States, the most prevalent structure for equitized real estate companies is a real estate operating company or REOC. A REOC is similar
          to a REIT, except that a REOC reinvests earnings into the business, while a REIT distributes earnings to the shareholders. In addition, REOCs may be able to
          make more types of investments than REITs can.
       10 Interestingly, this is the same trend we have witnessed between U.S. and non-U.S. equities over the past decade (see, for example, Philips, 2011).
          However, the trend is stronger in the broad equity market than in the real estate market, suggesting a potentially greater diversification benefit from
          combining U.S. and non-U.S. real estate.

10 
Figure 8.          Makeup of the global real estate market                   Conclusion
                                                                               Commercial real estate is a unique and significant
S&P Global Property Index country weightings                                   asset class. Because of this, an argument can be
                     0       5       10      15     20      25   30   35%      made for its inclusion in a diversified portfolio. The
  United States                                                        33.8%   challenge investors face, however, is that unlike
     Hong Kong                             12.80%                              equities, fixed income, or commodities, the available
           Japan                          11.00%                               vehicles do not offer pure exposure to the asset
        Australia                    8.30%                                     class. Whether utilizing REITs, a collective trust, a
      Singapore                  5.00%
                                                                               separate account, or direct property ownership,
           China                 4.80%
United Kingdom                   4.30%                                         investors are only exposed to a small slice of the
          France                 4.20%                                         broad commercial real estate market. As a result,
         Canada            2.10%                                               real estate investors must be comfortable with the
    South Africa          1.60%
                                                                               potential for their investment to deviate significantly
    Netherlands           1.50%
            India         1.10%
                                                                               from the performance of that broad market.
        Sweden            1.10%
            Brazil        1.00%                                                For those investors who desire exposure to
     Switzerland          1.00%                                                commercial real estate and are indeed comfortable
          Austria         0.90%
                                                                               with the potential short-term risks, we have shown
          Taiwan          0.80%
      Philippines        0.60%
                                                                               that a broad REIT index can serve as an effective
       Germany           0.50%                                                 proxy for the real estate market. In other words, we
        Belgium          0.40%                                                 believe it is unnecessary for investors to incur the
       Indonesia         0.40%                                                 illiquidity, high costs, and manager risk of a relatively
            Israel       0.40%
                                                                               concentrated privately managed portfolio of
        Malaysia         0.40%
           Egypt         0.30%                                                 commercial properties.
        Thailand         0.30%
          Finland        0.20%                                                 Finally, while we have shown that REITs offer liquid,
   New Zealand           0.20%                                                 diversified, transparent, and low-cost exposure to
          Poland         0.20%
                                                                               commercial real estate, investors must be
            Chile        0.10%
       Denmark           0.10%                                                 comfortable with one last risk—the risk of a sector
          Greece         0.10%                                                 overweight. At the end of the day, REITs are
             Italy       0.10%                                                 equities, and as such are represented in most
    Luxembourg           0.10%
                                                                               broadly diversified equity funds. For example, as of
         Norway          0.10%
           Spain         0.10%
                                                                               December 2010, REITs accounted for just over 1%
          Turkey         0.10%                                                 of the broad U.S. stock market. The reality is that
                                                                               any additional allocation to REITs can represent a
Source: Standard & Poor’s. Data are as of September 30, 2010.                  significant overweighting of a potentially volatile and
                                                                               concentrated sector.

                                                                                                                                           11
Figure 9.        Historically U.S. REITs and non-U.S. real estate have been imperfectly correlated

       12-month rolling correlations between U.S. REITs                                         12-month rolling impact on portfolio volatility
       and non-U.S. real estate
       July 1990–December 2010                                                                  July 1990–December 2010
        1.0                                                                                       10%
        0.8
                                                                                                   5%
        0.6
        0.4                                                                                        0%
        0.2
        0.0                                                                                       –5%

       –0.2                                                                                                    Allocations to non-U.S. real estate
                                                                                                 –10%
       –0.4                                                                                                          20%             30%             50%
       –0.6                                                                                     –15%

              1991 1993 1995 1997 1999 2001 2003 2005 2007 2009                                          1991 1993 1995 1997 1999 2001 2003 2005 2007 2009

       Sources: Morningstar and Standard & Poor’s. U.S. REITs are represented by the S&P U.S. REIT Index. Non-U.S. real estate is represented by the S&P Global Ex U.S.
       Property Index.

          1.0                                                                                    0.10

          0.8
                                                                                                 0.05
          0.6

          0.4                                                                                    -0.00
          0.2

          0.0                                                                                    -0.05

         -0.2
                                                                                                 -0.10
         -0.4

         -0.6                                                                                    -0.15
             1/1/91
                 1/1/92
                     1/1/93
                         1/1/94
                             1/1/95
                                 1/1/96
                                     1/1/97
                                         1/1/98
                                             1/1/99
                                                1/1/00
                                                    1/1/01
                                                       1/1/02
                                                           1/1/03
                                                               1/1/04
                                                                   1/1/05
                                                                       1/1/06
                                                                           1/1/07
                                                                               1/1/08
                                                                                   1/1/09
                                                                                       1/1/10         1/1/91
                                                                                                          1/1/92
                                                                                                              1/1/93
                                                                                                                  1/1/94
                                                                                                                      1/1/95
                                                                                                                          1/1/96
                                                                                                                              1/1/97
                                                                                                                                  1/1/98
                                                                                                                                      1/1/99
                                                                                                                                         1/1/00
                                                                                                                                             1/1/01
                                                                                                                                                1/1/02
                                                                                                                                                    1/1/03
                                                                                                                                                        1/1/04
                                                                                                                                                            1/1/05
                                                                                                                                                                1/1/06
                                                                                                                                                                    1/1/07
                                                                                                                                                                        1/1/08
                                                                                                                                                                            1/1/09
                                                                                                                                                                                1/1/10

12 
References                                             Lee, Stephen, and Simon Stevenson, 2005. The
CB Richard Ellis, 2004. Property Investment Funds:     Case for REITs in the Mixed-Asset Portfolio in the
On the REIT Road?                                      Short- and Long-Run. Journal of Real Estate Portfolio
                                                       Management 11(1):55–80.
Center for International Securities and Derivatives
Markets, 2005. The Benefits of Real Estate             Lindahl, David P. Making an Allocation to Real Estate.
Investment: 2005 Update. CISDM Research                Kennedy Associates Real Estate Counsel, Inc.
Department.
                                                       Ling, David C., Andy Naranjo, and M. Nimalendran,
Cerulli Associates, 2011. The Cerulli Edge: U.S.       2000. Estimating Returns on Commercial Real
Asset Management. Research report, January.            Estate: A New Methodology Using Latent-Variable
                                                       Models. Real Estate Economics 28(2):205–231.
Chen, Jun, Susan Hudson-Wilson, and Hans Nordby,
2004. Real Estate Pricing: Spreads & Sensibilities:    Lizierie, Colin, and Charles Ward, 2000. Commercial
Why Real Estate Pricing Is Rational. Journal of Real   Real Estate Return Distributions: A Review of
Estate Portfolio Management 10(1):1–21.                Literature and Empirical Evidence. University of
                                                       Reading Working Paper No. 01/00.
Chen, Lijian, and Thomas Mills, 2004. Global Real
Estate Investment Going Mainstream. UBS Real           Mueller, A.G., and G.R. Mueller, 2003. Public and
Estate Research.                                       Private Real Estate in a Mixed-Asset Portfolio.
                                                       Journal of Real Estate Portfolio Management
Conner, Philip, and Youguo Liang, 2005. Income and     9(3):193–203.
Cap Rate Effects on Property Appreciation: Some
Guidance for Future Pricing Trends. The Journal of     Pagliari, Joseph L. Jr., and James R. Webb, 1995. A
Portfolio Management, Special Issue, pp. 70–79.        Fundamental Examination of Securitized and
                                                       Unsecuritized Real Estate. The Journal of Real Estate
Craft, T.M., 2001. The Role of Private and Public      Research 10(4):381–426.
Real Estate in Pension Plan Portfolio Allocation
Choices. Journal of Real Estate Portfolio              Pagliari, Joseph L. Jr., Kevin A. Scherer, and Richard
Management 7(1): 17–23.                                T. Monopoli, 2003. Public Versus Private Real Estate
                                                       Equities: A Risk-Return Comparison. The Journal of
Fisher, Jeff, David Geltner, and Henry Pollakowski,    Portfolio Management, Special Edition, pp. 101–111.
2006. A Quarterly Transactions-Based Index of
Institutional Real Estate Investment Performance and   Philips, Christopher B., 2011. Considerations for
Movements in Supply and Demand. MIT Center for         International Equity. Valley Forge, Pa.: The Vanguard
Real Estate. Available at web.mit.edu/cre/research/    Group.
credl/pdf/credl-wp-0601.pdf
                                                       Seiler, Michael J., James R. Webb, and F.C. Neil
Kaiser, Ronald W., 2002. Public REITs vs. Private      Myer, 2001. Can Private Real Estate Portfolios Be
Real Estate: Assessing Your Options. Bailard, Inc.     Rebalanced/Diversified Using Equity REIT Shares?
                                                       Journal of Real Estate Portfolio Management
Kapas, Manidipa, and Youguo Liang, 2010. A Bird’s      7(1):25–41.
Eye View of Global Real Estate Markets: 2010
Update. Prudential Real Estate Investors.

                                                                                                                13
P.O. Box 2600
                                                                               Valley Forge, PA 19482-2600

Connect with Vanguard® > vanguard.com

                                     Vanguard research >
                                     Vanguard Center for Retirement Research
                                     Vanguard Investment Counseling & Research
                                     Vanguard Investment Strategy Group

                                     E-mail > research@vanguard.com

                                     ETFs are not redeemable with an Applicant Fund
                                     other than in Creation Unit aggregations. Instead,
                                     investors must buy or sell ETFs in the secondary
                                     market with the assistance of a stockbroker. In doing
                                     so, the investor will incur brokerage commissions
                                     and may pay more than net asset value when buying
                                     and receive less than net asset value when selling.

                                     For more information about Vanguard funds, visit
                                     vanguard.com, or call 800-662-2739, to obtain a
                                     prospectus. Investment objectives, risks, charges,
                                     expenses, and other important information about a
                                     fund are contained in the prospectus; read and
                                     consider it carefully before investing
                                     CFA® is a trademark owned by CFA Institute.

                                                                               © 2011 The Vanguard Group, Inc.
                                                                               All rights reserved.
                                                                               Vanguard Marketing Corporation, Distributor.

                                                                               ICREECR 032011
You can also read