Analysts Commentary

The Advantages of Dividend Growth Investing
March 27, 2017

Real estate as an alternative asset class

Background

After the credit crisis from 2008 asset correlations increased globally, giving fewer opportunities for portfolio diversification. Confirming the theoretical assumptions, when the systematic risk, also known as overall market risk increases and market values begin to quickly drop, the returns of different asset types start moving in tandem. Contrary to what a portfolio manager would want, after 2008 the correlation of foreign stocks, commodities and high-yield bonds to US domestic stocks is already quite above 0.5. Even investment-grade bonds are not to be in favor, due to the coming rate increases. To make it worse, equity returns might be constrained by the prolonged bull market and the expected lower global economic growth. This represents an opportunity for alternative assets, among which real estate investments.

Investment characteristics and risks

Traditionally alternative investments are not so popular among individual investors, but rather preferred by less risk-averse and more sophisticated investors such as institutional funds and foundations, which have set objectives to achieve specific target returns. Real estate in particular is less often a choice compared to traditional investments, such as stocks and bonds, due to several most important aspects:

  • Lower liquidity – real estate is illiquid, especially direct investments. Newly started projects take time to be completed and there can be many legal, town planning or purely commercial or financial obstacles until the product is ready. Still, there are some liquid options to invest, such as exchange-traded REITs;
  • Large deal size and complexity – compared to the possibility to trade small amounts in stocks or ETFs for example, real estate transactions are far more complex – there is a lot of due diligence involved. In addition, deal sizes are larger – for example, it is more difficult for an individual investor to buy an office building or a shopping center;
  • Generally higher transaction costs – the buyer would need to pay transfer tax, plus broker and legal fees. There is a strategy to balance this, such as structuring the purchase as a share-deal, instead of an asset deal;
  • Lack of transparency – information asymmetry is typical for real estate, meaning that the seller knows a lot more than the buyer;
  • Management-intensive – direct investments especially are not meant for the passive investor. A shopping center or a hotel for example, will need a hands-on approach in order to preserve and increase its value. However, investments in real estate have many benefits that allow meeting various investment objectives.

Benefits

  • Real estate can deliver returns similar to equity, which was recently evidenced by the return of the NCREIF Property Index, which is a quarterly, unleveraged composite total return for private commercial real estate properties held for investment purposes. For 2016 the overall return for 2016 was 7.97%, with industrial assets exceeding the average by far – 12.31%. What is more, historically, real estate returns have low correlation to the equity market;
  • It can provide a steady cash flow on an annual, but usually shorter-term basis. In a way, real estate can be viewed as a bond-like investment;
  • Real estate is known to be a natural hedge against inflation. It tends to appreciate with time and there is a logic behind it – take for example an office building leased at an average term of 5 years. Rental rates are usually indexed annually in the beginning of each year or at lease anniversary with some inflation-based index, thus increasing the capital value of the asset, all other things being equal;
  • It can be leveraged, thus enhancing returns – leverage is typical for real estate, very often existing assets are purchased or development projects are started at debt-to-equity of at least 60:40. Due to the leverage effect and the cost of debt lower than the cost of equity, the weighted average cost of capital for the project is decreasing. Along with the risks involved with the ability to serve the debt, such financing structures allow the developers to magnify their returns as they usually exit the project after 3-4 years when the property is assumed to be fully let;
  • Contrary to traditional financial assets, real estate properties are tangible assets. They can be seen and touched, and cannot disappear easily;
  • In addition, real estate includes multi-family residential, offices, retail, industrial, hotels, but also some other more exotic asset types – retirement living, student housing, healthcare, data centers, etc. Each of these alternative options comes with its own risk-return characteristics and deal sizes, making it suitable for various types of investors

How to invest

There are many options to be explored, depending on the type of the investor, their experience, objectives and specific investment circumstances. The investment vehicles used most often are:

  • Direct investment – as a single owner, or as a partnership and joint venture, often used to share the risk;
  • Participate in the project development funding – for more experienced investors;
  • Private real estate property fund;
  • Exchange traded options – REITs or stocks of development companies;
  • Commercial real estate debt, private or traded – able to meet objectives not only in terms of yield, but also risk reduction and portfolio interest rate diversification