PWL Capital January 9, 2017 Advanced Investing Getting Real with Real Estate: Part I Is real estate an investment asset and how does it compare with stocks and bonds? Frequently we are asked to incorporate real estate as an investment asset when we develop retirement and estate strategies for clients. In this context, we are not just talking about the principal residence or cottage but income yielding properties. To include real estate as part of a portfolio of investable assets requires data on the expected return, the price volatility (or risk) and how real estate prices are correlated with other investments such as stocks and bonds. With this information, we can help the client decide a strategy for managing their real estate assets as part of their total wealth. As we will see, this is more complex than may first appear because of two characteristics of real estate: illiquidity and leverage. Unlike stocks or bonds, real estate does not trade on an exchange with transactions taking weeks or months, a source of illiquidity. Investment in real estate is often financed by mortgages, a source of leverage. We will consider two separate ways of investing in real estate: direct ownership1 and real estate investment trusts (REITS). Direct Ownership Single or multi residence housing, office, industrial or retail properties are examples of investment real estate that can be purchased outright or partly financed with a mortgage on the property. The investment return comes from rental income and capital appreciation. Potential costs include financing, maintenance, capital improvements and management costs. In the U.S., the National Council of Real Estate Investment Fiduciaries (NCREIF) constructs a property price index from data reported by its members every quarter. NCREIF returns, as reported, are adjusted to remove the impact of leverage. The main challenge is that reported NCREIF data is artificially smooth because of lagged appraisal values and infrequent reporting. Imagine how different stock ownership would appear if a stock exchange displayed prices only every quarter and those stocks prices were based on an average of surveys of stocks stretching over the past year. Under these circumstances, stocks prices would be perceived to move only slowly and appear a much less risky investment than in reality. To put the NCREIF data on an comparable footing to stocks and bonds the data must be “unsmoothed”. This unsmoothing process involves making assumptions about the lag in reported data and the underlying economic drivers. The impact can be dramatic: during the financial crisis, raw NCREIF returns reached a low of -8.3% in December 2008, whereas the unsmoothed return for the same period was -36.3%. With unsmoothed data it is possible to compare real estate returns with returns from stocks and bonds. A 2014 study reviewing the Norwegian Government Pension Fund used a statistical method (regression analysis) to get the best fit of the unsmoothed real NCREIF data (from June 1978 to September 2013) to stocks and bonds: R = -2.0 + 0.49s + 0.51b + error term Where R is the annual real estate return, s is the annual stock return (S&P 500) and b is the annual bond return (U.S. long term corporates). The explanatory power of this equation (as measured by the coefficient of determination) is limited to 24%, meaning that factors other than bond and equity returns make a significant contribution to real estate returns. This equation implies that, on average, real estate investments underperform an investment portfolio of 51% bonds and 49% stocks. Put another way, the investor needs sufficient skill, not possessed by other real estate investors, to overcome the 2% annual drag on returns to match the bond/stock investor. The error term is a measure of how far any specific real estate investment return may stray from this average. Many real estate investors own one or two properties rather than a large, diverse, real estate portfolio. In just the same way that there is wide variability between individual Canadian stock returns and the S&P/TSX, it would be unwise to assume a specific real estate investment is going to yield the return predicted by the regression equation above, especially over short investment periods. Despite these limitations, the model is useful for helping clients manage their total wealth portfolio, including real estate. An Inflation Hedge? One of the claimed benefits of owning real estate is that is a good hedge against inflation. The research evidence for this is, perhaps surprisingly, inconclusive. Direct real estate ownership provides some inflation protection (a correlation with inflation of 0.2-0.3) in the long term (5 years) but not in the short term. An alternative approach to understanding the returns and risks from real estate is from examining the performance of REITs and this will be discussed in Part II. 1 Unless indicated otherwise, much of the information in this blog is drawn from two sources: Asset Management: a systematic approach to factor investing, Andrew Ang (2014) and Expected Returns: An Investor’s Guide to Harvesting Market Rewards, Antti Ilmanen (2011). Share: Facebook Twitter LinkedIn Email
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