Commercial real estate (CRE) has long been used by institutional and high net worth investors to diversify their portfolios. Meanwhile, retail investors are searching – often unsatisfactorily – for income and diversification.
The global quest for yield is driving a long-term shift from conventional investments to alternative assets. As interest in alternative investments grows, private fund managers are introducing more liquid, income-generating CRE investments that offer individual investors compelling risk-adjusted returns. With market volatility rising and equity valuations at all-time highs, the strong yields and diversification benefits these new products can provide are highly attractive.
U.S. commercial real estate is the third-largest asset class after fixed income and equities. If investors to want to explore options that aren’t highly correlated with stocks and bonds, the $10.7 trillion commercial real estate market is one to consider.
As the real estate investment landscape becomes increasingly dynamic based on changes in the way people live, work and play, financial advisers can help their retail clients invest smartly by understanding the spectrum of new products coming to market.
Economic conditions positive for real estate
The U.S. economy has entered its longest-ever economic expansion, with annualized GDP continuing to grow at a slow and steady pace. That growth has been driven by consumer spending broadly, with e-commerce, clothing stores, restaurants and building-material supply stores seeing particularly strong gains. The unemployment rate is at an historic almost-50-year low, and wages continue to rise. Occupancies, rents and asset values have continued to rise with demand, and supply remains largely balanced in the industrial, multifamily and office sectors. While growth will likely moderate going forward, healthy macro-economic conditions and property fundamentals should continue to support privately-held CRE investment performance.
Benefits of investing in CRE
The potential primary benefits of investing in CRE are:
- Stable income supported by contractual payments from rents and leases,
- Attractive risk-adjusted returns with current income complemented by the potential for capital appreciation,
- Diversification because CRE often performs differently than stocks, bonds and publicly traded REITs over time,
- Wealth preservation, serving as a hedge against inflation and volatile public markets, and
- Tax advantages, especially in increasingly common traditional mutual fund structures.
Institutional investors have gradually increased their exposure to alternative assets; today they typically allocate 8%-10% of their portfolios to real estate, according to Prequin, a source of data on the alternative asset industry. In contrast, the average individual investor has just 3% in alts.
Given recent market volatility and positive but slowing growth trends, investors are increasingly gravitating toward investments with stable income that are not highly correlated with bonds and stocks. Although past performance is not a guarantee of future results, over the past 20 years, institutional-quality private CRE has outperformed traditional asset classes on an income return basis, generating 6% income returns while bonds and the S&P 500 delivered 3.8% and 1.9% income returns, respectively, according to the NCREIF Property Index history.
Moreover, there are historically low or negative correlations between private real estate, stocks and bonds. The correlation of the National Council of Real Estate Investment Fiduciaries (NCREIF) Property Index to the S&P 500 Index is 0.19% based on the 20-year period of 1999-2018. At -0.12%, it is negatively correlated to the Bloomberg Barclays aggregate bond index. Classic mixed stock/bond portfolios with at least 10% invested in CRE historically offer higher returns with less risk. The strong income yield and diversifying benefits that real estate offers can be very attractive for individual investors. Please note that diversification does not assure a profit or protect against market loss, and investors cannot invest directly in an index.
Urbanization, technology and demographics are driving change
Funds that specialize in CRE can offer appealing diversification across real estate sectors, enhancing opportunity. Socioeconomic factors impact supply and demand dynamics across all property types. Also, urbanization, technology and demographics are also driving changes to demand in virtually all property sectors:
- Warehouses: E-commerce-focused spaces in major distribution markets and regional population centers.
- Apartments: Live/work/play environments appeal to both Baby Boomers and Millennials.
- Offices: Efficient, transit-oriented spaces in urban and other walkable locations are desirable.
- Retail: Neighborhood and community grocery-anchored centers in trade areas with high incomes and strong population growth are favored.
- Other property types: Hotels, student housing, medical offices, self-storage, life sciences, etc.
Many CRE funds can also invest in real estate securities to enhance returns and offer increased portfolio diversification. These may include mortgage debt, mezzanine debt, publicly traded commercial- and residential mortgage-backed securities and other equity or debt securities issued by CRE-related companies or real estate investment trusts (REITS).
It's important to keep in mind that all investments involve risk, including loss of principal, and there is no guarantee that investment objectives will be met. Investment in real estate is for long-term investors who can tolerate limited liquidiity. Risks typically associated with real estate include but not limited to local, state, national or international economic conditions, including market disruptions caused by regional concerns, political upheaval, sovereign debt crises and other factors. Mortgage-backed or mortgage-related securities are subject to prepayment and extension risks.
Onay Payne is a Managing Director at Clarion Partners, a subsidiary of Legg Mason. Her opinions are not meant to be viewed as investment advice or a solicitation for investment.