REITs: Effective exposure to commercial real estate?
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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.comWe 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.
2Public 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).
3Direct 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.
4ended 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
5Figure 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. 2010Figure 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
7gold 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.
8Figure 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.
9Overall, 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.
11Figure 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
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