Investors seeking solid income and low correlation to equity and fixed-income assets should not ignore the potential in investments that specialize in privately-held commercial real estate.
In the face of increasingly unpredictable financial markets, and the possibility of resurgent inflation and rising rates, the prospect of capital loss looms large in the minds of many income-oriented investors now.
Against that backdrop of concern, an allocation to real estate – which has historically behaved quite differently than stocks or fixed income – could represent a welcome opportunity for investors to further diversify their portfolios. Its striking lack of correlation to these traditional asset classes could prove especially attractive at a time when investors are concerned about short-term external events impacting long-term returns.
UNCORRELATED TO STANDARD INDEXES
Privately-held commercial real estate has the potential to be a valuable source of diversification in a portfolio primarily focused on equities and fixed income. Historical returns for the asset class have very low or negative correlations with US stocks and bonds. Academic and research has long demonstrated that, over the long term, adding uncorrelated asset classes to a portfolio of stocks and bonds enhances the portfolio’s mean-variance profile.
For investors focused on income, the low correlations of broad privately-held commercial real estate holdings with asset class indexes specifically related to income are of particular interest. Consider that for the 20-year period from 6/30/1996 to 9/30/2016, commercial property not traded on public markets (as represented by the NCREIF Property Index) was virtually uncorrelated with U.S. fixed income (as represented by Bloomberg Barclays U.S. Aggregate) and only very modestly correlated to equities (as represented by the S&P 500, Russell 2000 and MSCI EAFE Indexes).
Figure 1. Correlations: Real Estate and Selected Asset Class Indexes (Q2 1996 – Q3 2016)
Source: Bloomberg, MSCI, NCREIF, S&P, Clarion Partners Investment Research, Legg Mason, Q2 2016. Past performance is no guarantee of future results. An investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
DIFFERENT THAN REITS
In our view, a broad-based approach to real estate seeking sustainable income should focus on privately-held high-quality holdings, including well-leased apartment, industrial, office, and retail properties. A key aspect of investment management and selectivity involves effective property management, which can drive net operating income growth during economic expansions and stabilize asset cash flows in market downturns. Owning real estate in a form not directly affected by daily market swings can add an element of stability to returns as well.
In addition, diverse real estate collective investments can offer additional intra-class diversification because of its exposure to different property types, regions and metro areas, and industries. As an example, New York City’s office market is highly dependent upon financial services, while San Francisco’s office market is dominated by tech sector tenant demand.
The diverse nature of this type of real estate portfolio helps avoid one of the issues involved in investing in REITS, which tend to be much more focused on specific markets or types of properties. That explains why listed REITs tend to be more volatile than a well-diversified real estate program, and why there's low correlation with the NAREIT Index.
With low correlations to existing asset classes, real estate can offer the benefits of diversification in an environment where the correlations of other asset classes with each other might be elevated, to investors' detriment.