By Sundaram Rajagopal
Demand for real estate continues to grow, with investors attracted to its diversification, positive correlation to inflation, and its status as a safe haven with lower downside than equities and many alternative investments. Private real estate delivered a 6.9% average annual income return from 2000 through 2010, and that stream remains attractive in a market environment where few investments deliver meaningful real rates of return.
The downside to private real estate remains its illiquidity. In the shadow of the financial crisis when many real estate properties had no buyers, investors are now demanding increased liquidity, which presents opportunities for innovative real estate solutions using publicly listed real estate equities.
Public real estate equities are a seemingly obvious solution. REITs have delivered an average annual dividend yield of 6% from 2000 to 2012. In addition, the overall returns to the asset class have been attractive, as well, with U.S. REITs producing an annual average return of 14.7% in that timeframe. But public REITs are significantly more volatile than both private real estate and than the broader equity markets. The Dow Jones US Real Estate Index (IYR) had a volatility of 24.1% from 2000 to 2012, compared with the 15.4% volatility of the S&P 500 in the same time period.
In addition to this higher risk, listed real estate securities do not appear to be a meaningful diversifier. The average correlation between IYR and the S&P 500 is more than twice the level seen between private real estate and the equity index, and this correlation has been steadily increasing for the past decade. As these correlations suggest, in exchange for this liquidity, the investor ends up holding a security that acts like the broader equity market. Many investors would welcome a solution that makes their liquid allocation to real estate look less like the broader equity markets and more like real estate.
To provide an investor with such a solution, one needs to understand the contagion risk embedded within REITs. Public real estate securities have exposure to other asset classes (in addition to equities) and stock market factors such as size, value and momentum1. For example, REITS are now more exposed to currencies as foreign ownership in U.S REITs has increased over time. Achieving the objective of providing an investor with a liquid real estate solution would require the mitigation of contagion risk from other asset classes and unrelated risk factors to create a return stream with lower volatility than popular listed real estate indices.
This, in turn, would require a holistic understanding of the various drivers of real estate prices and not just fundamental real estate expertise. Consider that REITS have stable dividends and yet have higher, not lower, risk than the broader equity market. This suggests that the source of higher risk is unrelated to the variation in profitability or dividends. If not changes in dividends or profits, what could cause capital to flow in and out of REITs creating significant volatility in prices? One explanation is that the change in prices is driven more by the fluctuations in risk premia investors demand to hold equities and REITs in particular. In a valuation or an asset pricing framework, these are reflected as discount rates used to value future cash flows. An understanding of both determinants of capital flows – variations in profitability and in risk premia - is thus critical to provide liquid solutions for investors interested in real estate.
There also exists the opportunity to extract alpha from mispricing in the real estate sector through a hedged long-short strategy. One reason for this opportunity is that there exists a scarcity of players with expertise in both real estate specific features, as well as public markets in general. Another reason is that many quantitative hedge funds often exclude real estate as an asset class due to its idiosyncrasies, and thus the sector does not benefit from the resulting sophisticated market making techniques. Additionally, typical equity analysts and portfolio managers examine real estate equities in the context of earnings models and do not fully exploit detailed real estate specific information and databases. A potential long-short real estate investment theme would be to take advantage of the relative mis-valuation within REITS driven by the difference in calculating and using prices versus real estate fundamental asset values. Evaluating such an investment theme reveals that, in an otherwise competitive equity market, listed real estate can provide significant arbitrage opportunities.
Any solution that provides investors with liquid real estate exposure will need to combine real estate specific expertise with valuation specific discount rate dynamics driven by liquidity, sentiment and capital flows. It is within the gulf between cash flows and discount rates, between private equity investors and yield chasing public investors that unexplored opportunities to provide liquid solutions for real estate investors exist. As public real estate is a less crowded sector, it provides a unique opportunity for managers to cater to this specific, and growing, investor demand.
Sundaram Rajagopal is a senior partner at Ada Investments, an asset management firm in New York.
1. Andrew Ang (Ada Partner) et al, “Search For A Common Factor in Public and Private Real Estate Returns”, 2013.