Colin Lizieri: NBIM review provides valuable lesson for real estate investors

Much of the coverage of the recent reviews of the Norway’s sovereign wealth fund, Government Pension Fund Global, has focused on the apparent underperformance of real estate as an asset class – IPE Real Assets’s own headline was “Norway’s SWF finds no extra return from adding real estate after 10 years.” This seems somewhat strange: why would real estate be expected to generate higher returns than equities?

The principal justification for including real estate in the fund’s asset mix, as set out in the report produced by Martin Hoesli and I in 2006, as well as in subsequent studies, was that adding real estate should reduce the overall volatility of the fund and, hence, improve the risk-adjusted return. The return on a portfolio is just the weighted average of the individual asset returns and, given that the equity market has a higher expected return than directly held real estate, in substituting property for shares, one would anticipate lower returns. However, since real estate’s volatility is lower and because the returns of real estate and equities are not strongly correlated, the overall volatility of the portfolio should fall, increasing the risk-adjusted return. 

Norges Bank Investment Management’s (NBIM) December 2021 review for the Norwegian ministry of finance makes exactly these points. It shows that the volatility of real estate falls between that of equity and fixed-interest assets and, while confirming that real estate made a “negative contribution annually to the fund’s relative return”, notes that the fund including real estate produced about the same return but with lower volatility over the previous decade when compared to a hypothetical fund without real estate, improving the trade-off between return and risk. 

It also notes that, from 2017, returns on unlisted real estate had been better than the performance of the financial assets sold to fund acquisition. The negative stories, then, appear to be somewhat misplaced: unlisted real estate is performing as you would expect it to do in a portfolio, serving to diversify away risk and improve risk-adjusted returns.

The gains here, though, seem relatively modest and need to be set against the management costs and higher transaction costs of real estate. Unlisted real estate also brings measurement problems, with relatively low-frequency valuation-based performance measures contrasting with the high-frequency transaction-based data of the financial assets, along with tracking-error issues that make benchmarking problematic.

Unlisted real estate is, additionally, inherently illiquid, making portfolio rebalancing difficult – although one could argue that a sovereign wealth fund with a very long investment horizon should perhaps be less concerned with liquidity and could benefit from any illiquidity premia in the returns. Investment in listed real estate addresses the liquidity and rebalancing issues but does not bring the same gains in dampening volatility and diversifying risk – as confirmed in the NBIM review. 

There remains a problem for large institutional investors seeking to build a global unlisted real estate exposure – that execution of the strategy might result in a portfolio that is less than ideally diversified, reducing the potential gains in risk-adjusted returns. This effect is evident in the early stages of the Government Pension Fund Global’s real estate investment; the majority of investments were in prime offices, and to a lesser extent, shopping malls in large global cities. Even now, as the NBIM report makes clear, the unlisted real estate portfolio is heavily concentrated in New York, Boston, Washington, San Francisco, London, Paris, Berlin and Tokyo. Investment in logistics – via funds and joint ventures – is geographically spread, but this is a recent development. 

To an extent, such a concentration may be inevitable for a sovereign wealth fund. The need to place considerable capital without moving the market brings a focus on: the largest markets; concentrating investment to bring economies of scale; the need to find joint-venture partners with alignment of interest; and professional advisory and management services to focus investment.

There are behavioural factors here too. There is a widespread belief that global gateway cities provide better returns over the cycle and that the low cap rates of prime assets in those markets reflect lower absolute risk. Neither is supported by empirical evidence but are widely held and influence investor behaviour. 

There is an additional cost here, though, as my own research has shown. A focus on prime assets in global gateway cities reduces the diversification gains from building an international real estate portfolio. These markets are strongly interconnected – through networks of common ownership and occupier markets, and through linkages from the provision of debt. That office you own in Zurich may well be occupied by the same tenant in your office in London or New York. The owner of the office next to yours in Boston probably owns an office neighbouring yours in San Francisco. 

Moreover, these global cities are linked together by their global economic activity – much of which comes from the very financial markets whose assets you are seeking to diversify. Shocks in one market can be quickly transmitted to other similar markets, resulting in greater correlation of performance and, hence, less diversification.

The NBIM review, then, provides valuable lessons for all major global real estate investors. The good news is that real estate as an asset class has performed exactly as it is supposed to do, dampening volatility and improving risk-adjusted return. However, it shows that executing a global real estate investment strategy is more complex. Greater attention needs to be paid to where assets are acquired and what drives the performance and cash flow of those assets to ensure that diversification targets are fully realised.