In spite of recent market developments the case for both private and public real estate remains strong. They continue to complement other asset classes, although investors may be limiting scope. Timothy Bellman reports

Investors have increasingly come to accept the positive role real estate, in either the listed (public) or unlisted (private) form, can play in improving the risk-adjusted returns in a multi-asset portfolio. But with real estate at the heart of the credit crunch, how strong is that case now? What does pricing in listed real estate markets indicate for unlisted real estate? Will the experience of the UK be repeated in other markets in 2008-09? In current challenging market conditions, what role should real estate play in a portfolio?

Despite the onset of the credit crunch, unlisted real estate delivered another year of strong performance in 2007, in some cases a very strong performance. We believe it is likely to be the last in a sequence of very good years. In four of the five of the major markets with long-term performance indices in private real estate (figure 1), unlisted real estate was the best performing major asset type, outperforming equities and bonds. In contrast, in the same five markets unlisted real estate was the worst performing major asset class.

What does this tell us? Importantly it highlights that the listed real estate markets picked up and quickly priced in the emerging dislocation in the credit markets (with the effects magnified by the leverage within the vehicles). Taking its cue from nervousness in general equities markets, declines in the listed real estate market signalled the likely ramifications for unlisted real estate of a general re-pricing of risk - both an adverse movement in yields and cap rates and concern that real estate market fundamentals would weaken as the economic outlook deteriorates.

In 2007 the strong performance of private real estate worldwide occurred despite global financial turmoil, the housing crash in the US and growing fears of recession around the world. Of course, the private real estate performance indices are widely known to lag the indices of other asset classes due to illiquidity and the need to use appraisal-based valuations to determine value rather than a more immediate market-based process of price discovery. With transaction volumes sharply lower and debt hard and expensive to secure, a correction is now likely also underway in unlisted real estate capital values.

Much has changed in the last year. An economic slowdown, verging on recession in some key global economies, is upon us. The UK real estate market UK has been the most affected to date. Do listed real estate returns of -36.3% and unlisted real estate returns of -3.4% in 2007 point the way for other major real estate markets (figure 2)? Or is the UK somehow different? The answer is probably a little bit of both.

On the one hand, real estate in the UK appears to have been amongst the most highly priced worldwide. It also has a significant number of open-ended retail funds, which needed to sell properties quickly, often at sharply lower prices in order to meet redemption demands. Information is timely and widely available. The publication by IPD of monthly performance indices is rare outside the UK. The widespread practice of quarterly valuations of assets enabled valuers quickly to reflect emerging market conditions, even where few open-market transactions were taking place.

The correction in unlisted real estate market indices that started in the UK in 2007 will likely continue in the UK in 2008. It will almost certainly spread to other parts of the world, but not universally and to varying degrees and times.

Over the last 18 years, where the UK has led, others have followed. In general terms, performances in several other major real estate markets have followed the UK with a lag of about 12 months (figure 3). This is especially the case for Australian returns (0.86), US returns (0.77) and Canadian returns (0.69). The Netherlands is not significantly correlated (0.22).

Has the credit crunch revealed real estate to be a more risky asset class than previously thought? The risk-return profile of an asset class is one of the most fundamental characteristics in devising any allocation. Private real estate has been a consistently strong performer in terms of risk-adjusted returns in the five major countries where long-term (18-year average) performance indices are available. Even though this period includes the deep downturn of property returns in the early 1990s and excludes the period of high real estate returns preceding it in the late 1980s, it performs well. For these five countries, private real estate exhibits bond-like risk profiles on average over that long-term period, yet returns were higher in most of them (figure 4).

Selected shorter periods within those 18 years support the idea of relatively high returns from private real estate with a stable level of risk compared with other major asset classes. Public real estate exhibits higher returns than private real estate for three of these five countries but with a level of risk more closely approximating to equities than to private real estate. The higher volatility of both equities and public real estate suggests they can be added to global portfolios in periods of upturn in order to gain higher returns for shorter periods, but would likely best be underweighted in periods of downturn.

In addition to the attractive risk-adjusted returns offered over the long term, real estate can help to diversify a mixed asset portfolio. Diversification in asset allocation is recognised as an important way to mitigate risk in mixed asset portfolios - both within countries and across them. Within the five countries considered, private real estate shows in general terms low or negative correlation with other asset types (figure 5). Interesting to note is that the correlation is especially low or negative between unlisted real estate and bonds in all five of these countries.

So, is there room for private and public real estate in a portfolio at different levels of risk? Using the US for illustrative purposes, the favourable risk-adjusted return of real estate provides room for the asset type at different levels of risk (figure 6). On an unconstrained basis, real estate would garner a large share of any portfolio at all risk levels. Realistically however, most investors will consider bonds and equities a key component that would demand large allocations. This constrained optimisation model allocates large percentages to bonds complemented by private real estate at low risk levels and equities complemented by public real estate at higher risk levels. As a general rule, as risk appetite increases, the share of private real estate decreases in favour of public real estate.

Investing cross-border is a widely accepted strategy to diversify risk. But how useful is it? The theoretical case is that while capital markets are increasingly global, real estate fundamentals essentially remain driven by local demographic, economic and real estate factors. Occasionally these may become aligned (when global events affect all markets) but mostly there are marked regional and local variations. The case appears to hold over the longer term. Real estate shows less significant and generally lower correlations among countries than the other asset types (figure 7) over the long term.

Selected private real estate markets do exhibit very high correlations in some cases. US and Canadian private real estate returns have been very highly correlated over the 18-year period of study (0.91), which makes sense geographically. But US and Australian returns are also correlated (0.89). UK and Dutch public real estate returns are the most correlated of these five countries within that asset class (0.87).
What might be the allocation of an international investor considering any asset type globally? An investor considering cross-border real estate investments would probably have already ‘gone global' with bonds, equities and possibly public real estate earlier. If we choose the best property type in terms of risk-adjusted returns for each of the considered countries, among the other asset classes, we can calculate the optimal allocation for the portfolio figure 8).

There is a broad pattern of heavier private real estate and bonds in the allocations at the lower end of the risk return spectrum. Higher allocations go to public real estate and equities further up the risk return spectrum. There should be diversification and performance benefits in a global strategy for investors from all countries. The efficient frontier in this model of cross-border allocation is better than that in figure 6, thus strengthening the case for global real estate. It suggests that the global case for real estate is even stronger than the case for real estate at the national level; a global portfolio being more than just a sum of the parts.

Several decades have now passed since institutional investors began allocating to real estate. However, a new set of challenges now faces real estate, affecting all asset classes. The most recent four-year period, which ended in 2007, will likely go down in history as a truly golden era of exceptionally high returns for real estate both public and private. The middle of 2007 represented a turning point for investment markets everywhere as investors began to reassess their attitude to risk. Real estate investors will be watching carefully to see if where the UK leads others follow, as has been the case often over the past 18 years.

Real estate returns are likely to be lower than in the recent past but the case for holding real estate for the long term in a multi-asset portfolio still stands. Over the long term, we believe real estate delivers favourable risk-adjusted returns at all levels of risk and offers diversification (especially when international) to a multi-asset portfolio.

Timothy Bellman is global head of real estate research and strategy, ING REIM