The use of listed alongside non-listed real estate can create considerable benefits for the investor, especially in the current climate, says Brad Case

Private and public real estate portfolios produce different expected returns, and using a blended portfolio of public and private real estate can enable institutional investors to achieve multiple goals. First, and most importantly, the within-asset class diversification opportunity means that investors with a blended portfolio can earn higher returns while reducing the likelihood of negative or low returns.

For example, institutional core property portfolios have produced unlevered gross returns averaging between 10% and 15% per year during nearly 37% of the three-year investment periods for which we have data, and have averaged between 5% and 10% per year during another 32% of three-year investment periods. The same core investments have produced negative returns during 9% of three-year periods, and returns averaging less than 5% during another 7% of three-year periods. Unlevered core property investments have never returned as much as 20% on average over a three-year period.

As figure 1 shows, equity REIT returns have averaged 20% or more per year during 29% of historical three-year periods; between 15-20% per year in 20% of periods; between 10-15% per year another 18% of the time; between 5-10% per year in another 20% of three-year periods; and have been negative during 6% of three-year periods.

A blended portfolio, however, has been much more likely to produce steady returns in the range of 10-15% per year. For example, a portfolio composed of one-quarter equity REIT investments and three-fourths institutional core properties has produced returns averaging between 10-15% per year in 36% of three-year periods, with returns averaging between 15-20% in another 24% of three-year periods, and between 5-10% another 25% of the time.

Investment objectives will vary widely, both by investor circumstances - risk tolerance, investment philosophy, and other assets already in the portfolio—and over time as beneficiary populations change. For example, an endowment or foundation with minimal distribution requirements, or a pension fund with a young beneficiary population far from retirement, can afford to accept more portfolio volatility and be rewarded with higher total returns. Conversely, a pension fund with an older population of beneficiaries in or near retirement, or a foundation with substantial distribution goals, must protect against portfolio volatility and be willing to accept lower returns.

The ease with which institutional investors can blend the real estate allocation between public and private markets makes it a much more valuable tool for meeting distribution goals than a portfolio confined to illiquid private real estate assets.

For example, taking the perspective of a risk-averse institutional investor, a real estate allocation invested one-quarter in equity REITs and three-fourths in institutional core properties has almost completely protected investors against negative returns, which have occurred during fewer than 1% of historical three-year periods. Investors seeking higher returns have been able to achieve them - while still protecting against losses - by deploying more to publicly-traded REITs: a portfolio with 35% of the real estate allocation invested in REITs has achieved 20%+ returns in 4% of three-year periods with no increase in the frequency of negative returns.

The value of a blended portfolio is even more evident when we look at long investment horizons. For example, since 1978, the entire period for which data are available, there has never been a five-year investment period during which a blended portfolio - even with up to half of its allocation invested in equity REITs - has produced negative returns. Blended portfolios with 35% allocated to REITs have still been able to achieve returns averaging at least 15% per year in 26% of five-year periods. (See figure 2.)

Another advantage of the publicly-traded REIT market is that, as a transparent and closely-watched window on the aggregate real estate market, it can provide investors valuable signals on how to deploy their real estate allocations. The premium or discount to NAV in the public (REIT) market also provides information about the private real estate market.

In particular, since 1990 an investor who bought stock in the average REIT during a month in which REITs were trading at a substantial discount (at least 10%) to NAV would have realised returns averaging 15.26% more per year over the next three years than an investor who had instead purchased the average institutional core property.
Conversely, during months in which REITs were trading at a substantial premium to NAV investors would have done better buying the average institutional core property, with returns higher by 4% per year over the next three years than for equity REITs. (See figure 3.)

Of course, a tactical asset allocation strategy works only because of three critical attributes of the equity REIT industry:

Liquidity: investors have the ability to buy and sell REIT stocks on a monthly or even daily basis; Transparency: REIT investments, and investment manager behaviour, are easy to monitor while the actions of private equity real estate managers are enormously difficult to monitor; REITs provide a closely watched window on the entire real estate asset class.

Over the past two years - and for perhaps another four years to come - investors will re-live the events of 1989-94, in the aftermath of the last severe real estate market downturn. This stage of the real estate market cycle provides the best possible vantage point to observe the value of a blended real estate portfolio.

During the past two years, just as in 1989-90, the coming weakness in commercial property values was reflected in equity REIT stock prices, while values and returns on the private side continued toward their peak and only recently began to decline. In the first quarter of 2009 the equity REIT market reached its bottom and then started its recovery, while the private side moved into the steepest phase of its decline. During that phase of the market, investors with a blended portfolio saw asset declines on the public side that were substantially moderated by their holdings on the private side.

In the second quarter of 2009 equity REITs began their recapitalisation in earnest with a surge in secondary equity offerings to more than $14bn (€9.8bn)- a phase in which private-side real estate investment managers will be unable to share.

In the coming months equity REITs will continue to strengthen their capital structures and to prepare for the coming wave of asset offerings prompted by debt maturities. During this phase of the market, it will be holdings on the public side that will moderate losses on the private side - losses that, for investors in highly leveraged private equity real estate funds, will be magnified by the massive amounts of debt taken on during the bubble of 2005-07.

Brad Case is vice-president, research and industry information, NAREIT