Institutional Allocation to Real Estate - An Evolving Landscape

Institutional Allocation to Real Estate - An Evolving Landscape

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  Skyler MacGowan, 250634552 Geography4460 Term Paper Due April 5th , 2016 Institutional Allocation to Real Estate – An Evolving Landscape Table of Contents Executive Summary……………...………………………………………………………..1 1.0 Preface………………...…………………………………………………………….....2 2.0 Factors Behind the Increased Institutional Allocation to Real Estate…..……………..3 2.1 Macro Environment – Changing Interest Rates……………………………….4 2.2 Increased Demand for Assets of Offering Stable Income Growth……………5 2.3 Increase Returns……………………………………………………………….5 2.4 Structural Changes in the Real Estate Investment Environment……………...7 3.0 Real Estate Allocation Between Types of Institutional Investors..………….………..8 4.0 The Future Role of Real Estate in Institutional Portfolios……………………………9 4.1 Conclusion…………………………………………………………………...10 Bibliography……………………………………………………………………………..12
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  1 Executive Summary This paperexamines some of the reasons behind the significant increase in institutional allocation to real estate investments that has occurred since the early 1980s. I also analyse whether this increase has been observed homogenously across all types of institutional investors. Finally, I consider the future role of real estate assets in institutional portfolios. While traditional reasons for investing in real estate (diversification, inflation protection, and liability matching) remain important, four other factors have played a major role in contributing to the increased institutional portfolio weightings towards real estate investments. These are: 1) Decreased interest rates 2) Increased need for current income 3) Increased availability and interest in opportunistic real estate investments 4) Structural changes in the real estate investment environment There have been significant disparities in the extent to which real estate allocation has increased among specific types of institutional investors. Real estate allocation is highest in pension funds where it constitutes approximately 20% of their asset mix. Conversely, smaller institutional investors (family offices and wealth managers, for example) typically allocate much less to real estate. The reasons for these disparities are primarily due to the variances in investment objectives, risk tolerance, and capital accessibility among different types of institutional investors. Most literature suggests institutional allocation to real estate will continue to increase in the future, albeit at a somewhat lesser pace due to the expected rise in interest rates. Although precise predictions are difficult, most commentators forecast real estate will constitute 15-20% of institutional portfolios by 2030, with some recent estimates in the range of 20-30%.
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  2 1.0 Preface Since the1980s, there has been a consistent trend of increasing institutionali allocation to real estate investments (Figure 1). Specifically, over the past 35 years institutional allocation to real estate has increased from just 2.1% in 1980 to 8.8% in 2013, reaching about 11% by 2015.1 What are the reasons behind this change? Have they been observed homogenously across all types of institutional investors? Will this trend continue going forward? Through a review of recent literature, this paper strives to answer these questions and in so doing provide insight into an asset class that is playing an increasingly important role in the global investment climate. Figure 1: Asset Allocation of All Institutional Investors Since 19802 i In this paper, reference to “institutional investors” refers to those investors in a North American context.
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  3 2.0 Factors Behindthe Increased Institutional Allocation to Real Estate The historic rationale for investing in real estate centered upon diversification as a means of improving risk-adjusted returns, inflation protection, and matching long-duration liabilities with future cash inflows.3 While these traditional benefits to real estate investment endure, as demonstrated by Figure 2 they are not presently the most important reasons why institutional investors invest in the asset class. Therefore, they are not the focus of this paper. Instead, I examine the top three current reasons institutional investors are investing in real estate and how these factors have contributed to the increased institutional allocation to real estate that has taken place since 1980. Figure 2: Current Motivators for Institutional Investors’ Allocation to Real Estate1
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  4 2.1 Macro Environment– Decreased Interest Rates Bond yields have decreased substantially in the past two decades, with current rates being approximately one-third of what they were at the turn of the twenty-first century (Figure 3). As a result, bonds as an investment class are no longer able to keep pace with institutional investors’ liquidity needs, forcing them to look elsewhere for sources of current income. The predictable long-term income streams from the contractual revenues obtained through real estate investment have proved a viable substitute for the income lost through decreased bond yields.4 Additionally, the availability of cheap debt facilitates real estate development, meaning that there is an increasingly wide-array of opportunities available to real estate investors in this low interest rate environment.1 As Figure 4 illustrates, rising interest rates would significantly impact the investment strategy of the majority (59%) of institutional real estate investors. This implies that just as decreased interest rates have contributed Figure 3: Falling Bond Yields4 Figure 4: Effect of Interest Rates on Institutional Allocation to Real Estate1
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  5 significantly to increasesin real estate investment, the anticipated rise in interest rates could decrease investors’ enthusiasm with this asset class going forward. 2.2 Increased Demand for Assets of Offering Stable Income Growth The problems associated with the decreasing yields from fixed income investments are compounded by the increasing liquidity requirements of institutional investors, particularly pension funds.4 Their increasing liquidity requirements have been driven largely by the growing number of retirees drawing on accrued pension liabilities due to the ageing population typical of most developed countries.5 Of particular concern are the liabilities associated with the Baby Boom generation (ages 52-70), the majority of whom who will retire in the next 10-15 years.5 Also, as the most recent financial downturn in 2008 is still in recent memory, the presence of a stable income stream to weather future market cycles is a priority for institutional investors.4 2.3 Increase Returns As mentioned, one of the major reasons traditionally cited for making an allocation to real estate was the diversification it provided. Essentially, real estate’s reduced cyclicality relative to bonds and equities meant that it was perceived as a safe investment, effective in increasing a portfolio’s risk-adjusted return.3 While real estate’s diversification benefits endure, today’s institutional investors also appreciate the asset class’s ability to provide well-rewarded opportunistic investments. Indeed, as illustrated by Figure 5, institutional investors in real estate currently favour value-add and opportunistic investment strategies over core investments.
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  6 When making value-addand opportunistic investments in real estate, investors strive to capitalize on three main types of premiums. The increased willingness of current investors to take these risks is due in large part to the significant reduction in rates of return on alternative investment classes that has occurred since 1980.1 1) Illiquidity: The illiquidity of direct real estate investment relative to publicly traded securities provides a strong risk premium.1 2) Emerging Markets: The increasing integration of global capital markets means that current real estate investors have access to a wide-array of high-risk investment opportunities in emerging markets that were previously unavailable.1 3) Asset Mispricing: For a few different reasons (i.e. appraisal smoothing, fewer listed transactions relative to bonds and equities), pricing errors of real estate assets are relatively common.6 These pricing errors provide an opportunity for astute real estate investors to take a risk on what they perceive to be an undervalued asset.1 Figure 5: Risk Tolerance of Institutional Investors for Real Estate Investments2
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  7 2.4 Structural Changesin the Real Estate Investment Environment Real estate’s rise in institutional portfolios has been enabled largely by the lifting of various barriers to investment in the asset class.2 Some of these historical barriers include an inadequate regulatory framework surrounding real estate investment, a relative lack of transparency and liquidity, as well as limited investment vehicles available to access possible real estate investments.2 With time however, various developments have significantly reduced these barriers and doing so has played a major role in the increased institutional allocation to real estate that has occurred since 1980.2 Some of the key developments that have increased the accessibility to real estate investments include: 1) 1982: Creation of the National Council of Real Estate Investment Fiduciaries (NCREIF). NCREIF launches its index of institutional real estate returns, providing a critical institutional benchmark.2 2) 1986: To address real estate’s role as a tax shelter, targeted tax reform creates an even playing field for tax-exempt (institutional) investors.2 3) Late 1980s and early 1990s: Creation of real estate opportunity funds in the late 1980s show the strong investment returns available through real estate. As a result, there is a proliferation of comingled real estate funds in the 1990s, increasing institutional accessibility to the asset class.7 4) 1992: Beginning of rapid growth in the equity REIT market, as decreased debt availability caused by the 1986 tax reform led many owners to public markets for their capital requirements.2 The rise of REITs permitted smaller-cap investors to invest in real estate, further increasing the asset class’s accessibility.
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  8 5) Early 2000s:Rise of third-party real estate data providers (i.e. CoStar, Real Capital Analytics) results in increased data availability and research into the asset class.2 6) 2010-Present: Maturing of sovereign wealth funds, helping stimulate continued growth of global capital flows to real estate investments.2 3.0 Allocation to Real Estate by Type of Institutional Investor As demonstrated by Figure 6, the increasing institutional allocation to real estate has not been observed homogenously across the different types of institutional investors. The primary reason for these differences is due to the variation in investment objectives and risk tolerance of different institutional investors.3 For example, while the steady source of income generated by real estate investments is highly valued by pension funds, this Figure 6: Allocation to Real Estate by Type of Institutional Investor3
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  9 characteristic is notnearly as important for the typical wealth manager looking to maximize capital appreciation. The different investment objectives of institutional investors are also illustrated by the specific type of real estate investment they prioritize. For example, as pension funds really value the income stream generated by real estate they invest primarily in core assets.8 Conversely, endowments are more concerned about maximizing their returns and hence allocate more to value-add and opportunistic real estate investments.8 Also, although the accessibility of real estate investment has increased significantly in recent years, many real estate investments still involve very significant capital expenditures that are only accessible to the largest institutional investors.8 This is reflected in Figure 6 which shows real estate allocations are generally highest among the largest institutional investors (i.e. pension funds, foundations, and endowments) and lowest among the smaller ones (i.e. family offices and asset managers). 4.0 The Future Role of Real Estate in Institutional Portfolios As discussed, the majority of institutional investors indicated that a rise in interest rates would significantly influence their allocation to real estate investments. Therefore, some analysts predict the expected rise in interest rates that will occur as central banks stop flooding markets with liquidity in the wake of the financial crisis will decrease the current enthusiasm for real estate investments.9 Also, there is speculation that the increase in competition for real estate assets will soon start to reduce the asset class’s upside potential.9 Essentially, the argument is that the significant increase in real estate investment that has taken place over a relatively short time period has resulted in an
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  10 overly optimistic perceptionof the asset class, not reflective of its underlying fundamentals.9 Despite these arguments, most researchers predict institutional allocation to real estate will continue to increase in the foreseeable future.9 Although interest rates are expected to rise, the general consensus is that such growth will be relatively modest, with rates of return on fixed income investments unlikely to come close to pre-2000 levels anytime soon.4 Furthermore, to the extent fixed income yields do go up, so too will the demand for the inflation protection capability provided by real estate. Also, the opinion that there is an overly optimistic perception of real estate assets is not widespread. Indeed, most literature finds that if anything, real estate assets continue to be undervalued because despite recent improvements there is still relatively little information on real estate assets compared to bonds and equities.6 4.1 Conclusion The ongoing increase in accessibility to pursue higher-risk real estate investment opportunities in emerging markets is likely to continue in the foreseeable future.4 Therefore, the trend of institutional investors allocating capital to the asset class for its upside potential is likely to continue.4 Additionally, even with a rise in interest rates, ageing populations in most developed countries will cause institutional investors (especially pension funds) to continue to invest heavily in real estate for its predictable income stream.9 As a result, institutional allocation to real estate assets is likely to continue to increase going forward, although perhaps at a lesser rate due to the expected rise in interest rates.
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  11 Indicative of this,recent studiesii predict institutional real estate allocations of 20-30% by 2030, with more conservative estimates suggesting real estate allocations of 15-20% by that time.9 Also, due to their differing investment objectives and risk tolerance, future real estate portfolio weightings will likely continue to vary significantly depending on the specific type of institutional investor. ii For example, in its 2013 study entitled “Real Assets: The New Essential”, Brookfield Asset Management writes, “we expect this trend (towards increasing real estate allocation) to accelerate materially over the course of the next decade, with allocations to real estate reaching 20% to 30% of portfolios by 2030, with some institutional investors allocating upwards of 50% to the asset class.”3
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  12 Bibliography 1) BlackRock, Incorporated.(September 2014). The Ascent of Real Assets: Gauging Growth and Goals in Institutional Portfolios. New York, NY: McCombe, M. Botein, M. Sperber, M. Barry, J. 2) Commercial Real Estate Development Association. (Spring 2015). Real Estate Takes Its Place as the Fourth Asset Class. Cornell University. Ithaca, NY: Funk, D. 3) Kennedy Associates Real Estate Counsel, Inc. (2002). Making and Allocation to Real Estate. Toronto, ON: Lindahl, D. 4) Brookfield Asset Management. (2013). Real Assets: The New Essential. New York: NY. 5) Congress of the United States, Congressional Budget Office. (2003). Baby Boomers’ Retirement Prospects: An Overview. Purdue University. Holtz-Eakin, D. 6) European Business School. Real Estate Risk in Equity Returns, Empirical Evidence from US Stock Markets. Wiesbaden, GER. Gaston, M. Johanning, L. 7) Higgins, D. (2007). Comingled Four Quadrant Property Funds: Creating an Investment Framework. University of Technology, Sydney. 8) Massachusetts Institute of Technology. (2011). Alternative Investment Opportunities in Real Estate for Institutional Investors. Harper, J. 9) PricewaterhouseCoopers. (2016). Emerging Trends in Real Estate: Canada and the United States. Washington, D.C. Kelly, H.