Competitive Risk-Adjusted Returns
Based on July 2018 data from the National Council of Real Estate Investment Fiduciaries (NCREIF), private market commercial real estate returned an average of 9.85% over the past five years. This credible performance was achieved, together with low volatility relative to equities and bonds, for highly competitive risk-adjusted returns.
High Tangible Asset Value
Unlike stocks, and to some extent, bonds, an investment in real estate is backed by a high level of brick and mortar. This helps reduce the principal-agent conflict or the extent to which the interest of the investor is dependent on the integrity and competence of managers and debtors. Even real estate investment trusts (REITs), which are listed real estate securities, often have regulations that mandate a minimum percentage of profits be paid out as dividends.
A key feature of real estate investment is the significant proportion of total return accruing from rental income over the long term. Over a 30 year period from 1977 to 2007, close to 80% of total U.S. real estate return was derived from income flows. This helps reduce volatility as investments that rely more on income return tend to be less volatile than those that rely more on capital value return.
Another benefit of investing in real estate is its diversification potential. Real estate has a low and in some cases negative, correlation with other major asset classes. This means the addition of real estate to a portfolio of diversified assets can lower portfolio volatility and provide a higher return per unit of risk.
The inflation hedging capability of real estate stems from the positive relationship between GDP growth and the demand for real estate. As economies expand, the demand for real estate drives rents higher and this, in turn, translates into higher capital values. Therefore, real estate tends to maintain the purchasing power of capital by passing some of the inflationary pressure on to tenants and by incorporating some of the inflationary pressure in the form of capital appreciation.
The Drawback: Lack of Liquidity
The main drawback of investing in real estate is illiquidity or the relative difficulty in converting an asset into cash and cash into an asset. Unlike a stock or bond transaction, which can be completed in seconds, a real estate transaction can take months to close. Even with the help of a broker, simply finding the right counterparty can be a few weeks of work.
The Bottom Line
Real estate is a distinct asset class that is simple to understand and can enhance the risk and return profile of an investor’s portfolio. On its own, real estate offers competitive risk-adjusted returns, with less principal-agent conflict and attractive income streams. It can also enhance a portfolio by lowering volatility through diversification. Though illiquidity can be a concern for some investors, there are ways to gain exposure to real estate yet reduce illiquidity and even bring it on-par with that of traditional asset classes.