A lesson in role play

The modern real estate investment arena has changed dramatically over the past 15 years in the US. Today, real estate investment can take the form of a debt or equity investment in either the public or private markets, as summarized by defining the four quadrants:

n Private equity - assets held individually or through an indirect fund

n Private debt - whole loans on individual properties

n Public equity - either a real estate investment trust (REIT) or real estate operating company (REOC) traded in the public equity markets

n Public debt - commercial mortgage-backed securities (CMBS)

Property is different from stocks and bonds, as it has both equity-like and debt-like characteristics. In the US since 1987, the correlation between real estate (defined as a weighted return across the four quadrants) and stock equity has been -0.05, and between real estate and the bond market, 0.35. Investors look to real estate to help to reduce portfolio risk, hedge inflation, and generate cash flows.

Real estate has not, from a strict total return perspective, outperformed stocks and bonds over the very long run. But it has enjoyed periods of superior returns, and it has performed better than other asset classes on a risk-adjusted basis.

Although a sizeable asset class, real estate has not historically been very accessible to many investors, nor has it been an easy asset class into which to allocate capital. In the past, several issues prevented it from becoming mainstream: a lack of pricing transparency and continuity, relatively high management costs, the size of investment required to control an individual asset, the specific risk associated with each individual property and, most notably, a lack of liquidity. Yet many of these issues have been ameliorated, at least in part, by the greater options available to investors today.

There are important differences among the vehicles used to invest in real estate, consisting of the four distinct quadrants. While US-based data has been used for this analysis, we believe many of the conclusions hold for European markets as well.


Defining the playing field

Underlying all the investment vehicles are properties themselves. An individual asset is a quasi-bond/quasi-equity hybrid investment. Leases provide investors with bond-like returns, affected by the credit of the tenant and interest rates. There are also options for equity returns through rental increases, the leasing up of empty space, and changes in the residual value of the building. Investors in real estate benefit from two distinct components of return: net operating income and value appreciation.

Net operating income comprises the occupancy rate of the building and the rent paid by the tenants, less the expenses involved in the management of the building. Appreciation is affected by movement in the capitalization rate and by the rents paid by the tenants. The combination of these characteristics makes real estate attractive to a range of investors and contributes to the differences among the quadrants.

Public and private debt and public and private equity comprise the quadrants of modern real estate investment.

In the past, private vehicles dominated the investment universe. Public debt and equity played a much smaller role until the real estate recession of the early 1990s, when distressed investors turned to the public markets for capital. Prior to that time, real estate had primarily been defined as private equity only, as the public markets were small and the private debt market was not very accessible to most investors.

Today, over 25% of the US real estate universe is traded in the public markets, while the comparable number is approximately 10% in Europe. On the equity side, over 200 publicly-traded REITs and REOCs allow investors to participate in the equity returns in portfolios exposed to a large variety of property types and geographic areas.

REITs are exempt from all federal taxation at the corporate level (although their dividends are still taxable) but are required to pay out at least 90% of all accrual-based accounting earnings. REOCs are not tax-exempt, but neither are they subject to these distribution requirements. On the debt side, the CMBS market carves up the cash flows from pools of mortgages to produce tranches with different credit ratings.

Chart 2 shows the evolution of real estate ownership over time. Particularly noteworthy is the shrinking share of private debt and the corresponding ascendancy of public debt in the overall investment pie. The reason for the shift is straightforward: public debt markets make sense. Securitization has created instruments that are more accessible, diversified, and suitable for disparate investors than large, lumpy commercial mortgages. In contrast, the expansion of public equity has been more muted. To be sure, REITs bring liquidity and transparency to equity investing, but they also bring volatility and management constraints, including short-term investment horizons and mandatory income distributions.


The lines are blurred

While there are four methods of investing in real estate, their investment characteristics frequently overlap. For example, the performance of each real estate quadrant is produced by a mix of equity-like and debt-like behaviours. At one extreme is the building fully occupied by a creditworthy tenant with a long lease. In this case, lease payments resemble a bond's cash flows, and the building's value is heavily influenced by factors that drive the price of debt, such as interest-rate movements, inflation, and the creditworthiness of the tenant.

At the other extreme is the empty, speculative, multi-tenant property. The value of that building is a function of equity forces, such as the economic cycle, real estate market conditions, and the property's location, visibility, and other features.

Most assets, however, reside not at one extreme or the other but somewhere along the debt/equity continuum. As the empty building is leased up, it evolves into more of a debt investment. Conversely, as the long-term lease ages, the residual value of the property at lease-end becomes increasingly important, and equity forces hold greater sway. A similar phenomenon can be found in debt, where CMBS produce more bond-like cash flows in the senior tranches and more equity-like cash flows in the subordinate pieces.

The connection between the private and public quadrants is clear from the number of individual assets that have moved, in both directions, in the debt and equity worlds, across the dividing line — especially recently. The experience of the 1995-97 period showed that publicly-traded REITs were the dominant competitors in the bidding for privately held real estate assets.

Now REITs are being privatized at a furious pace. At the same time, traditional lenders faced stiff competition for borrowers from the conduits that would lend and then securitize the mortgages. Public assets "go private" and private assets "go public" with increasing fluidity in a search for capital and relative value, encouraged by investors seeking ways to manage real estate portfolio risk.

So we can see that the quadrants are related to one another at an intuitive level, but how do they actually behave in practice?

It turns out that for all their theoretical similarities, each quadrant delivers markedly different investment results primarily relating to the methods of pricing in the market where they reside. The public equity quadrant offers the highest return, but it is also by far the most volatile, with annual returns ranging from 58% to -21% (see chart 3).

The private equity quadrant is more stable, consistent with its debt-equity hybrid nature. The private debt quadrant shows significant volatility during the high volatility/tight money era prior to 1986 but has since settled down.

The public debt market shows volatility little different from that of the more recent mortgage era, in part because the index captures all of the tranches' behaviors and not just the behaviors of the smaller, junior pieces.

The oscillations of each quadrant's performance differ not only in magnitude but also differ in timing (see chart 4). Public and private equity are actually negatively correlated! If you are an investor, you have to live with the reality of mark-to-market valuation and so have two distinct assets in your portfolio when you have public and private equity. They are not substitutes in a portfolio context. And even across public and private debt markets, where you would expect similar behaviour, the correlation is only 0.56. Across public and private and debt and equity, there is much room for portfolio management, with low correlations between private equity and public debt (0.42) and private debt and public equity (0.03).

So we have intuitive stories rationalizing the relationships between the four quadrants within the unified asset we call real estate. Yet the stark differences in the behaviors of these quadrants leave plenty of room for active portfolio management. Much as stocks are considered a different asset class than corporate bonds — though both investments have underlying ties to the performance of a pool of corporate firms — so the empirical data shows that real estate equity investments can perform quite differently than real estate debt. While the underlying drivers are one and the same, investors benefit by understanding and capitalizing on the different natures of each real estate quadrant.

Brett Wilkerson is CEO of Property Portfolio Research Inc. Kevin White is senior real estate economist at PPR.

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