The Advisor’s Guide to Commercial Real Estate Investment

Index

Introduction

Commercial real estate has been increasingly recognized as an attractive asset class by institutional investors because of its high cash flow stream, diversification benefits, and potential to hedge inflation. Real estate is a broad asset class with numerous ways to invest that vary greatly in terms of their key drivers and risk/return profile. Each method of real estate investing is unique on its own merit, and suitability depends on individual investor preferences.

Broadly speaking, the universe of commercial real estate investment opportunities can be divided into four categories based on whether the properties are held in public or private market vehicles and whether the investment structures are equity or debt. This Four Quadrant Model, as shown in Figure 1, illustrates the range of real estate investment opportunities available to investors today.

SOURCES: Cole Real Estate Investments, ULI’s Emerging Trends 2011.

Figure 2 illustrates the approximate value of each quadrant.

In each strategy, the fundamental revenue source is the rent paid by tenants who occupy commercial properties. This income is augmented by the potential capital appreciation of the asset, realized at the time of sale. Private-equity investment involves the purchase and management of commercial buildings including office buildings, industrial warehouses, multifamily apartment complexes, hotels, and retail shopping centers. This investment may be made through other private equity vehicles. Public equity investment involves the purchase of shares in publicly traded REITs and real estate operating companies (REOCs). Private debt investment includes the origination and acquisition of senior debt (whole mortgages) on commercial properties. The public-debt market includes the origination and trading of commercial mortgage-backed securities (CMBS).

SOURCES: Cole Real Estate Investments, ULI’s Emerging Trends 2011.

The four sectors can be differentiated by their relative risk and return profiles, as shown in Figure 3. Debt assets provide a senior claim on future rents at a specified rate over a specified period. They sacrifice some potential return in favor of stability. Equity investments, on the other hand, carry higher risk because the claim on future cash flows is subordinate to the debt position. The benefit of the equity position lies in an enhanced ability to control the property through active management and to benefit from the growth of future rents and property appreciation. Over the past ten years, equity investments have generally delivered higher returns and volatility than debt investments, consistent with their lower priority in the capital stack.

The debt markets have evolved to provide an increasing number of sophisticated financial products to investors. Public-debt investing, predominantly in the form of CMBS, emerged as a strong global trend beginning in the early 1990s. The liquidity provided by trading CMBS in a public market, as well as the ability to securitize large income streams and tranche loans into various risk profiles, helped make CMBS an increasingly attractive investment opportunity, although upheaval in the capital markets in 2008 and 2009 severely impacted the origination and values of CMBS. During this period private debt, which for many years was the primary vehicle for commercial debt investment, took on an increasingly prominent role. Figure 4 illustrates the relative risk and liquidity characteristics of some of the major types of commercial real estate investment vehicles.

In this book, we take a deep dive into real estate and its multiple components and investment options. In Section 1, we talk at a higher level about why real estate is a viable asset class and follow with various investment strategies. In Section 2, we discuss private real estate in depth with an analysis of potential returns, private equity, property types, international real estate, and green real estate. In Section 3, we discuss public real estate including REITs (both listed and nonlisted) and international markets. In Section 4, we conclude with advanced real estate topics including a detailed analysis of cap rate changes over time and risks/returns. We expect that after reading this book, advisors and their clients will have a better understanding of commercial real estate, its various components, and the benefits of investing in this asset class. We also expect that the readers will better understand the suitability of various investment strategies and options for their own portfolio.

Section I: Why and How to Invest in Commercial Real Estate

Chapter 1: Why Real Estate as an Investment

Chapter 1 underscores the principle that there are several different ways of investing in commercial real estate and each method is unique in terms of the key drivers and variability in returns. Commercial real estate investing as a whole provides benefits that include a large investable universe, income returns, low volatility, diversification for a broad portfolio, and inflation hedging—all of which are described in detail. Finally, we discuss commercial real estate investing in the context of a diversified investment portfolio to show how risk-adjusted returns can be improved.

Chapter 2: Commercial Real Estate Property Types

Chapter 2 provides the reader with an overview of the major commercial real estate property types (office, multifamily, retail, industrial, and hospitality) and several niche sectors (student housing, senior housing, self-storage, single-family housing, data centers, and farmland). We examine current market dynamics and relevant trends for each of the property types. We also provide the recent macro-economic context for assessing the commercial property market, generally.

Chapter 3: Investment Products and Strategies

Chapter 3 breaks the realm of real estate investing into categories based on whether the properties are held in public or private market vehicles and whether the investment structures are equity or debt. All four types of investment have different expected return and risk characteristics. Some key investment types that fall into these categories include private equity, commingled funds, private entity-level investments, public-equity real estate securities, whole mortgages, mezzanine loans, CMBS bonds, unsecured REIT debt, unsecured portfolio-level debt, and mortgage REITs. The chapter goes on to discuss more advanced strategies and give an overview of key real estate investment styles (core, core-plus, value-add, and opportunistic) and their associated risk/return profile.

Chapter 4: Tax Considerations for Real Estate Investments

Chapter 4 explains the taxation concepts that both generally and in particular affect real estate investments. Traditionally, the objectives of investment in real estate have been income and appreciation in the value of the property. In addition, there can be attractive tax advantages: tax deferral for several years; eventual conversion of ordinary income into capital gain; and, with certain kinds of real estate investment, immediate or continuing tax savings through tax credits. This chapter moves from such general tax considerations through those that impact specific types of real estate investments, including REITs.

Chapter 5: Choosing an Advisor

Chapter 5 explains why it is important for an investor to perform due diligence with respect to real estate investment advisors and also includes a rather detailed list of due diligence topics. Assessing advisor operations is time consuming, and many investors or wealth managers are not staffed appropriately to perform a thorough review. Therefore, the chapter presents a menu of topics and issues, and investors can prioritize the topics according to their investment goals and can determine their own preferences on depth and processes. A summary of the due diligence topics covered and a checklist are presented at the end of the chapter.

Section II: Private Real Estate

Chapter 6: Private Real Estate

Chapter 6 describes some of the critical characteristics of private-equity real estate. It outlines how to invest in private equity, presents some of the most common indices investors can use to benchmark their property performance, discusses potential returns and risks associated with this asset class, and addresses what the future might hold for private-equity commercial real estate.

Chapter 7: Portfolio Returns and Volatilities

The purpose of Chapter 7 is to understand business cycles, connect that understanding with the commercial real estate market, and identify whether a certain portfolio strategy is better suited to certain business cycles. Commercial real estate return data is now becoming more robust, which allows portfolio analytics to draw more thoughtful conclusions about the cyclical nature of commercial real estate and to link those perspectives to the risk and return characteristics for commercial real estate in a portfolio. Within the chapter, the performance of commercial real estate (using the National Council of Real Estate Investment Fiduciaries (NCREIF) index as a proxy) is compared to other major asset classes such as equity and debt.

Chapter 8: Private Real Estate Allocations

Chapter 8 looks at commercial real estate investment from the perspective of a strategic asset-allocation decision. A wide variety of commercial real estate investment strategies can be employed within a multiasset portfolio depending on the needs of the specific investor. In setting policy portfolios, it is typical to consider the investment characteristics of an asset class; therefore, the focus is on the broad characteristics of equity investment in institutional-quality commercial property. Higher risk developments, turnaround situations, and other strategies within the opportunistic and value-add spaces can certainly provide benefits to a portfolio if executed properly, but they are not the focus of this chapter as the decisions involved with each investment are situation-specific. Rather, the chapter examines decisions taken from a portfolio level: what benefits might an allocation to the broad real estate market provide to a mixed-asset portfolio, and how much should that allocation be?

Chapter 9: Private Equity Real Estate

The goal of Chapter 9 is to provide an overview of private equity real estate, presenting information that will help financial advisors understand the range of different vehicles that are typically considered. Special attention is paid to the strategic choices advisors face, so that they can ask the right questions of both their clients and of real estate managers. Finding the right fit for a private real estate investment program depends on understanding the liquidity and risk-return preferences, as well as the time horizon and tax status, of a client. This chapter discusses the role of private equity funds and other vehicles, including the advantages they can provide to investors, the structures, the assets they own, the functions they perform, and the way their performance is tracked and analyzed.

Chapter 10: Portfolio Management

Chapter 10 provides the fundamental concepts for managing a portfolio of properties. Similar to portfolio management for a portfolio of stocks, efforts around diversification, benchmarking, monitoring, and rebalancing are necessary. The primary differences in managing a real estate portfolio stem from valuation and liquidity constraints that are inherent in the asset class, along with the measures of how to judge diversification (e.g., property types and geography). We also discuss guidelines for evaluating a fund manager.

Chapter 11: International Commercial Real Estate

Chapter 11 provides information on the rationale for making an investment in international real estate, as well as on identifying the risks that such an investment entails. Increasing global economic integration makes the opportunities in international real estate investment more compelling than ever before—especially given weakness and slow growth in the domestic real estate markets of most developed economies. Although traditional international capital flows were largely directed toward U.S. and Western European opportunities, in the last several years substantial interest has developed in Asian markets. More recently, investment has been growing in Latin America, Eastern Europe, and Russia.

Section III: Public Real Estate

Chapter 12: Public Real Estate

Chapter 12 provides an overview of today’s real estate investment landscape in the public markets. We first define the real estate market and explain the mechanics of investing in real estate through REITs. We also define the criteria necessary to become and maintain REIT status. We later discuss how to measure real estate investment returns and examine the advantages of holding real estate assets. We address possible reasons why listed public real estate has outperformed private real estate over the thirty-five-plus years during which comparative data is available. Finally, we note several risks that real estate investors should bear in mind when deciding how to allocate their capital.

Chapter 13: Investing in REITs

Chapter 13 provides a basis for understanding the fundamentals of investing in REITs. The REIT vehicle has democratized commercial real estate investing by making participation in the asset class available for low investment minimums. This section explains the genesis of the REIT, the variety of REITs, and the basics of benchmarking performance of REITs.

Chapter 14: International Real Estate Equity Markets

Chapter 14 delivers a primer on investing in public-equity real estate outside the United States. The chapter also provides support for the rationale for investing internationally because of the varying return profiles from U.S. real estate and because of the potential for greater growth in certain regions. The chapter includes a listing of resources to further research the international real estate equity markets and an overview of products through which to gain international real estate exposure.

Chapter 15: Nonlisted REITs

Chapter 15 provides a closer look at nonlisted REITs and how they vary from REITs that trade on exchanges. Nonlisted REITs—by virtue of not being traded—have different correlations to other asset classes, and even to publicly traded REITs. This chapter also explains the lifecycle of a nonlisted REIT product that is critical for any nonlisted REIT investor to understand.

Section IV: Advanced Topics and Risks

Chapter 16: The Importance of Yield

Chapter 16 defines cap rates and applies the concept to an example in order to better understand the various ways cap rates are stated. Next, we perform an extensive study on cap rate changes over time based on various going-in cap rates. We then take this analysis and link cap rates changes over times to internal rates of return (IRRs) both with and without leverage. The examples in the chapter are designed to help an investor understand the way movements in cap rates affect both the risk and return profiles of their investment.

Chapter 17: Investing in Green Real Estate

Chapter 17 provides an introduction to the definition of a green property and many of the ways to make properties more energy efficient (ranging from light retrofitting to heavy retrofitting). When faced with making green improvements, property owners must analyze the costs and benefits of investing in new technologies. With the support of several studies, this chapter will help the reader understand that it is both socially responsible and economically beneficial to move toward greener properties.

Chapter 18: Evaluating Real Estate Returns

Chapter 18 introduces and gives examples of three approaches to valuing property: income, sales comparison, and cost. The income approach translates the economic benefits of a property into a property value through a direct capitalization or a discounted cash flow technique. Through the use of numerous examples we discuss the importance of estimating cash flows. The sales comparison approach uses recent sales data on price per square foot, rent multipliers, and other metrics in order to estimate a fair value. Finally, the cost approach uses replacement value for the land and building as a proxy for what a property is worth.

Chapter 19: General Risk Considerations

Although previous chapters have described what is likely to happen in real estate investing, this chapter will concern itself with what could happen. An understanding of risk should not prevent investors from reaping the benefits of real estate or make them fearful, but rather it should allow the investors to be prepared for pitfalls that could strike their investment.

Why Real Estate as an Investment

David Lynn, Ph.D; Kevin White, CFA; Dan Occhionero, CFA; and Ross W. Tieken

Introduction

Chapter 1 underscores that there are several different ways of investing in commercial real estate and that each method is unique in terms of the method of investment and advantages and disadvantages. Commercial real estate (CRE) investing as a whole provides five primary benefits:

1.    Large investable universe: In the United States, CRE composes a large share of the investable universe which makes it accessible for a variety of investors.

2.    Relatively high income returns: CRE has provided high levels of current income relative to cash or government bonds.

3.    Lower volatility: CRE has been less volatile than stocks.

4.    Diversification: Real estate generally exhibits low correlations with other asset classes, creating opportunities to increase portfolio returns for a given level of risk.

5.    Potential inflation hedging: CRE is a tangible asset that can partially hedge inflation risks.

Later in this chapter, we apply commercial real estate investing principles into the context of a diversified investment portfolio to show how risk-adjusted returns can be improved.

Finally, we discuss determining suitability based on an investor’s investment policy statement and two examples of investors accessing commercial real estate.

In this book, we will discuss several methods of investing in real estate, including private, private equity, international, public, debt, and nonlisted. Each type of investment comes with its own expected return, risk profile, advantages, and disadvantages (Figure 1.1).

Private Investment

Private investment is done through equity interest in individual or groups of assets or via debt such as a commercial mortgage or construction loan. The return profile is generally solid over the long term and is driven mostly by income. Private real estate investment faces the constraints of high initial capital requirements and low liquidity.

Private Equity Investment

Private equity investment also entails equity and debt investments in property done via a fund that pools capital from investors. Funds are actively managed over a ten-year horizon at which point properties are liquidated. Private equity investors tend to be institutions or high-net-worth investors due to high capital requirements and long-term commitments. Because of these limitations, returns can often be very lucrative—in excess of 20 percent annually for well-run funds. Examples of large real estate funds include entities such as Blackstone, Lone Star, Brookfield, and Starwood (Figure 1.2).

International Investing

International investing is done through private investment, or more often, via an exchange-traded fund (ETF). ETFs trade on an exchange much like a stock and track the performance of a variety of asset classes and indices. International investment increases the investment universe for domestic investors, therefore offering higher risk-adjusted returns via diversification. The primary disadvantage of international investing is exposure to a variety of risk factors including exposure to country, political, economic, and currency risk. Investing in international REIT stocks and ETFs will also carry exposure to systematic risk associated with publicly traded markets. Some of the large international real estate ETFs include SPDR Dow Jones Global Real Estate ETF, Vanguard Global ex-US Real Estate ETF, SPDR Dow Jones International Real Estate ETF, WisdomTree Global ex-US Real Estate Fund and several others. ETF data is readily available from Morningstar, Inc., a leading provider of independent investment research in North America, Europe, Australia, and Asia.

Public Real Estate Investing

Public real estate investing is done through individual REIT stocks and REIT mutual funds, or through property managers, brokers, or developers. Investing in public real estate offers the unique advantage of high liquidity, which allows investors with a low capital base to enter the space. The primary disadvantage of public real estate investment is high exposure to macroeconomic risk factors, which create general stock market volatility. Some of the large REIT mutual fund managers include Cohen & Steers, Fidelity, TIAA-CREF, Invesco, T. Rowe Price, and several others. ETFs have also gained in popularity. An ETF is an investment fund that trades similar to a stock. It holds assets such as stocks, commodities, or bonds and generally trades close to net asset value. Many of them track broader stock indices or more narrow sectors such as real estate. Large real estate ETFs include Schwab US REIT ETF, SPDR Dow Jones REIT ETF, Vanguard REIT ETF, iShares Cohen & Steers REIT ETF, and several others. Real estate mutual fund and ETF data is readily available from Morningstar.®

Real Estate Debt Investments

Real estate debt investments include whole mortgage, high-yield, CMBS, mezzanine loans, and unsecured REIT debt via public markets. Returns are generally stable (compared to other methods of real estate investments) but appreciation potential is also limited.

Nonlisted REITs are purchased through a financial advisor. The primary advantage of nonlisted REITs is that investments are not exposed to the same systematic risk factors as public REITs. However, nonlisted REITs require a lock-up period, which means that investments offer no immediate liquidity.

The ways in which different types of commercial real estate are accessed (essentially, the investment products) creates varying investment return characteristics. For example, a portfolio of retail net-lease buildings offered in a private, commingled vehicle uses appraisal-based pricing to contribute to coming up with a net asset value per share of ownership in the portfolio. This is typically done on a quarterly basis when investors are allowed to invest and redeem. Meanwhile the same portfolio offered through a publicly listed REIT will have its shares priced throughout trading sessions in the public market. The same investment in underlying buildings would never have the same return profile because of the way in which they are packaged into products.

Five ‘Whys’ for Commercial Real Estate Investing

Commercial real estate (CRE) is a unique asset class that warrants consideration by investors given the many benefits. Five of the key benefits of CRE investment, as discussed in the following sections, are:

(1)   A large investable universe,

(2)   Income returns,

(3)    Lower volatility,

(4)   Diversification, and

(5)   Inflation hedging.

Large Investable Universe

After bonds (61.9 percent) and stocks (28.7 percent), CRE is the third largest asset class in the United States representing approximately $5.1 trillion, or 9.4 percent, of the $54.5 trillion investable universe, as shown in Figure 1.3. Accordingly, an investor that excludes it from a portfolio is significantly narrowing the universe of potential investment opportunities.

SOURCES: BEA, IMF, Cole Real Estate Investments, Inc.

NOTE: Data as of December 2011.

Income Returns

Investments in general produce two kinds of returns: cash yields (income returns) and value changes (capital gains or losses). In the case of CRE, income returns (generated from tenants’ rental payments) have historically accounted for more than 90 percent of total returns (compared with 23 percent in the case of stocks). Real estate’s healthy income component is attractive to investors seeking stable cash flow. Stable income is also safer during periods of financial-market stress when liquidating assets may prove problematic.

Income returns on commercial property have been particularly attractive in recent times relative to other investment alternatives. Aggressive Federal Reserve policies aimed at promoting economic recovery (close to 0 percent short-term interest rates and several rounds of asset purchases) have pushed cash and Treasury bond yields down to near-record lows. Although corporate bond and equity dividend yields are attractive, they still do not match those available from CRE (see Figure 1.4).

Past performance is no guarantee of future results.

SOURCES: National Council of Real Estate Property Index (NCREIF NPI) (CRE); Moody's Baa Corporate (Corporate Bonds); National Association of Real Estate Investment Trusts (NAREIT) All Equity REITs (Publicly Traded REITs); S&P 500 (Stocks); 10-Yr US Treasury (Government Bonds); 3-Month US Treasury (Cash).

Lower Volatility

Real estate’s substantial income component helps to temper its volatility relative to asset classes that derive a higher proportion of returns from price movement. Additionally, longer rental lease terms help to mitigate the impact economic fluctuations have on rental income. CRE as an investment has historically exhibited stability similar to bonds while being much less volatile than equities, whose prices are more sensitive to systematic risk factors and overall sentiment (see Figure 1.5). This relative stability may be especially alluring in today’s uncertain financial climate.

Past performance is no guarantee of future results.

SOURCES: NCREIF NPI (CRE); Barclay's US Aggregate (Bonds); NAREIT All Equity REITs (Publicly Traded REITs); S&P 500 (Stocks); 10-Yr US Treasury (Government Bonds); 3-Month US Treasury (Cash).

Note: Volatility is measured from quarterly annualized data.

Diversification

On a stand-alone basis, CRE may offer compelling value as a source of current income. Yet its capacity to reduce volatility is enhanced when it is included in a balanced portfolio. Like stocks and bonds, real estate is influenced by economic and financial drivers, such as economic output and interest rates. But it also has unique characteristics, including extended lease terms, sensitivity to development activity (currently near an all-time low), and other factors. Correlation coefficients are used to compare risk and the similarity of risks between asset classes. Accordingly, the return correlations of CRE with other asset classes have historically been low (see Figure 1.6).

The fact that CRE has a low correlation with stocks implies that a crisis in equity markets would not likely affect real estate proportionately, limiting the overall damage to a portfolio containing both investments. With correlations of less than 0.25 to all major asset classes, CRE has meaningful capacity to reduce portfolio volatility through diversification.

Practice Pointer: If your clients are heavily weighted in a portfolio of publicly traded stocks or equities, investing in CRE will reduce their risk exposure and help reduce the volatility of the portfolio. As we will see later, this mixed approach will also maximize portfolio returns over the long run.

Additional diversification can be found within the CRE market through exposure to a broad range of property types, geographies, and tenants.

•      Property types: The major CRE property types have unique economic drivers that can impact their performance, including job growth (office), demographics (multifamily), retail sales (retail), business and leisure travel (hotel), and manufacturing and international trade (industrial).

•      Geographies: Local CRE markets behave differently due to structural factors (e.g., physical or regulatory barriers to new supply) or economic drivers (e.g., a significant presence of specific industries, such as energy, technology, finance, or government).

•      Tenants: The selection of tenants making rental payments and the industries they compete in allow for additional diversification. Over economic cycles, government or healthcare tenants may prove more resilient in recessions, but they can be more vulnerable to policy risks. Finance, technology, and other companies may be sensitive to factors transcending the broader economy (e.g., global oil prices, financial regulation, and business capital spending).

Inflation Hedging

Inflation is currently modest, in line with the Federal Reserve’s implicit target of around 2 percent, and elevated levels of unemployment will likely keep inflation fears at bay for the time being. However, the Fed’s rampant money printing (its balance sheet has more than tripled since the financial crisis of 2008 to more than $3 trillion) has raised the possibility of a significant upturn in inflation once economic conditions firm.

CRE can help to mitigate inflation risks. Fundamentally, the value of real estate is supported by the rental payments it generates. In periods of high inflation, rising wages and profits increase the nominal amount tenants are willing to pay for any given amount of space. Meanwhile, higher construction costs (due to rising labor rates and commodity prices) restrict commercial development. The resulting increase in demand and decrease in supply lift rental rates and cash flows. Even if rents do not respond immediately, inflation-fearing investors typically price future rent increases into current values. Over the long term, CRE prices tend to rise with replacement costs, which are driven by inflation.

Several academic studies have confirmed CRE’s ability to hedge inflation. Although many of these studies are statistically complex, at the most basic level CRE has exhibited a strong correlation with inflation relative to other investments (Figure 1.7). It certainly proved its worth during the United States’ last major inflation scare, following the oil crisis of the 1970s. From 1979 to 1982, as consumer prices increased 10 percent per year, CRE delivered strong returns averaging 14 percent, while stocks (9 percent) and bonds (6 percent) lost ground on an inflation-adjusted basis.

SOURCES: NCREIF NPI (CRE); Barclay's US Aggregate (Bonds); NAREIT All Equity REITs (Publicly Traded REITs); S&P 500 (Stocks); 10-Yr US Treasury (Government Bonds); 3-Month US Treasury (Cash); BLS CPI (inflation); Cole Real Estate Investments.

Existing Portfolio Allocations

The characteristics of CRE—the potential for relatively higher income returns, lower volatility, broader diversification and inflation hedging—demonstrate the potential benefits of adding an allocation to this asset class. Institutional investors have long reserved a substantial allocation to the sector. In 2011, U.S. institutions allocated 9.3 percent of their portfolios to CRE, up from 8.5 percent in 2010. Although publicly traded REITs comprised a portion of that allocation, nearly 90 percent of it consisted of directly owned buildings or investments in nonlisted funds.

For many individual investors, exposure to CRE is limited due to the high cost of direct investment via individual property purchase. This challenge is compounded by the fact that in order to achieve sufficient diversification across geographies, product types, and tenants, a prudent investor would need to purchase a large number of assets. Moreover, there have historically been few options for investing in private CRE through conventional savings vehicles, such as 401(k) plans. Publicly traded REITs offer an alternative investment vehicle, but they are not a substitute for private CRE.

The Next Frontier: Expanding Access to CRE

Classic portfolio maximization models show that during the past thirty years, CRE has significantly improved risk-adjusted returns in a diversified portfolio.

SOURCES: NCREIF NPI (CRE); Barclay’s US Aggregate (Bonds); NAREIT All Equity REITs (Publicly Traded REITs); S&P 500 (Stocks); 10-Yr US Treasury (Government Bonds); 3-Month US Treasury (Cash); BLS CPI (inflation); Cole Real Estate Investments.

Consider a conservative portfolio (Portfolio A) consisting of bonds (40 percent) and stocks (60 percent). Over the past thirty years (1983 Q2–2013 Q1), this portfolio would have earned annual returns averaging 13.0 percent with a standard deviation of 21.0 percent (see Figure 1.8). By investing 20 percent of the portfolio in real estate (while reducing exposure to stocks), this portfolio could have achieved higher risk-adjusted returns (Portfolio B). Alternatively, by reducing exposure to bonds and investing 20 percent of the portfolio in real estate (while keeping exposure to stocks at 60 percent), the returns could have been the same as the conservative portfolio at 13.0 percent while reducing volatility (Portfolio C).

Determining Suitability of the Institutional Investor

As with any investment plan, creating an investment policy statement is always the first step. This process begins by determining the investor’s risk tolerance and return expectations based on the particular situation. Only then can an assessment be made of the investor’s ability and willingness to take risk. The investor than sets an objective composed of a realistic risk/return statement. For example, an institutional investor may want to preserve the capital base while earning a rate of return high enough to compensate for inflation (2 percent) and annual spending (3 percent). In this case, income-oriented investments with little or no risk of loss and a 5 percent expected return should be considered. Institutional investors must also consider investment constraints: liquidity needs, time horizon, tax concerns, legal and regulatory issues, and unique circumstances.

With a complete investment policy statement, an advisor can determine asset classes that meet the profile of the investor—known as suitability. At this point, an allocation to real estate via one or more of the methods discussed previously should be considered. An investment in a single-family home as a primary residence should not be considered a real estate investment but should be considered as part of the investor’s overall financial situation. Suitability is driven by the investment policy statement and the way the different types of investment in real estate can potentially meet the objectives without breaching the constraints.

Institutional Investor–Example

University XYZ has an investment objective of providing stable cash flow to fund operations while preserving purchasing power. Given the University’s 5 percent spending requirement, the fund targets an annual return of inflation plus 5 percent while minimizing the frequency and magnitude of temporary declines in portfolio value.

Potential investment constraints for University XYZ include the following:

•      Liquidity—The need is limited to approximately the 5 percent annual spending.

•      Time horizon—The investment timeline is infinite.

•      Tax—As an endowment, the University fund is exempt from tax.

•      Legal and Regulatory—The fund can invest in most asset classes but it is prohibited from shorting stocks and trading options.

•      Unique Circumstances—The University has no unique circumstances to consider.

Real estate can be used by the University to help meet its investment objectives. Certain types of real estate would be more suitable than others. For example, real estate debt would provide the stable income the University needs to fund operations. Private real estate also provides stable income and should be considered given the long-term horizon and low liquidity need of the university. Nonlisted REITs and international real estate could be suitable given their diversification benefits. Private equity offers potentially high returns, but it probably is not suitable given the downside risk. Public equity REITs also offer too much volatility and not enough diversification given the exposure to systematic risk factors.

Given the suitability of various types of real estate, a sample allocation might contain 10 percent of the fund in real estate with half of that amount invested in both real estate debt and half in nonlisted REITs.

Individual Investor—Example

A married couple in their mid-30s with two young children is considering a recommendation by their financial advisor to add an allocation to real estate in their portfolio. Both the mother and father are currently employed with a total gross annual salary of $250,000. Their income is substantially higher than their living expenses. Their investment portfolio is worth approximately $400,000, to which they are adding roughly $50,000 per year. They plan to fund their children’s education starting fifteen years from now.

The advisor/client relationship is slightly different for the individual investor compared to the institutional investor. The financial advisor is not required by law to complete an investment policy statement. However, the advisor may be acting as a fiduciary in client dealings and must hold the client’s interest above its own at all times. According to the SEC, this means the advisor must:

•      Make reasonable investment recommendations independent of outside influences;

•      Select broker-dealers based on their ability to provide the best execution of trades for accounts in which the adviser has authority to select the broker-dealer;

•      Make recommendations based on a reasonable inquiry into a client’s investment objectives, financial situation, and other factors; and

•      Always place client interests ahead of its own.

Despite the lack of a formal policy statement, it is still the advisor’s responsibility to understand the client’s financial situation and suggest appropriate investments. In the case of the married couple, the couple has a long-term outlook and little need for liquidity. They also have the ability to take on a lot of risk in exchange for higher returns given their long time horizon.

This couple could benefit greatly by adding real estate to their existing portfolio with an allocation of 10 to 15 percent. Although most types of real estate could be appropriate, private equity and public equity real estate would probably be best given their high return potential. The volatility and potential for near-term losses are not a concern. Nonlisted REITs could also be a possibility that would enhance diversification with the lack of systematic risk.

The views and opinions expressed in this commentary are those of the contributors as of the date of publication and are subject to change. The forward-looking statements in this paper are based on Cole Real Estate Investment’s current expectations, estimates, forecasts and projections, and are not guarantees of future performance. Actual results may differ materially from those expressed in these forward-looking statements, and you should not place undue reliance on any such statements .

Commercial Real Estate Property Types and Selection

Peter Burley, CRE, FRICS, and Dan Occhionero, CFA

It used to be pretty easy, traveling from city to city, and market to market, to understand the local dynamics and to determine the best property investment. One could get off a plane, hop in a cab—at just about any airport in the country—and ride into town watching the real estate roll by. One would gaze toward the center of town, watch for For Lease signs on warehouses and office buildings, Now Leasing signs on newly built apartment properties, and look for the dirt—and the construction cranes—to see what was being built and what was hot in any given metropolitan market. One could ask a few questions, especially of the cab driver (the best kept secret for on-the-ground, local market research is the cab driver) and get a pretty good picture of the place. It used to be easy.

Then, along came the dot-com collapse, followed by heightened investor caution and the tentative reemergence of a few property types. In those post-dot-com days, we became more selective. We focused on specific property sectors in specific markets that demonstrated the greatest likelihood of better-than-average returns and eschewed others. We found them among the few opportunities for Class A central business district (CBD) offices, Class A suburban offices, and Class A apartments and condos. They were the property types that were in demand by the tenants who used those spaces and by investors who knew tenants were seeking out those spaces.

Several years into the recovery from the Great Recession, uncertainty continues to fog the screen for investors across the board. Although the corporate sector, and financials in particular, have managed to set a strong pace over the past few years, lingering imbalances have acted as a drag on the broader economy, in the US and elsewhere, holding economic growth to unexceptional levels. A host of factors have come into play, including the fiscal wars, healthcare battles, sequestration in Washington, geopolitical strife across the globe, and even slower growth in China.

Of particular importance to commercial property investors, the housing and labor markets have been particularly affected in recent years. The housing slump erased significant homeowner and consumer wealth, dampening confidence and spending—more than two-thirds of GDP—and ultimately shifting construction and consumer spending into low gear. Substandard gains have been a particularly sad truth in the labor market in particular, where job growth has been subdued at best. By historical post-recession standards, the recent recovery has exhibited unusually slow job gains.

Job growth is the key to space demand in all quarters of the real property market, driving the demand for and the use of commercial space—from office to industrial to retail to multifamily and hotels. During the late 1990s and early 2000s, job growth had run apace, pushing unemployment rates to historic lows. Absorption rates in the commercial real estate sector increased across the board and vacancies fell sharply, in many cases to all-time lows. Rents posted healthy gains. Property returns, as reflected in the National Council of Real Estate Investment