With record low interest rates around the globe, real estate investments are gaining increased attention from the broader investment community and becoming an integral part of many portfolios. Here we explore the blend of benefits that a real estate mutual fund or ETF may add to an existing investment portfolio, including potential income, capital appreciation, inflation protection, and diversification.
What is real estate investing?
Investors typically view commercial real estate and real estate-related securities as a compelling alternative asset class for producing income, total return, and other potential portfolio benefits. Real estate can be purchased directly or invested indirectly through the purchase of real estate investment trusts (REITs)—real estate owners and operators that issue special shares, exchange-traded funds (ETFs) that invest in a portfolio of REITs, and real estate mutual funds.
Five main types of commercial property
Real estate is a diverse asset class
Real estate asset managers invest in properties that reflect the evolving needs of businesses, consumers, and occupiers. Some asset managers choose to create strategies that are diversified across geographies, commercial property sectors, and property types, while others choose to focus on sector-specific strategies.
While real estate can be affected by the larger real estate cycle, sector and property performance can vary widely depending on factors such as demographics, economic growth, and supply-and-demand dynamics. Understanding the underlying drivers of performance is vital to constructing a diversified real estate investment portfolio. Investors often choose to partner with real estate asset managers to take advantage of evolving market trends and economic factors to generate potential long-term positive returns.
Historically, real estate has delivered competitive returns
Source: Bloomberg, based on annual data between 12/31/06 and 12/31/20. The S&P 500 Index is the source for U.S. stocks, the Bloomberg Barclays U.S. Aggregate Bond Index is the source for U.S. corporate bonds, and the FTSE NAREIT All Equity REIT Index is the source for U.S. real estate. It is not possible to invest directly in an index. Past performance does not guarantee future results.
What are the benefits of investing in real estate?
With more traditional assets appearing fully valued, such as segments of the U.S. large-cap stock market, and fewer income-generating opportunities available today, investors are appreciating the favorable mix of characteristics real estate may add to a portfolio of stocks and bonds. In addition to current income and capital appreciation potential, this alternative asset class may offer inflation protection and portfolio resiliency benefits.
- 1. Real estate may offer portfolio income and price appreciation potential
Real estate investments generate steady income through rent collection from owned properties. After accounting for various operating expenses and financing costs, this income gets passed to investors. In fact, over the last 15 years, the income generated by real estate has been higher than stocks and bonds¹.
U.S. real estate has been an income generator
Source: Bloomberg, based on annual data between 12/31/06 and 12/31/20. U.S. real estate is represented by the dividend yield for the FTSE NAREIT All Equity REIT Index, U.S. stocks are represented by the dividend yield for the S&P 500 Index, and U.S. corporate bonds are represented by the bond yield to maturity for the Barclays U.S. Aggregate Bond Index. It is not possible to invest directly in an index. Past performance does not guarantee future results.
Real estate asset managers not only purchase property to generate potential income, but also to benefit from expected price appreciation over time. This increase in property value can occur as a result of a number of factors, including market supply-and-demand dynamics, population growth, location, inflation, economic trends, and property renovations. After a certain period of holding the property, gains are realized and become a vital part of an investor’s total return.
- 2. Real estate may offer potential inflation protection
- 3. Real estate may offer diversification benefits through low to moderate correlation
U.S. real estate has a lower correlation to other asset classes
Source: Bloomberg, based on quarterly data between 1/01/97 and 12/31/20. The Bloomberg Barclays U.S. Aggregate Bond Index is the source for U.S. corporate bond and the S&P 500 Index is the source for U.S. stocks. It is not possible to invest directly in an index. Past performance does not guarantee future results.
While market drawdowns commonly occur throughout various market cycles, attempting to market time these can be difficult. A strategic asset allocation among a mix of asset classes that includes real estate can help mitigate portfolio risk through diversification and help alleviate the consequences of negative effects on wealth creation.
Consider the risks involved
While investing in real estate may offer numerous benefits, investors should also consider the inherent risk of this sector of the market. These risk factors include:
- Business conditions risk—Demand for commercial real estate space depends on things such as economic conditions, GDP, employment, demographics, household income, and market demand/supply conditions. Changes in these could potentially affect both current income and real estate values and, therefore, potential total returns.
- Interest-rate risk—Rising interest rates are a risk factor for commercial real estate as properties are typically purchased with borrowed funds. Often, rising rates increase the cost of borrowing, which in turn may potentially affect profits and, therefore, potential total returns.
- Management risk—Real estate investments are managed at two levels: by the asset manager for financial performance and by the property manager to ensure smooth day-to-day operations of the property. Management risk refers to the ability of all involved in managing the asset to make the right decisions. Suboptimal management could have an impact on potential returns.
Other risk factors exists such as systemic risk, property-specific risks and natural disasters. While not all risks can be identified ahead of time, risks that are identifiable can be planned for to an extent with a disciplined risk management process in place.
Real estate can diversify risk and contribute to long-term returns
From 2018 to 2019, the professionally managed global real estate investment market grew from $8.9 trillion to $9.6 trillion, driven in part by changing market dynamics and asset growth.³ In today’s income-starved world, this trend is likely to continue as more investors come to appreciate how real estate can complement a multi-asset portfolio of stocks and bonds. Not only does real estate offer stable income-generation and appreciation potential, it also has a history of complementing mainstream assets by introducing diversification benefits, potential inflation protection, and greater resiliency into investor portfolios.
1 jllipt.com/benefits-of-real estate, Q2 2020. 2 Bloomberg, based on annual data between 12/31/06 and 12/31/20. The S&P 500 Index is the source for U.S. stocks, the Bloomberg Barclays U.S. Aggregate Bond Index is the source for U.S. corporate bonds, and the FTSE NAREIT All Equity REIT Index is the source for U.S. real estate. 3 msci.com/documents/1296102/19878845/MSCI_Real_Estate_Market_Size_2020.pdf/06a13e2c-0230-f253-26fa-3318cecb1c59, 2019.