Real Estate Takes Its Place as the Fourth Asset Class
By: David L. Funk, director of the Baker Program in Real Estate at Cornell University and a NAIOP Distinguished Fellow
Norges Bank Investment Management purchased a 45 percent interest in the 1.325 million-square-foot 100 Federal Street building in Boston in October 2014, part of a three-property portfolio that included Atlantic Wharf and Citigroup Center in New York. Seller Boston Properties retained an interest in all three properties, according to Real Capital Analytics.
When and why commercial real estate joined stocks, bonds and cash.
BEFORE 1980, COMMERCIAL real estate was invisible in institutional investment portfolios. More recently considered an “alternative investment,” today’s institutional investors typically allocate an average of almost 10 percent of their portfolios to real estate, which continues to gain a foothold among limited partners, with enduring implications for the industry. Has real estate joined the big three institutional asset classes — stocks, bonds and cash — as a permanent fourth asset class?
The Standard & Poor’s Dow Jones Indices recently concluded that real estate is due an upgrade and will elevate it from a subsector under “financials” to one of 11 sectors within its Global Industry Classification Standard (GICS), effective with the market close on August 31, 2016. (See sidebar below.)
Given that real estate constitutes 13 percent of U.S. gross domestic product (GDP) annually, according to the U.S. Department of Commerce’s Bureau of Economic Analysis, its formal recognition as a sector by S&P Dow Jones is overdue. It is CRE’s slow but steady adoption by global institutional investors as an asset class ready for “prime time,” however, that may have reached a tipping point, with significant consequences.
The Institutional Real Estate Allocations Monitor, jointly published by Cornell University’s Baker Program in Real Estate and advisory firm Hodes Weill & Associates, found that institutional investors have a targeted 9.6 percent allocation to real estate for 2015. This represents a continuation of annual increases to the asset class approaching the watershed 10 percent figure, as illustrated in the graph labeled “Asset Allocations of All Institutional Investors.”
The History of Investment in CRE
As recently as 1975, alternative asset classes were not accepted in institutional investment portfolios, and the “big three” asset classes dominated. Institutional fund managers started moving away from a traditional balance among the three asset classes in the 1980s, increasing exposure to equity and alternatives at the expense of fixed-income assets. Just 20 years ago a typical institutional investment portfolio, according to The Conference Board, might have been allocated 50 percent to equities, 40 percent to bonds and 5 percent each to cash and alternatives, which included real estate.
Today, that allocation more typically consists of 55 percent equities, 20 percent bonds, 10 percent each in real estate and alternatives, and 5 percent cash. Alternatives now include hedge funds, private equity and real assets such as timber, oil and gas, agriculture, and infrastructure.
Institutional investors are defined as entities that pool together funds, are professionally managed, and invest in selected financial instruments and asset classes. These institutions are often symbolized by the large private and public pension funds, but they also include such investors as endowments, family offices, foundations and others, as illustrated in the graph labeled “Allocations to Real Estate by Institutional Investor Type.” Their impact becomes clear when one realizes that U.S. institutional investors control more than $25 trillion, or 17 percent, of all U.S. financial assets, and globally institutional investors control roughly $70 trillion of assets under management, with an increasing percentage allocated to real estate, according to the Boston Consulting Group.
The Cornell/Hodes Weill Allocations Monitor, a comprehensive annual assessment of institutions’ allocations and objectives in real estate investment, found that the real estate asset class continues to experience an acceleration of institutional capital allocation. While institutions were 8.89 percent invested in real estate in 2013, their target allocations were 9.38 percent for 2014, with an additional increase of 24 basis points to 9.62 percent for 2015. While a 73 basis point increase in targeted allocations over two years does not seem overly significant, if realized, it would result in an influx of $511 billion in capital to real estate globally.
Perhaps even more important than the actual investments targeting commercial real estate is the pace of adoption of real estate as a permanent allocation and “institutionalization” as an asset class. Witness Norway’s $923 billion Government Pension Fund, the world’s largest sovereign wealth fund, and its 5 percent target allocation to real estate. Advised by Norges Bank Investment Management, the fund intends to go from zero investment in real estate in 2010 to 5 percent, or $46 billion, by the end of 2015. The California Public Employees Retirement System (CalPERS), a bellwether $300 billion U.S. pension fund, increased its allocation in real estate from 9 to 11 percent in 2014.
Despite the current flow of institutional capital chasing commercial real estate, the history of how institutional acceptance unfolded is one of innovation, regulatory change and investment opportunity. Historical barriers to the acceptance of CRE and its banishment as an alternative include its complex nature, limited regulations, and relative lack of transparency and liquidity, as well as the limited investment vehicles available to access the asset class. Real estate investment trusts (REITs) were a key vehicle that blazed the trail for most institutional investors to begin adding CRE to their portfolios. Subsequent development of other investment vehicles, including fund structures and direct investment approaches, further facilitated investment in CRE. Some of the key watershed events that have moved CRE towards its current status as an institutional asset class include the following:
1960s: Insurance companies such as Wachovia and Prudential created separate accounts to allow diversification into commercial real estate.
1972: The Employee Retirement Income Security Act (ERISA) required pension funds to diversify, opening the door to real estate.
1982: The National Council of Real Estate Investment Fiduciaries (NCREIF) launched its index of institutional real estate returns, providing a critical institutional benchmark.
1986: Tax reform eliminated many real estate tax shelters and created an even playing field for tax-exempt (institutional) investors.
Boston Properties sold a 45 percent interest in New York’s iconic 1.8 million-square-foot, 59-story Citigroup Center to Norges Bank Investment Management in 2014.
1988: The first Zell/Merrill Lynch Real Estate Opportunity Fund was created, raising $400 million to target real estate, in anticipation of pursuing assets through the Resolution Trust Corporation’s (RTC’s) liquidation program. Subsequent funds demonstrated the investment returns available via real estate.
Early 1990s: Proliferation of real estate funds increased institutions’ access to the asset class.
1992: Beginning of rapid growth in the equity REIT market as constraints in traditional bank lending led many owners into the public markets. This birth of the modern REIT era facilitated greater options and access for institutional investment.
Early 2000s: Institutions needed data in order to make defensible, informed investment decisions. With CoStar’s IPO in 1998 and Real Capital Analytics’ founding in 2001, third-party real estate data providers began to meet the research and transparency needs demanded of an asset class.
Late 2000s: A long-term slide in interest rates forced institutions to expand their search for higher yields into real estate. The pricing correction brought on by the global financial crisis was the further impetus for new institutional entrants to add higher risk, higher yielding real estate to their portfolios.
2010s: The maturing of sovereign wealth funds (SWFs) and the growth of global capital flows to real estate established an additional steady source of capital to U.S. real estate, further resetting institutional investment in CRE.
What’s Behind This Phenomenon?
Institutions’ drive to real estate investment today is less about innovation and regulation, and more about portfolio diversification, competitive returns and investment access. Real estate’s low correlation to other assets provides portfolios with protection against a volatile cycle as well as an inflation hedge. Real estate also represents an appealing income and yield opportunity, compared to competing asset classes, as an era of abundant global institutional capital necessarily pushes out the frontier of investment options in search of returns. In 2014, for example, global equities (stocks) averaged a 5.2 percent return, U.S. bonds 6 percent and global real estate 15 percent.
Not surprisingly, Cornell/Hodes Weill found that institutions favored value-add and opportunistic real estate investment strategies over core investments in 2014. Real estate clearly has come in from the wilderness of alternatives and, indeed, the question now has become how far will the search for returns push what is considered an acceptable alternative investment? Is the next frontier collectibles, such as stamps, coins or artwork — or even Internet domain names?
Real estate is taking its place in institutional portfolios at the same time that institutions are actively constructing new portfolio strategies to better weather inevitable cycles, as well as looking for more strategic, efficient investment vehicles to target commercial real estate. Over 70 percent of institutions currently have all their real estate managed by third parties. They utilize a breadth of investment structures, including direct investments, separate accounts, joint ventures and a full array of private funds. The sheer amount of institutional capital targeting real estate will increase the pressure on fees and efficiency in addition to continued innovation in investment structures.
Real estate is not just an asset class for U.S. institutions. In fact, the appetite for real estate is strongest among non-U.S. institutional investors. According to Cornell/Hodes Weill, in 2014 average allocations to real estate among Asia Pacific institutions were 10.9 percent. Among European institutions they were 10 percent. U.S. institutions brought up the rear at 9 percent.
Real estate is an asset class now baked into many emerging market institutions’ and sovereign wealth funds’ portfolios, and that capital is crossing borders seeking real estate opportunities. The U.S. is the top destination for foreign institutional capital.
Future Implications for CRE
The Abu Dhabi and Qatar Investment Authorities now have $37 billion and $35 billion invested in real estate, respectively. Yet they will soon be surpassed by Norway’s Government Pension Fund, which has targeted $46 billion in real estate investment by 2015. Those numbers help cement real estate as a global asset class.
Global allocations to real estate, based on a targeted allocation of 9.62 percent, could reach an estimated $6.7 trillion of institutional capital flowing to real estate. Beyond the total numbers, the slow but steady increase in portfolio allocations to real estate — and enduring commitment to it as a fourth asset class — portend healthy and enduring capital flows to institutional-grade CRE. Institutional capital, as opposed to private investor decision-making, is patient and can serve to mute cyclical swings due to capital availability.
Targeted allocations are just that, targets, but if institutional investors actually deploy their targeted allocation in 2015 it would result in upwards of $500 billion of new, unexpected global capital chasing commercial real estate, much of it in the U.S. Exacerbating this potential tsunami of capital is the over $200 billion in existing “dry powder,” according to Preqin — capital that has been raised but not yet called — not to mention individual investors’ dry powder still on the sidelines.
If an allocation to real estate approaching 10 percent signifies asset class status, will this fourth institutional asset class continue to gain share in the institutional portfolio? Cornell/Hodes Weill found that family offices already invest an average of 16 percent of their portfolios in real estate. Some estimates, including those of PricewaterhouseCoopers LLP, have proposed that investment in real estate could eventually double and stabilize as a 20 percent allocation in institutional portfolios.
While institutions increased their targeted allocations to real estate going into 2015, the pace of planned increase (26 basis points) declined from the 49-basis point increase from 2013 to 2014. Investor sentiment has also begun to moderate. Participants in the Cornell/Hodes Weill study rated their view of the investment opportunity in real estate from a risk/return perspective at 5.7 for 2015 (with one being lowest and 10 highest), which remains optimistic yet represents a decline from 6.4 the year before. Why the slight decline in outlook? So much capital is pushing valuations ahead of fundamentals, compressing yields, and creating an overly competitive context for the formerly alternative investment option. Welcome to official asset class status.
Real Estate Joins the GICS
The Global Industry Classification System (GICS) methodology has been commonly accepted as an industry analysis framework for investment research, portfolio management and asset allocation. The GICS classification system currently consists of 10 sectors (listed below), 24 industry groups, 68 industries and 154 sub-industries. Real estate is set to become the 11th sector in 2016.
- Consumer Discretionary.
- Consumer Staples.
- Financials (currently includes real estate).
- Health Care.
- Information Technology.
- Telecommunication Services.