U.S. Real Estate as a Diversification Tool

The stock market corrections that began in early March in China and quickly spread around the world, particularly to emerging markets, have again reminded investors of the importance of having a high degree of diversification in their investment portfolios. In considering U.S. commercial real estate as a diversification tool, investors should focus on a number of factors that Falcon Real Estate believes are inherent in this asset class. Among such factors are the following:

1. 1. The relative stability of real estate;
2. 2. Real estate’s competitive investment returns;
3. 3. The lack of correlation between real estate returns and those of other asset classes; and
4. 4. The real estate market in the United States.

It is Falcon Real Estate’s belief that, on balance, these factors provide support for the view that U.S. commercial real estate is an effective and rewarding diversification tool.

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The Relative Stability of U.S. Commercial Real Estate

In the 60 years since the end of World War II, there have been only two significant periods in which U.S. commercial real estate has endured a major decline. The most important of these was in the late 1980’s and early 1990’s when the market suffered from the extraordinary over-building that had been fueled by the savings and loan industry, and which led to the demise of that industry. The second occasion was the period immediately following the 9/11 attacks on New York and Washington that triggered a sharp recession in the U.S. economy. Aside from those two periods, however, all studies of U.S. commercial real estate clearly show that it should be considered a relatively stable asset class.

The National Council of Real Estate Investment Fiduciaries (NCREIF) has been accumulating data on investment-quality commercial properties for almost thirty years, and is now monitoring over 5,300 properties with a current value of over $250 billion. The NCREIF record shows that investments in U.S. commercial real estate experience less fluctuation during an economic cycle than do other asset classes. Capitalization rates (or yields) on U.S. real estate, which are the primary valuation measure for income-producing real estate, have generally remained in a range of from 6% to 9%, while yields in the bond markets have moved in a significantly wider band. And valuation measures for common stocks have, of course, shown the greatest volatility.

The relative stability of income-producing real estate can be at least partially attributed to the fact that a real asset is involved – an asset that has an original construction value and a current replacement value. In addition, investors in real estate are generally of necessity long-term investors, and therefore the real estate market is usually not as susceptible to short-term investment considerations. Because there are so many different common stock investors with so many different analytical approaches, and because access to the stock markets of the world is virtually instantaneous, those markets are constantly in the process of responding to every piece of news and every rumor that originates anywhere in the world. This is one of the great strengths of the major stock markets of the world – strengths that have been enhanced by the internet and the non-stop flow of information to investors. But these very strengths turn stock investing into the most volatile asset class.

Investments in commercial real estate, on the other hand, are generally made at the end of a rather lengthy process. Letters of intent are exchanged; contracts are drafted; due diligence activities are carried out; and financing is arranged before a purchase is finally consummated. Therefore, because of the very nature of the market, real estate investors do not react to every piece of news and every rumor, as common stock investors do. More importantly, earnings projections for a piece of property are much more predictable and, with leases in place, much more stable than are earnings from a corporation. These factors all point to income-producing, investment quality real estate as being a relatively stable asset class.

Another factor that should be emphasized in connection with U.S. real estate is that diverse trends regularly co-exist in different geographies and in different sectors of the market. At the present time, for example, the commercial office market in Manhattan is extraordinarily strong while the suburban office market in the Chicago area is still in a recovery phase. Given the fact that U.S. commercial real estate tends to track general economic variables, longer-term trends can easily be identified and appropriate strategies can be adopted using geographic and sector diversification, thereby contributing to the stability of the returns from a diversified U.S. real estate portfolio.

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