Understanding The Role Of Core Real Estate

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Includes: DRA, DRN, DRV, FREL, FRI, FTY, IARAX, ICF, IYR, JRS, KBWY, LRET, NRO, PSR, REK, RFI, RIF, RIT, RNP, RQI, RWR, SCHH, SRS, URE, VNQ, WREI, XLRE
by: Brian Haskin

Real estate is a unique and multi-faceted asset class that can improve the efficiency of almost any portfolio. Non-core real estate, which includes non-stabilized assets and other higher risk projects, can provide attractive opportunities at the higher end of the risk/return spectrum, and there are sub-classes of real estate at the lower end of the spectrum, too.

Core real estate, by contrast, refers to stable and high-occupancy assets, and according to a recent blog post from Aon Hewitt's David Rose, core real estate provides the highest potential for improved efficiency in most multi-asset class portfolios, regardless of their positioning on the risk/return spectrum.

Beyond Traditional Assets

As an asset class, core real estate is distinct from stocks and bonds but shares elements of each. Like bonds, income properties generate cash flow similar to coupon payments. But unlike bonds, real estate leases are reset (i.e., they do not mature), and more akin to stocks, core real estate assets have underlying capital value that tends to grow over time.

Despite having similar features to stocks and bonds, core real estate has historically had low correlations to either asset class. Mr. Rose lists several reasons why: "stickier income streams due to the longer term contractual nature of leases, distinctive new supply cycles, private market ownership, and unique factors associated with the physical assets."

Portfolio Benefits

The low correlation between real estate and traditional assets works to extend the efficient frontier of multi-asset portfolios that include all three. This means that the same returns can be achieved with less risk or, alternatively, higher returns can be achieved with equal risk. The image below depicts the expected risk and returns of portfolios with (red line) and without (blue line) core real estate exposure. It is based on Aon Hewitt's Q3 2015 ten-year forward-looking capital market assumptions:

Efficient Frontier - Portfolio Mixes of Return Seeking and Return Reducing Assets

A Question of Timing

According to Mr. Rose, now may be a good time to start building a core real estate allocation. In his view, core real estate should be a staple of most institutional portfolios, and a 5-15% allocation of return-seeking assets is typically an appropriate allocation size. Ultimately, holding core real estate over a full real estate cycle may be necessary to gain the highest potential benefit from its inclusion.

For more information, download a pdf copy Real Estate Beta: Understanding the Power of Core.

Past performance does not necessarily predict future results.