Constructing a Better Real Estate Portfolio

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The National Association of Real Estate Investment Trusts (NAREIT, my employer) just came out with a great new tool that investors or investment consultants can use to evaluate how to construct a better real estate portfolio. It's intended to help institutional investors--pension funds, endowments, foundations, and the like--to improve the returns and reduce the risk of their real estate portfolios. But it's also great for anyone who either is (or will be) covered by a pension fund, or is (or will be) taking care of a pension beneficiary.

The idea of the Real Estate Portfolio OptimizerTM is to look at the returns that investors have received, on average, over the last 22 years from investing in different combinations of private equity funds following core, value added, or opportunistic strategies, along with publicly traded equity REITs. Most institutional investors invest heavily in private real estate, including private equity funds, and may not realize how much risk they've taken on; the Optimizer shows how balancing their private real estate investments with publicly traded REITs can reduce portfolio volatility and generate better risk-adjusted returns. Different portfolio allocations would have resulted in different portfolio performance; the Optimizer shows the average net return, volatility, and Sharpe ratio (risk-adjusted returns) for each of more than 176,000 different combinations.

What's most important for pension beneficiaries and their caregivers is to compare the real estate portfolio allocations that their pension fund managers have actually invested to other possible real estate allocations, to evaluate whether the pension fund could have been generating better net returns (including on a risk-adjusted basis) by making better decisions.

Here's an example. A pretty typical way for pension funds to put together their real estate portfolios is to invest about half of it (50%) in core private equity funds; 9% in publicly traded equity REITs, 20% in value-added private equity funds, and the remaining 21% in opportunistic funds. If you use the sliders on the Optimizer to find that portfolio, you see that historically it has produced net returns averaging 6.70% per year with volatility of 8.2% per year, which gives a Sharpe ratio of 0.446.

Now, move the sliders again to find a portfolio with one-fourth (25%) in publicly traded equity REITs, 69% in core funds, 6% in opportunistic funds, and none (0%) in value added funds. You'll see that the new portfolio had much higher net returns, averaging 7.48% per year, but exactly the same volatility at 8.2% per year--and, as a result, risk-adjusted returns (the Sharpe ratio) were much better at 0.536. That's 20% better without taking on any additional risk. (In truth, it's with even less risk, since the illiquidity of private real estate holdings represents a risk that is not measured by the volatility.)

You can move the sliders to find portfolio allocations with even stronger risk-adjusted returns. For example, a portfolio with 30% invested in publicly traded equity REITs, 49% in core funds, 21% in opportunistic funds, and 0% in value added funds would have increased volatility to 9.5% but would have raised average net returns all the way to 8.23% per year--more than enough to compensate for the added volatility, as shown by an increase in the Sharpe ratio to 0.541.

The optimizer is available on the web, and NAREIT also published a Special Report, "Optimizing Risk and Return in Pension Fund Real Estate: REITs, Private Equity Real Estate and the Blended Portfolio Advantage," detailing the analysis behind the Optimizer. Several writers have already reported about it, including David Levitt in Bloomberg and Arleen Jacobius in Pensions & Investments (which, unfortunately, is available only to subscribers). NAREIT has also posted a video in which I describe the Optimizer and demonstrate how to use it.

One more thing: see the button that says "Embed"? You can use that to drop the Optimizer into your own e-mail message, online article, blog, or web site. Pass it along, especially if you're part of a group covered by the same pension plan.

Disclosure: I am long Vanguard REIT Index Fund and ING Global Real Estate Fund.

Disclaimer: The opinions expressed in this post are my own and do not necessarily reflect those of the National Association of Real Estate Investment Trusts ((NAREIT)). Neither I nor NAREIT are acting as an investment advisor, investment fiduciary, broker, dealer or other market participant, nor is any offer or solicitation to buy or sell any security investment being made. This information is solely educational in nature and not intended to serve as the primary basis for any investment decision.