MetLife Investment Management
US Core Real Estate: A Past, Present, and Future View
About MetLife Investment Management
With more than 100 years of real estate experience, MetLife’s Real Estate Group leverages its
powerful regional presence and long-standing industry relationships to seek attractive, long-term
investment opportunities for institutional investors. MetLife Investment Management, the company’s institutional investment management platform, provides investment management services
in asset sectors including real estate equity and commercial mortgages.
MetLife Investment Management’s investment methodology is based on a disciplined underwriting process utilizing in-house credit, legal and architectural expertise for each real estate transaction. Our performance—and accountability—oriented culture is supported by over 180 real
estate investment professionals. Institutional investors can have full access to MetLife Investment
Management’s in-house real estate capabilities, including origination and underwriting, investment
management, proprietary market research and risk management. Our regional experience, with
strong capabilities in seven U.S. offices, keeps us close to the market and well positioned to serve
our clients’ commercial real estate needs.
Atlanta, GA | Chicago, IL | Dallas, TX | Los Angeles, CA | Whippany NJ
San Francisco, CA | Washington, DC, with global affiliates in London, Mexico City, Santiago and Tokyo
Contents
3
Executive Summary
4
Core Real Estate in a Historical Context
6
Core Real Estate in the Modern Portfolio
12
A Forward View of Core Real Estate and Volatility
13
Other Reasons to Consider Core Real Estate
– Liability Driven Investing
– Defeasing Long-Tail Liabilities
17
Conclusion
2
> US Core Real Estate: A Past, Present, and Future View
Executive Summary
• US core real estate offers attractive investment opportunities. Relative to other asset
classes, we believe it has a high risk-adjusted return, low volatility over long hold periods,
and a high and stable income return.
• Such favorable attributes have transformed core real estate over the last 35 years from a
rather obscure asset class to an institutional asset class that is represented in most modern
portfolios.
• Core real estate’s institutional acceptance and favorable investment characteristics position
it well for a role in the return-seeking component of liability driven investing (LDI) and in
defeasing long-tail, or long-term, liabilities that many defined benefit pension funds face.
3
Core Real Estate in a
Historical Context
Before understanding core real estate’s role in a modern portfolio, it helps to understand its
evolution from a relatively obscure asset class with little data to an institutional asset class with
a rich set of performance and market fundamentals data.
In 1978 the National Council of Real Estate Investment Fiduciaries (NCREIF) published the first
property level US core real estate index, known as the NCREIF Property Index (NPI). Despite the
introduction of the NPI in 1978, real estate was not widely accepted as an institutional asset
class until the early to mid-1990’s. Table 1 illustrates the development of these two indices since
1978. For context, the NPI end market value in 1996 was $50 billion before reaching over $100
billion in 2001 and $336 billion in 2013.
Table 1: Core Real Estate Universe
Market Value (billions)
Contributors/funds
Properties
Leverage
Occupancy
Data availability
2013Q2 NPI
1978Q4 NPI
336
0.580
126
0.151
14
19
6
233
1,965
57
7,099
2013Q2 NFI-ODCE 1978Q4 NFI-ODCE
99
Unlevered
Unlevered
22.5%
3.5%*
90.3%
93.4%
91.1%
89.0%
1978Q1-present
1977Q4-present**
Source: NCREIF
*As of 1985 when data was first made available on NFI-ODCE leverage levels.
**Data for the NFI-ODCE goes back to 1977Q4, but the index was not introduced until 2005.
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> US Core Real Estate: A Past, Present, and Future View
The NPI is an unlevered index that aggregates US property level performance while the NFI-ODCE
is a levered index that aggregates US fund level performance. The NPI includes the four main
property types (office, industrial, retail, apartment) plus hotels. The NFI-ODCE tracks the same
property types with just over a 3% allocation to “other” property types which include resorts, selfstorage, parking, and land. Both are considered core real estate benchmarks because a property
or fund needs to meet strict core-like requirements, such as occupancy levels, before inclusion is
granted.
Although core real estate’s historical performance will be discussed further on, Table 2 provides
a brief overview of its performance since 1978 over a variety of economic cycles. Of note are
core real estate’s relatively high cash flow and income return, high average occupancy rate, and
relatively low beta.
Table 2: NPI Property Type Characteristics 1978-2013
Apartment
CBD office
Suburban office
Industrial
Retail
Appreciation Return
3.2%
2.3%
-0.2%
1.2%
2.0%
Income return
7.3%
4.9%
7.6%
8.0%
7.5%
Cash flow return
7.3%
5.9%
4.8%
5.5%
5.0%
Beta*
0.90
1.44
1.09
0.95
0.73
Average occupancy rate
93.4%
88.8%
87.6%
91.0%
92.4%
Source: NCREIF Property Index (NPI)
*
Beta measures the sensitivity of an asset’s total return to that of the market which is defined here the total NPI. The betas derived here measure the covariance of each property type with the total NPI divided by the variance of the total NPI.
Data from 1978Q1-2013Q2
5
As the NPI and NFI-ODCE grew over the last 35 years, so too did the amount of information on
real estate market fundamentals and pricing. An era of more rapid and accurate price discovery
in the US core real estate market was born. Property appraisals that did not quickly or accurately
reflect price declines during economic downturns were a once-criticized feature of the NPI. This
changed during the most recent recession as properties held in the NPI were swiftly appraised
downwards to reflect much more accurate property values. During the 2007-2009 recession,
appraisers had a variety of price-based real estate indices at their disposal which had not been
available to appraisers in prior recessions, such as the NCREIF Transaction Based Index, the
Moody’s/RCA Commercial Property Price Index, and Green Street Advisors Commercial Property
Price Index.
Core Real Estate in the
Modern Portfolio
As the performance history of the NPI and NFI-ODCE grew, core real estate could be properly
analyzed within the Modern Portfolio Theory (MPT) framework. The foundational components
of MPT—risk, return, correlation—can readily be applied to core real estate. Chart 1 shows the
risk and return profiles of various asset classes over the last 20 years1. Core real estate tends
to have similar volatility as corporate and government bonds with a higher return over the long
term. The reasons vary, but we believe core real estate uniquely possesses both stock and bond
characteristics. A stockholder gains from rising stock prices just as a real estate equity investor
gains from rising property values. Absent a default, a bondholder receives a contractual income
stream; absent a tenant default or vacancy, a real estate equity investor receives a contractual
rental income stream. As examined later, we would argue that core real estate’s most defining
and important feature is its relatively high and stable income stream.
Chart 1: 20-Year Return and Risk Profile Across Major Asset Classes
Annualized total
return
10.0%
Large cap stocks
NFI-ODCE
9.0%
NPI
8.0%
Small cap stocks
Corporate bonds
7.0%
6.0%
Government bonds
5.0%
4.0%
Commodities
3.0%
0.0%
5.0%
10.0%
15.0%
20.0%
25.0%
Annualized risk (standard deviation)
Source: Thomson Reuters Datastream
Data from 1993Q3-2013Q2
The indices used for each asset class are: Government bonds, Bank of America Merrill Lynch Treasury Master; Corporate bonds Baa-rated, Barclays
US Aggregate Corporate Intermediate; Core Real Estate, NCREIF Property Index (NPI), NCREIF Fund Index—Open-End Diversified Core Equity
(NFI-ODCE); Large capitalization stocks, Russell 1000 index; Small capitalization stocks, Russell 2000 index; Commodities, S&P GSCI Commodity
Index. The risk free rate is the 10-year US Treasury note yield.
6
We used 1993 as a starting point because it was the first time data was consistently available across these asset classes. Although core real estate is typically compared to just equities and bonds, we recognize that modern portfolios hold a wide variety of assets.
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> US Core Real Estate: A Past, Present, and Future View
Core real estate has demonstrated a relatively high risk-adjusted return over
the long term, as compared to other investment products. We believe this will
continue going forward, providing a strong argument that core real estate be
included in any multi-asset portfolio.
For investors not singularly focused on receiving an income stream, core real estate’s risk-return
profile is an equally important performance metric. Chart 2 shows the Sharpe ratio of each asset
class in five-year increments, sorted from lowest to highest, to illustrate the time varying nature of
risk-adjusted returns. The Sharpe ratio measures the unit of return, in excess of the risk-free rate,
for each unit of risk. A higher Sharpe ratio indicates a higher return per each unit of risk. Over
various real estate and economic cycles, core real estate’s Sharpe ratio has typically fallen between
that of stocks and bonds. This should not be surprising given its equity and bond-like features
explained earlier.
Chart 2: Sharpe Ratios by Asset Class Over Time
1.40
1.20
1.00
Commodities
NPI
NFI-ODCE
Corporate bonds
Government bonds
Large cap stocks
Small cap stocks
0.80
0.60
0.40
0.20
0.00
-0.20
-0.40
25 years
7
20 years
15 years
10 years
5 years
Source: Thompson Reuters Datastream
Data for each period is through 2013Q2
The indices used for each asset class are: Government bonds, Bank of America Merrill Lynch Treasury Master; Corporate bonds Baa-rated, Barclays
US Aggregate Corporate Intermediate; Core Real Estate, NCREIF Property Index (NPI), NCREIF Fund Index—Open-End Diversified Core Equity (NFIODCE); Large capitalization stocks, Russell 1000 index; Small capitalization stocks, Russell 2000 index; Commodities, S&P GSCI Commodity Index.
The risk free rate is the 10-year US Treasury note yield.
An astute reader might wonder why real estate should be considered in a modern portfolio
when bonds have consistently produced the highest Sharpe ratio over time. We would caution
that bond yields have fallen precipitously from 12%-13% in the mid-1980’s to as low as 1.5%
in mid-2012. It is easy for bonds to outperform in a continuously falling rate environment.
We believe that interest rates are likely to rise at some point in the medium term, causing
losses across low yielding bond portfolios. The last section of this paper addresses how equity
instruments perform better than fixed income instruments in a rising interest rate environment—
an environment that looks increasingly more likely the longer interest rates hover near historical
lows. Irrespective of the interest rate environment, we believe core real estate’s relatively high,
consistent income return positions its risk-adjusted return favorably relative to other asset
classes.
In addition to core real estate’s relatively high risk-adjusted return, it has three distinguishing
features that solidify its position within a modern portfolio.
1. Since 1990, the average 5-year rolling total return correlation between core real estate
and large capitalization stocks and that of US government bonds was 0.56 and 0.67,
respectively2. Core real estate may not have the highest Sharpe ratio, but its low correlation
relative to other asset classes boosts its weighting within a modern portfolio. Core real estate
is a portfolio diversifier over a long-term hold period.
2. For investors heavily focused on an asset’s ability to produce a consistent income steam, this
next point is both illustrative and imperative. Chart 3 shows that core real estate consistently
produces a higher income stream than equities. Over the last 10 years core real estate has
also produced a higher income stream than government bonds.
Core real estate’s cash flow return averaged 5.6% with annual standard deviation of 0.6% since
1978. Over the same time period, stocks produced a 2.9% dividend yield with a 0.7% standard
deviation and bonds produced an average coupon rate of 5.3% with a 0.9% annual standard
deviation. All three measures of income (cash flow, dividend yield, coupon rate) attempt to reflect
the cash an investor actually receives each period.
8
The Russell 1000 index was used for large capitalization stocks and the Bank of America Merrill Lynch Treasury Master was used for the US government bonds.
2
> US Core Real Estate: A Past, Present, and Future View
Over the last several decades, core real estate outperformed stocks and bonds
from an income perspective.
Chart 3: Core Real Estate from an Income-Oriented Standpoint
Real estate cash flow return
Real estate income return
10-year US Treasury coupon
S&P 500 dividend yield
9.0%
8.0%
7.0%
6.0%
5.0%
4.0%
3.0%
2.0%
1.0%
0.0%
1980’s
1990’s
2000’s
Source: Thomson Reuters Datastream, S&P 500 Composite, NCREIF Property Index (NPI)
Data from 1980Q1-2009Q4
9
Since inception, properties held in the NPI have produced an annualized income return of 7.5%,
or 82% of the entire total return. In this regard core real estate differs from value added and
opportunistic real estate strategies which derive only 40%-50% of their total return from the
income component3. Investors pursuing value added or opportunistic real estate strategies
are typically trying to achieve high absolute returns whereas investors pursing core real estate
strategies may have several different goals such as diversification and a stable income return.
3
The All Opportunistic and All Value Added Value Weight indices were used from the Townsend fund series.
Investors should not be overly concerned about core real estate’s volatility if
they plan to hold real estate over a long time period of 20 years or more.
3.
Volatility, as measured by annualized standard deviation, declines over long hold periods across all asset classes with core real estate experiencing particularly low volatility over a 20-year hold period (chart 4). The lower volatility is partially due to the fact that the core real estate indices used here are based on valuations, rather than market prices. We agree that market, rather than valuation, prices are highly relevant when investors sell an asset; however, valuations are much more relevant for investors holding, rather than selling, core real estate for very long periods of time.
Chart 4: Volatility Over Different Hold Periods
Stocks
NPI
Corporate bonds
NFI-ODCE
REITs
Standard deviation of annualized total returns
25%
20%
15%
10%
5%
0%
1 year
2 year
3 year
4 year
5 year
6 year
7 year
8 year
9 year
10 year 15 year 20 year
Source: Thomson Reuters Datastream, NCREIF
Data from 1979Q1-2013Q2
The indices used for each asset class are as follows: Corporate bonds Baa-rated, Barclays US Aggregate Corporate Intermediate;
Core Real Estate, NCREIF Property Index (NPI) NCREIF Fund Index—Open-End Diversified Core Equity (NFI-ODCE); Stocks,
Russell 1000 large capitalization index; REITs, FTSE NAREIT US Real Estate All Equity Index.
10
> US Core Real Estate: A Past, Present, and Future View
To be clear, we are not suggesting that holding core real estate for a long period of time (20+
years) removes all risk associated with the asset class. Investors might ask what happens if they
hold core real estate for 20+ years but need to sell at a less-than-favorable point in the real estate
cycle. Chart 5 shows the NPI total return index since 1978. If core real estate was purchased at
its peak in 2008Q2, the losses incurred in subsequent years would have been fully recovered by
2012Q1. Similarly, the NPI total return index peaked in 1990Q3 before declining and reaching its
1990Q3 peak level in 1995Q2.
Chart 5: NPI Total Return Index Over Time
Index
100=Q1:1978
2500
16 quarters before index returned to
pre-recession levels
2000
1500
1000
24 quarters before index returned to
pre-recession levels
500
11
1978Q2
1979Q2
1980Q2
1981Q2
1982Q2
1983Q2
1984Q2
1985Q2
1986Q2
1987Q2
1988Q2
1989Q2
1990Q2
1991Q2
1992Q2
1993Q2
1994Q2
1995Q2
1996Q2
1997Q2
1998Q2
1999Q2
2000Q2
2001Q2
2002Q2
2003Q2
2004Q2
2005Q2
2006Q2
2007Q2
2008Q2
2009Q2
2010Q2
2011Q2
2012Q2
2013Q2
0
Source: NCREIF Property Index (NPI)
The influx of foreign pension and sovereign wealth capital into US core real
estate could further reduce its volatility given the generally long-term hold
investment objective of such capital.
A Forward View of Core
Real Estate and Volatility
Going forward, core real estate’s volatility may decline further given the potential influx of
foreign capital into the US real estate market. Earlier this year, the Obama Administration
proposed a reform which would exempt foreign pension funds from paying US federal
taxes on the sale of US real estate properties. Lobbyists are also pushing to have the same
tax exemption for sovereign wealth funds and other foreign investors. Although it is unclear
if and when the reform will occur, any level of reform could boost foreign capital flows
into US real estate. Both developed and developing countries are seeking investments
with stable income streams and relatively high risk-adjusted returns to meet the growing
pension liabilities of their aging populations.
The amount of foreign, or cross border, capital targeting US real estate assets increased
dramatically over the last 10 years (chart 6). In 2000, US real estate attracted around
$3.0 billion of cross border capital or 3.5% of total US acquisition volume that year. In
2012, cross border real estate purchases totaled $24 billion or about 10% of total US
acquisition volume. Since 2007, five of the ten largest buyers of US office properties were
Kuwait Investment Authority, Qatar Investment Authority, Caisse de dépôt, National Pension
Service of Korea, and the Canadian Pension Plan Investment Board. The majority of the
office purchases were made in New York, Washington, DC, Los Angeles, and San Francisco4.
Chart 6: Cross Border Purchases of US Real Estate
Billions USD
$18
$16
$14
$12
$10
$8
$6
$4
12
$2
2013Q2
2012Q4
2012Q2
2011Q4
2011Q2
2010Q4
2010Q2
2009Q4
2009Q2
2008Q4
2008Q2
2007Q4
2007Q2
2006Q4
2006Q2
2005Q4
2005Q2
2004Q4
2004Q2
2003Q4
2003Q2
2002Q4
2002Q2
2001Q4
2001Q2
$0
Source: Real Capital Analytics; Data from 2001Q2-2013Q2
4
Data from this paragraph is from Real Capital Analytics.
> US Core Real Estate: A Past, Present, and Future View
Core real estate fits within the return-seeking component of liability driven investing due to its relatively high risk-adjusted return.
Other Reasons to Consider
Core Real Estate
Core real estate’s attributes presented thus far—high risk-adjusted returns, low volatility, relatively
high and consistent income stream—have established its place within a modern multi-asset
portfolio. However, core real estate’s role in the return-seeking component of liability driven
investing (LDI) and its ability to defease long-tail liabilities should not go unnoticed.
LIABILITY DRIVEN INVESTING (LDI)
Not all investors are solely concerned with maximizing returns and minimizing risk. For pension
funds, or any entity that must match assets to liabilities, the goal is to meet future benefit
payments5. Under LDI, the biggest risk is when an increase in liabilities is not perfectly matched
with an increase in assets. Asset values that move perfectly with liability values provide the best
hedge under LDI.
Many LDI strategies have a return-seeking and a liability-hedging component. The return-seeking
component is used to achieve high absolute returns. This is particularly important for under-funded
pension plans seeking to become fully funded. The liability-hedging component is used to perfectly
match the movement in liability values to the movement in asset values.
Given that most liabilities are discounted using some sort of fixed income instrument, real estate
assets do not neatly fit into the liability-hedging component. Although real estate prices move
in response to interest rates, the correlation between the two variables is not 1.0 over short and
medium time periods. The correlation between core real estate and a broad basket of pension fund
liabilities is estimated at around 14% versus a 97% correlation with corporate AA-rated bonds6.
From this perspective, real estate debt instruments, such as commercial mortgages or commercial
mortgage-backed securities (CMBS), should be more effective liability hedges since they are priced
relative to swaps or US Treasuries.
13
Core real estate does have a place in the return-seeking component of LDI because it has the
ability to achieve the higher returns under-funded pension plans need. One problem with perfectly
matching liability values to asset values is that a pension plan may have difficulty achieving high
absolute returns. This is critically important today when some pension funds are under-funded and
need to achieve high absolute returns to reach a fully funded status.
5
This assumes that the pension fund has to discount its liabilities at changing interest rates. That is not true for all pension funds, particularly public pensions funds.
6
MacKinnon, Greg, “Liability Driven Investing: What Is It and Does Real Estate Fit?”, PREA Quarterly, September 2011. The basket of pension fund liabilities was estimated using the Citigroup Liability Index.
As a result, many under-funded pension plans are implementing a dynamic LDI strategy which
also has a return-seeking component. The goal of the return-seeking component is to move an
under-funded pension plan to a funded status via higher absolute returns.
CORE REAL ESTATE EQUITY CAN HELP DEFEASE LONG-TAIL LIABILITIES
Life insurers and many defined benefit pension funds face long-term, also known as long-tail,
liabilities. Being able to meet these long-tail liability payments requires the proper allocation
between equity and fixed income strategies. The proper allocation rests on two key elements:
1. The initial interest rate environment and
2. whether the long-tail liabilities were issued at rates above or below initial interest rates.
Initial interest rates dictate the future performance of fixed income investments
(chart 7). Investing in today’s low yielding fixed income instruments will not likely produce
enough return to meet future long-tail liability payments. In fact, investing in fixed income
instruments today has the potential to lock in losses, further reducing the ability to meet
future long-tail liabilities. Initial market interest rates have little impact on core real estate’s
performance over a 10-year hold period (chart 8).
In general, if long-tail liabilities are issued at rates above current interest rates, then equity rather
than fixed income strategies have a higher probability of meeting future long-tail liabilities.
On the other hand, if long-tail liabilities are issued at rates below current interest rates, then a
combination of fixed income and equity strategies are appropriate.
Since average equity returns, including those of core real estate, are greater than average fixed
income returns, the majority of equity terminal values will exceed fixed income terminal values.
This is particularly acute in persistently low interest rate environments where fixed income
instruments have little chance of outperforming equity strategies.
14
> US Core Real Estate: A Past, Present, and Future View
The implication is that in today’s low interest rate environment, core real estate equity has a higher chance of meeting future long-tail liabilities than fixed income strategies.
10-year hold US government bond total return
Chart 7: Government Bond Performance versus Initial Market Interest Rates
16.0%
R2 = 0.876
14.0%
12.0%
10.0%
8.0%
6.0%
4.0%
2.0%
2.0%
4.0%
6.0%
8.0%
10.0%
12.0%
14.0%
16.0%
Initial 10-year US treasury yield
Source: Thomson Reuters Datastream
Data from 1978Q1-2013Q2
Chart 8: Core Real Estate’s Performance versus Initial Market Interest Rates
15
10-year hold core real estate total return
OCTOBER 2013
14.0%
R2 = 0.0775
12.0%
10.0%
8.0%
6.0%
4.0%
2.0%
2.0%
4.0%
6.0%
8.0%
10.0%
Initial 10-year US treasury yield
Source: NCREIF Property Index (NPI), Thomson Reuters Datastream
Data from 1978Q1-2013Q2
12.0%
14.0%
16.0%
Why do initial interest rates have little impact on core real estate’s performance over a 10-year
hold period? Initial interest rates can affect a real estate asset’s purchase price, but a real estate
asset’s value can increase over time irrespective of interest rates. Re-tenanting a retail asset with
more desirable tenants, renovating an outdated office building lobby, or buying an apartment in
demographically changing neighborhood can increase real estate values.
For the most part US pension funds understand the equity versus fixed income tradeoff explained
above. According to the latest OECD Pension Market in Focus report, US pension funds, in
aggregate, have a 50% allocation to equities. The other 50% is a split allocation between other
(which includes real estate among other asset classes) and bonds. However, a strong case exists for
allocating more to core real estate equity given its ability to both defease long-tail liabilities and to
produce a higher risk-adjusted return than stocks over a long hold period (chart 1).
16
> US Core Real Estate: A Past, Present, and Future View
Conclusion
Core real estate is well positioned to play a more significant role in institutional investing going
forward. Core real estate belongs in a multi-asset portfolio due to its high risk-adjusted return, low
correlation to other asset classes, high and stable income return, and low volatility over long hold
periods. Such favorable investment characteristics have transformed core real estate from a rather
obscure asset class to an institutional asset class over the last 35 years. Core real estate also has a
role in the return-seeking component of liability driven investing (LDI) and in defeasing long-tail, or
long-term, liability risks that face pension funds and other financial institutions.
To learn how you can access our unique platform and capabilities, contact:
David Rothenberg
Global Head of Institutional Client Group
MetLife Investment Management
[email protected]
17
Disclaimer
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> US Core Real Estate: A Past, Present, and Future View
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