Business Advice
Abstract
Endowments funds are investment funds or financial assets that are donated to academic institutions like universities, NGOs, hospitals and churches. Endowments are generally invested by the fund management teams of the institutions into investment vehicles like real estate assets, equities, bonds and investment funds to generate an extra inflation adjusted income which helps in further asset formation and meeting the ongoing operational costs. XYZ University has decided allocate a portion of its endowment fund for direct investment in commercial real estate. The investment committee needs to take the decision by evaluating the options available in commercial real estate markets for investment of around $200-400 million in order to build a diversified real estate investment portfolio. Myself as the investment consultant retained by the XYZ university endowment investment committee has to evaluate the options available in the real estate markets for direct investment. Moreover the return of investment of the REITs, bonds and equities needs to be evaluated and produced before the committee to gauge in to the investment viability scenario of various investment vehicles. The relative position of direct real estate investment in comparison to other investment options needs to be shown to the committee. In this paper I will analyze the options available for direct investment in commercial real estate market and its comparative analysis with REITs, bonds and equities and will provide a comparative outlook of each option available.
Commercial real estate property refers to the income or rent producing properties such as offices, Retail spaces, industry, warehouses, hotels and multi-family residential apartments. Manufactured housing, self-storage and healthcare also come under the category of commercial real estate owners of the commercial real estate property receive monthly rents from the tenants in the commercial building. (Brady, 2016, p. 2). The post-recession era real estate market is characterised by cross border investment flow, a trend towards diversification of portfolio and willingness to look beyond the traditional commercial real estate options of offices, retail and industrial. The specialist real estate property is becoming a popular option among the institutional investors for led by fixed income sectors like healthcare and retirement homes. It also encompasses automotive hotels, student accommodation and private rented sector residential accommodation. Commercial real estate assets like petrol pumps, service areas, data centres and waste management are becoming an important part of diversified investment portfolio. (Mazur, 2016, p. 1)
According to a report by World Economic Forum, the global real estate investments reached pre- recession level in 2014 and the investments should reach $1 trillion in the coming five years. The research identifies the top 30 cities across the globe for real estate investment. Globally, London was the top city to invest in real estate followed by New York and Tokyo. In the American continent, New York, Los Angeles, Boston, San Francisco, Washington and Toronto were the top real estate investment markets. London, Paris, Munich, Stockholm, Dublin and Berlin were leading markets in Europe. The Asian cities of Tokyo, Shanghai, Hong Kong, Seoul and
Singapore featured as top real estate investment destinations in the emerging economic region of Asia. Melbourne and Sydney were the best cities to invest in Australian continent. None of the cities from the African continent made it in to the top 30 city list. (Dyer, 2015, p. 1)
Advantages and Disadvantages of investing in REITs as compared to direct commercial real estate investment
Real Estate Investment Funds (REITs) generally have access to the debt and equity market thus can benefit from the low cost of capital and flexibility of capital structure. Additionally, they tend to benefit from the operational efficiencies, especially the tenant retention in the retail space. The primary benchmark for REITs is MCSI US REIT index (RMZ) which is a free-float adjusted market-capitalization-weighted index of equities REIT securities. REITs are especially suitable for investors seeking passive or indirect investment to institutional, professionally managed real estate with potential for current income and daily liquidity. The risks associated with REITs are that they are positively correlated to the broader equity market which gives them similar volatility. Secondly, their performance is highly dependent on the overall stock market conditions. Lastly, when capital markets are on a slowdown, REITs have difficulty in accessing capital with which to grow as 90% of their earnings are distributed as dividends. The drawback of private REITs is that they provide minimal transparency and liquidity.
An alternate to buying REITs is to invest directly in to the real estate in private markets and outright purchase of property. The real estate property whose price rises during the inflationary period can be purchased to hedge against inflation. Moreover, the rents and leases of the property can be readjusted depending on the inflation scenario and fluctuations in demand and supply.
Real Estate has historically displayed low correlation with bonds and stocks. This characteristic of real estate can be used by investors to allocate funds in a diversified portfolio. In comparison to REITs, direct real estate investment requires day-to-day involvement in the management activities like leasing, property management and various other activities. Direct investment enables the investors to target specific markets and meet their risk and return expectations. Direct ownership of the property allows investor to have direct control of the management and operations of the property without having to pay the fees prevalent in investment funds. The NCREIF property index is an index that tracks the direct real estate investments. The returns vary greatly depending on investor’s experience, knowledge and skills in managing the real estate property. Moreover, the condition of the market and timing of purchase of the property also play an important role in determining the returns from direct real estate investments.
The risks involved with direct investment in real estate that firstly the investment tends to be concentrated in a few large transactions. Secondly the cost of direct real investment maybe higher as the investor maybe required to outsource the property management or asset management. Lastly, the private real estate market is not as liquid as the REITs and the time required to liquidate the property maybe long, costly and in some cases unsuccessful (Brady, 2016, p. 2).
Comparative study of REITs, equities and bonds with the direct real estate investment through statistical analysis of available data. From the data available on the rate of return of NCREIF, equities like SP 500 and Russell 2000, REIT, 30 years bonds and 30 day treasuries for each quarter the period of 1979-2014, the attractiveness can be compared by key statistical indicators like average rate of returns and variance. Moreover the correlation of the other investment options in comparison to direct real investment will provide a clear picture on the relation of upward or downward movement of rate of returns of the commercial real estate index in comparison with other options.
Average Rate of Returns: ARR is a financial ratio used in capital budgeting. The ratio does not take into account the concept of time value of money. ARR calculates the return, generated from net income of the proposed capital investment. The ARR is a percentage return. As per the blow given analysis of the data available the highest ARR is for REITs whereas the lowest ARR is given by 30 days treasuries.
Variance: The variance measures how far each number in the set is from the mean. Higher variance depicts volatility whereas lower variance shows stability of the entity. The highest variance as per the data is depicted by the equity Russell 2000 whereas the lowest variance belongs to 30 day treasuries bonds.
Correlation of commercial real estate investment index NCREIF with other investment options:
Correlation is used to measure and describe the strength and direction of the relationship between two variables. As per the inference from the data the positive correlation is the strongest between
NCREIF and REIT whereas the negative correlation is with 30 year bonds.
Findings from the comparative data analysis of different investment options:
The data analysis clearly depicts that average rate of returns is of direct real estate investment is lower than all the other options except the 30day treasuries which depicts its weakness as far as returns are concerned. But the second lowest variance of direct real estate investment proves that it is a less volatile investment option as compared to others options except 30 day treasuries. The negative correlation between real estate property investment and 30 year bonds indicates that to hedge risk and instability of markets the portfolio should be diversified to include more of 30 day bonds along with real estate investments.
Outlook for 2016 for commercial real estate and other options:
The sharp rise in the volatility of the stock markets has been the starting event of the investment ecosystem. The sluggish global growth, political instability and slowdown in Chinese economy is bound to make the equities market risky and unattractive for an institutional investor.
Moreover the Central Banks are under pressure to make the monetary policies more accommodative which indicates towards low returns from the government bonds and treasuries (Koesterich, 2016, p. 1). The Outlook for real estate looks positive as there are positive macroeconomic steps being taken by governments across the globe. Moreover the reducing unemployment in US and other parts of the world and the reducing commodity prices are bound to fuel the demand for real estate since other investment options remain volatile or provide low return. The moderate pace of expansion in the GDP of most of the nations across the globe will substantially benefit the real estate. The real estate industry has been achieving higher occupancy rates in existing properties and has shown measured growth in new property development. The diverse and plentiful investment options available in the global real estate markets for investor in mature markets like US, Europe and Japan along with emerging markets like Brazil, Nordics and China are attractive investment signals to a large institutional investor. To conclude, the comparative outlook for 2016 for the real estate markets looks stable and it is a safe return paying option compared to other investment vehicles. (Grinis, 2015, p. 35)
Conclusion
Commercial real estate investment plays an important part in diversifying the portfolio of an institutional investor. The chief benefits of investing in commercial real estate are opportunity for attractive total returns, inflation protected investment and low-to-moderate correlation with other investment option classes. Direct real estate investment has historically generated attractive returns for the investors according to the NCRIEF. The combination of current income and capital appreciation makes real estate and attractive and stable investment option to institutional investors.
Recommendations
The investment committee of XYZ University should diversify its portfolio by directly investing diversified properties in top real estate markets across the globe. Due to increasing trend of cross border investment in real estate during the present decade, investing in property in a growing and high return off shore real estate destination is easier and safer than ever. An investment of $200 to 400 Million is substantial to hold a diversified portfolio of commercial real estate property.
The mix of property should be according to the market conditions and emerging trends. A combination of high rent paying office, retail and industrial property is advisable along with speciality properties like hospital and hotel. Moreover, the risk created due to volatility of the equity market due to macroeconomic reasons can be hedged by reallocating financial liquidity towards high return real estate and more secure 30 year government bonds. The investment committee also needs to acquire a strong team for real estate and asset management of its acquired properties for assured and hassle free returns.
Reference:
Brady, J. (2016). Oaktree Insights. Strategy Primer: Investing in Real Estate, 2, Retrieved from http://www.oaktreecapital.com/docs/default-source/default-document- library/oaktreeinsights_real-estate_final.pdf?sfvrsn=2
Dyer, C. (2015). World Economic Forum. 30Top cities for real estate investment, 1, Retrieved from http://www.weforum.org/agenda/2015/01/30-top-cities-real-estate-investment
Koesterich, C. (2016). BlackRock. Year of Bear? Investment Directions, 1, Retrieved from http://www.blackrock.com/investing/insights/investment-directions
Grinis, M. (2015). Ernst &Young. Global Market Outlook: Trends in real estate private equity, 35, Retrieved from http://www.ey.com/Publication/vwLUAssets/EY-global-market-outlook-2016-trends-in-real-estate-private-equity/$FILE/EY-global-market-outlook-2016-trends-in-real-estate-private-equity.pdf
Mazur, J. (2016). Knight Frank. Five future trends in capital markets. 1, Retrieved from www.knightfrank.com/globalcities/2016/investing/property-investment-opportunities
