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Real Estate-A Must For Diversity
by Peter Palandjian
REAL ESTATE IS A MUST FOR ANY RETIREMENT FUND seeking prudent balance in its allocation of assets. To be sure, nearly everyone has a good story, or bad one, about investing in real estate. Often the story will include a condo investment or an experience with buying or selling a home. But personal real estate experiences notwithstanding, one must consider real estate in the context of one of the world's oldest professions. People need a place to work, to shop, to manufacture, to incubate, indeed to live and retire. There are all forms of real estate. Excellent diversity of your investment can be achieved just within this asset class. So the question should not be whether to invest or not to invest in real estate, but rather how to invest with the very same rigor and discipline, with the same careful manager selection process, with the same balance as is performed when investing in any other asset class.
Before getting into the how's of investing in real estate, let's address three basic reasons why to consider investing in this asset class. First, real estate generally has a low correlation to other asset classes. This is critical to the doctrine of diversity. If your investments in the areas of other alternative assets, or for example, in Pacific Rim equities are lagging, it is unlikely that your real estate portfolio will share directly any such poor performance. Second, real estate historically has provided a good hedge against inflation. Consider your own home: if you have owned it for a long period of time, hasn't it held its value and even appreciated relative to the general economy? In the commercial real estate world, leases, which drive the economics of a given property, are generally driven off of escalation formulas that often are calculated including factors of CPI. As a result, values in real estate, if held long enough and acquired the right way from start, will appreciate even in real dollar terms. Third, real estate provides excellent risk adjusted returns. It is not for nothing that for centuries many of the great personal fortunes have been amassed in real estate. Insurance companies and the largest pension plans in the world hold major real estate portfolios. The key here, though, as with any other asset class, is to invest intelligently and with discipline.
Within your real estate allocation, you have decisions to make across a large matrix: private or public; geographic focus or diversity; property type; direct or pooled investment. In this regard, you must spend time as a board, together with your consultants and managers, in arriving at the right fit and balance for your fund. What I would like to lay out, rather, are the issues to consider.
Real estate historically has been a private industry, at least on the equity side of the balance sheet. The last seven years, however, have seen a proliferation of REIT's- real estate investments trusts- which in their public form are securities instruments that trade on the open markets. Personally I am not a great believer in REIT's: I do not believe that the factor of time and the pressure of quality earning-per-share on management leads to good decision making. REIT's too can be structurally awkward since development and value-add practices are difficult in the face of a tax requirement (90% of earnings must be distributed annually). But herein lies the attractiveness of REIT's: (i.) you can count on the 90% dividend (assuming the company is profitable) since it is mandated; and (ii.) you can sell your shares whenever you want since they are publicly traded. A final consideration about public REIT's is the question whether over time they will behave like real estate as a class or whether they will come to be seen as behaving more like other fixed income instruments. This is an important discussion to have with your consultants, since when you make an allocation to real estate in the form of REIT's- and you think you are accomplishing your hedging and diversity goals-you want to make sure you have indeed invested in real estate. Unfortunately, since the REIT industry is in its infancy, there is little historical data to make such determination.
Private real estate, though less readily sold, has been the mode of investment since the beginning of time. You have several options here. Separate account investing is a choice for those who prefer to have direct ownership. You should still have a manager, but as the 100% owner you retain most approval rights; and most importantly you can choose to sell when you want. The down-side to this form of ownership is that unless you have a very, very large fund- large enough to own multiple such separate account properties across all property types and all geographies- then you are courting too much risk in terms of lack of diversity and single asset dependency. Pooled or commingled funds, on the other hand, are a way to get the same benefits of private real estate ownership while achieving, if you are careful in your product and manager selection, appropriate diversity. In this regard, it is imperative that you focus on the terms of a fund. Most important to you should be whether the product is structured to align your interest as an investor with that of the manager: how much of their own money are the principles putting in? is the term 7-12 years or is it longer? does the manager make money only when you make money?
Your other chief considerations revolve around property type and geographic focus. Within real estate, obviously you can choose to invest in many buckets. There is commercial real estate, which includes office, industrial, lab/life-science, retail, and sometimes timber (not all consultants and planned sponsors consider timber to be real estate). There is hospitality and leisure real estate, which includes single-family, multi-residential (for rent and for sale), townhouse condo, and a spectrum of elderly living property types. Geographic focus and diversity must also be considered: should you be regionally focused, nationally, or internationally. There are allocation issues to consider: how does the geographic investment in your other asset classes. Then there are political considerations: is your plan union oriented, do you like to create jobs locally?
Decision making across such a complicated matrix of choices is between you and your consultants and managers and will involve, no doubt, the same careful debate, analysis, and selection as with all your other asset classes. What I can say for sure, though, is you should have real estate- classically in the range of 6-12% of your portfolio. What I can also say for sure, to quote an Armenian proverb that dates back more than a thousand years, is that "real estate maybe sometimes get sick, but it never dies." Do not get too dizzy with the hi-tech and dot.com performance,-boom and bust- that we've seen in recent years. Real estate is enduring and should have a major role in achieving your actuary targets.