Commercial Real Estate Return Characteristics

Bonds, equities or real estate – most investors choose from these few primary asset classes.

According to data from the National Council of Real Estate investment Fiduciaries (NCREIF), you might want to put some of your money into commercial real estate.

The NCREIF Property Index (NPI), which tracks 6,971 investment-grade, income-producing properties in the U.S., posted an average 8.16 percent return over a 10-year period, compared to 3.99 percent posted by the Barclays Capital Government Bond Index and 7.89 percent posted by the Standard & Poor Index in that same timespan.

In recent years, real estate has been helped by the relative economic strength of key gateway cities in the U.S. and a relative lack of development activity. This has made real estate investment an attractive alternative to other asset classes. “People have slightly lost faith in equities, which used to be a bulk of institutional portfolios,” said Richard Barkham, global chief economist for CBRE, a leading real estate services company. “There was quite a lot of concern about inflation after the recession, and property gives you a good income return and potentially some protection against inflation.”

Lower Risk, Higher Returns over the Long Term?

The NPI is an unlevered index that aggregates U.S. property-level performance. NCREIF also produces an aggregate real estate fund performance index, NFI-ODCE (NCREIF Fund Index – Open End Diversified Core Equity), a levered index of investment returns reporting on both a historical and current basis the results of 33 open-end commingled funds pursuing a “core” (high-quality properties) investment strategy.

Each of these measures has been used to compare the risk and return profiles of real estate against other major asset classes. A recent MetLife study presented one such comparison, which showed that core real estate tends to have relatively low volatility, similar to corporate and government bonds, but with a higher return over the long term. This seems to be attributable to real estate possessing both stock and bond characteristics. A real estate equity investor potentially gains from rising property values, just as a stockholder gains from rising stock prices. And, absent defaults, a real estate equity investor receives a contractual rental income stream, just as a bondholder receives a contractual income stream.

20-Year Return and Risk Profile Across Major Asset Classes

We’ve noted before the advantages of long-term investing. Volatility generally declines over long hold periods for all asset classes, but what do long-term real estate returns typically look like?

Another chart based on NCREIF data shows the NPI total return index since 1978.

NPI Total Return Index Over Time

Real estate experiences market cycles just like other asset classes, but the above chart indicates that patient investors are generally able to overcome economic downturns if the asset is held for a sufficiently long period. If core real estate had been purchased at its peak in Q2 2008, the losses incurred in subsequent years would have been fully recovered by Q1 2012. Similarly, after peaking in Q3 1990, the NPI total return index declined during the economic downturn of the early 1990s but ultimately returned to that level in Q2 1995.

Data from Private Real Estate Transactions can be Hard to Evaluate

The data produced by NCREIF are among the most widely used available for privately owned real estate, but it’s still not a perfect measure of real estate returns. It is primarily an appraisal-based index, and so is based to some extent on non-market based estimates. Since appraisals are typically only conducted annually, the NCREIF indices are typically “smoothed” and can lag market valuation changes. It is also largely focused on “core”-like assets – the primary commercial property types with generally “Class A”-quality buildings.

Another widely used index, the National Association of Real Estate Investment Trust (NAREIT) index, measures the total return (appreciation and income) on the portfolio of publicly traded REITs. The NAREIT data is essentially a stock price transaction-based index; this characteristic of capturing share prices, and not the underlying properties, makes it a much more volatile measure.

It is difficult to find a useful return benchmark for real estate private equity funds, although the NFI-ODCE makes an attempt. Funds have different investment strategies that may or may not align with traditional real estate investment approaches. Some funds develop and redevelop, while others focus on acquisitions of core assets; some focus on distressed debt and non-performing loans, while others acquire portfolios of corporate or government assets; some invest abroad, while others focus domestically.

Dr. Peter Linneman, a prominent real estate professor at the Wharton School of Business, performed NAREIT data brief analysis of the different indices and how they might compare to a typical private equity real estate investment that buys unstabilized assets that take 3 years of work to stabilize. He noted that the typical return for such a private equity fund is roughly an S-curve, and that neither the cash flows nor the mark-to-market equity returns for such a fund could be expected to resemble those of either the NCREIF or NAREIT scenarios. The first few years might often under-perform those benchmarks, but once the property has been renovated and stabilized, the private equity fund surpasses the performance of the NCREIF and NAREIT benchmarks and achieves a higher IRR.

The upshot is that neither NCREIF nor NAREIT provides truly appropriate return benchmarks for private equity funds. Since they remain the most commonly used real estate return indices, however, investors continue to rely on them for many purposes.

Lawrence Fassler
Corporate Counsel
Lawrence has over 15 years' experience as a corporate attorney and has also run a real estate construction business. He previously worked with Realty Mogul, AVE (acquired for over $4 billion), Shearman & Sterling in NYC, and Cooley in their Sand Hill Road office.