The Outlook for Commercial Real Estate in a Multi-Asset Portfolio

Guy: I’d like to start by establishing some context around Commercial Real Estate Equity as an Investment. Could you tell us about the historical performance of the asset class, say, over the last 20 years; I like choosing that time period because as you know, it includes a few recessions, as well as the 2008 global financial crisis?

Will: Since 2000, despite the economic and market ups and downs that you mentioned, real estate equity has delivered gross unlevered returns of 8.7%, according to tracking by NCREIF.

Bigger picture, most types of risk-adjusted return analysis between real estate and other sectors, including analysis we have completed using NCREIF data, has indicated that real estate has had an attractive relative value profile.

Guy: Your analysis shows that it is attractive from a relative value profile, but it looks to me that its historical absolute return performance per unit of risk hasn’t been too shabby either. Is it this historical risk-adjusted return profile that’s the main attraction for institutional investors?

Will: It certainly doesn’t hurt, but I think an equally or more important consideration may be the diversification it brings to a multi-asset portfolio, with primary drivers being employment growth and the rate of inflation whereas most other investment sectors are more closely tied to economic growth and corporate profits. Partially as a result of those factors, we’ve estimated that commercial real estate returns has a low R-Squared correlation with the stock market, specifically around 0.2 or 0.1 over a 20 year time period, and it’s actually been a slightly negative correlation with corporate bonds!!

Guy: The rise in the general level of asset correlations since the Great Financial Crisis of 2008 has certainly been a much-discussed topic, particularly in recent months as global central banks appear to be starting the process of removing accommodation, so I think it is important that you pointed out the low and negative correlation of Commercial Real Estate. I must admit that I am quite surprised by how low those figures are. Another area of focus lately is “Inflation”. Can you explain to me, and our listeners, how commercial real estate can act as a hedge against inflation?

Will: Over time, we believe that the value of commercial and residential real estate buildings have approximately tracked, and actually slightly exceeded, the rate of inflation. NCREIF has trackedcommercial real estate prices going back to the 1970s, and it shows that the price of a building today is about the same as the that building in the past, adjusted only for the rate of inflation.

One way to rationalize the inflation relationship relates to thinking about real estate value as a function of what appraisers and underwriters call “the cost-to-build approach to value”. Developers considered new construction profitable when the market price of the buildings exceeds the cost to build. When the inverse is true and the cost to build exceeds the market price, then new construction slows. Since the cost to build a building is very closely tied the rate of inflation, with the main factors being things like the cost of labor and the cost of concrete, and steel, the rising or declining construction pipeline tends to cause the price of real estate to gravitate back towards the inflation adjusted trend.

Guy: From a portfolio construction point of view, I find your analysis about Commercial Real Estate regarding, the two things we just talked about, correlation and the asset class’s relationship with inflation to be particularly interesting and insightful. The real estate market itself has many sub-categories, so for a multi-asset portfolio, are there other potential, let’s call them diversification benefits, that could be derived?

Will: The main diversification benefit probably being more tied to inflation, and less tied to factors that other investment sectors rely on such as corporate profits, or GDP growth, or corporate tax rates.

Beyond that, there can also be diversification within real estate, as you suggest, and this comes from either property type or geography. Commercial real estate includes many different property types and as an example office, retail, and hotel assets generally struggled during the covid-19 pandemic, while apartments and warehouses have generally benefitted from it. Geographic diversification can also play a role, as some cities have economies and labor forces that are more or less correlated with each other.

Guy: That’s interesting, yet I get a sense that Real Estate is more complex than most people realize.

Will: That may partially be my fault – I went on a bit of a tangent on types of diversification there – but bigger picture, I don’t think understanding that the asset class offers diversification is complicated, but evaluating it in an effective manner probably requires expertise. One way we’ve tried to identify and evaluate best geographic diversification benefits for the portfolios we manage, was to create a regional office networks so that we have real estate staff close to the investments we are considering, rather than housing all of our employees in a single headquarters location.

Guy: Having people on the ground locally certainly makes sense to me. Before we sign-off, I’d like to make one final comment and that is With central banks beginning to remove accommodation, I thought your mention of the inflation-hedging and low correlation aspects from Commercial Real Estate exposure, were interesting and give our listeners something important to think about. Thank you, Will, for sharing your insights.

Will: Thank you for having me.

ⁱ As of September 30, 2021

Disclosure:

This material is intended solely for Institutional Investors, Qualified Investors and Professional Investors. This analysis is not intended for distribution with Retail Investors.
This document has been prepared by MetLife Investment Management (“MIM”)¹ solely for informational purposes and does not constitute a recommendation regarding any investments or the provision of any investment advice, or constitute or form part of any advertisement of, offer for sale or subscription of, solicitation or invitation of any offer or recommendation to purchase or subscribe for any securities or investment advisory services. The views expressed herein are solely those of MIM and do not necessarily reflect, nor are they necessarily consistent with, the views held by, or the forecasts utilized by, the entities within the MetLife enterprise that provide insurance products, annuities and employee benefit programs. The information and opinions presented or contained in this document are provided as the date it was written. It should be understood that subsequent developments may materially affect the information contained in this document, which none of MIM, its affiliates, advisors or representatives are under an obligation to update, revise or affirm. It is not MIM’s intention to provide, and you may not rely on this document as providing, a recommendation with respect to any particular investment strategy or investment. Affiliates of MIM may perform services for, solicit business from, hold long or short positions in, or otherwise be interested in the investments (including derivatives) of any company mentioned herein. This document may contain forward-looking statements, as well as predictions, projections and forecasts of the economy or economic trends of the markets, which are not necessarily indicative of the future. Any or all forward-looking statements, as well as those included in any other material discussed at the presentation, may turn out to be wrong.
All investments involve risks including the potential for loss of principle and past performance does not guarantee similar future results. Property is a specialist sector that may be less liquid and produce more volatile performance than an investment in other investment sectors. The value of capital and income will fluctuate as property values and rental income rise and fall. The valuation of property is generally a matter of the valuers’ opinion rather than fact. The amount raised when a property is sold may be less than the valuation. Furthermore, certain investments in mortgages, real estate or non-publicly traded securities and private debt instruments have a limited number of potential purchasers and sellers. This factor may have the effect of limiting the availability of these investments for purchase and may also limit the ability to sell such investments at their fair market value in response to changes in the economy or the financial markets.
In the U.S. this document is communicated by MetLife Investment Management, LLC (MIM, LLC), a U.S. Securities Exchange Commission registered investment adviser. MIM, LLC is a subsidiary of MetLife, Inc. and part of MetLife Investment Management. Registration with the SEC does not imply a certain level of skill or that the SEC has endorsed the investment advisor.
This document is being distributed by MetLife Investment Management Limited (“MIML”), authorised and regulated by the UK Financial Conduct Authority (FCA reference number 623761), registered address Level 34 One Canada Square London E14 5AA United Kingdom. This document is approved by MIML as a financial promotion for distribution in the UK. This document is only intended for, and may only be distributed to, investors in the UK and EEA who qualify as a "professional client" as defined under the Markets in Financial Instruments Directive (2014/65/EU), as implemented in the relevant jurisdiction, and the retained EU law version of the same in the UK.
For investors in the Middle East: This document is directed at and intended for institutional investors (as such term is defined in the various jurisdictions) only. The recipient of this document acknowledges that (1) no regulator or governmental authority in the Gulf Cooperation Council (“GCC”) or the Middle East has reviewed or approved this document or the substance contained within it, (2) this document is not for general circulation in the GCC or the Middle East and is provided on a confidential basis to the addressee only, (3) MetLife Investment Management is not licensed or regulated by any regulatory or governmental authority in the Middle East or the GCC, and (4) this document does not constitute or form part of any investment advice or solicitation of investment products in the GCC or Middle East or in any jurisdiction in which the provision of investment advice or any solicitation would be unlawful under the securities laws of such jurisdiction (and this document is therefore not construed as such).
For investors in Japan: This document is being distributed by MetLife Asset Management Corp. (Japan) (“MAM”), a registered Financial Instruments Business Operator (“FIBO”).
For Investors in Hong Kong: This document is being issued by MetLife Investments Asia Limited (“MIAL”), a part of MIM, and it has not been reviewed by the Securities and Futures Commission of Hong Kong (“SFC”).
For investors in Australia: This information is distributed by MIM LLC and is intended for “wholesale clients” as defined in section 761G of the Corporations Act 2001 (Cth) (the Act). MIM LLC exempt from the requirement to hold an Australian financial services license under the Act in respect of the financial services it provides to Australian clients. MIM LLC is regulated by the SEC under US law, which is different from Australian law.
¹ MetLife Investment Management (“MIM”) is MetLife, Inc.’s institutional management business and the marketing name for subsidiaries of MetLife that provide investment management services to MetLife’s general account, separate accounts and/or unaffiliated/third party investors, including: Metropolitan Life Insurance Company, MetLife Investment Management, LLC, MetLife Investment Management Limited, MetLife Investments Limited, MetLife Investments Asia Limited, MetLife Latin America Asesorias e Inversiones Limitada, MetLife Asset Management Corp. (Japan), and MIM I LLC.