The Evolution of Modern Real Estate and its Role in a Multi-Asset Portfolio
CFA Society Chicago gathered in the Vault at 33 North LaSalle to hear Professor James Shilling from the DePaul Department of Real Estate discuss the evolution of commercial real estate and its increasing role in a diversified portfolio. Shilling was the James A. Grasskamp Professor of Real Estate and Urban Land Economics at the University of Wisconsin and currently holds the George L. Ruff Endowed Chair in the Real Estate Center at DePaul University.
Professor Shilling began his presentation by showing that the value of diversification has been recognized since the days of King Solomon (circa 970 BC). He then goes on to discuss how Nobel Laureates Harry M. Markowitz (1952) and Robert C. Merton (1973) quantified the concept of diversification for the portfolio.
Harry M. Markowitz is known as the Father of Modern Portfolio Theory. His work set the stage for the Capital Asset Pricing Model (CAPM) and a two-fund theorem. This theorem holds that for diversification purposes investors should hold a combination of the risk-free asset and a market portfolio of risky assets.
Robert C. Merton extended the Markowitz framework by allowing for multiple sources of uncertainty. In this framework commercial real estate can now assume a critical role as investors require another “hedge” against risk. However, real estate was slow to enter portfolios as there were only a few indices that could track performance. Beginning in the late 1970’s and early 1980’s the development of appraisal-based commercial real estate indices ameliorated this problem.
Professor Shilling pointed out that during prolonged periods of low economic growth and low interest rates the inclusion of commercial real estate is of great benefit to any investment portfolio. He argued that the current US economy continues to reflect this “secular stagnation”. The persistence of low interest rates has incented portfolio managers to leave fixed income and increase their investments in real estate. Current pension portfolios average around a 10% exposure to commercial real estate. If recent trends continue, this exposure will only increase.
The present state of the US commercial real estate market reflects the continuance of a slow growth economy. With portfolio managers searching for yield, the vehicle of choice has in many instances been commercial real estate. Professor Shilling argues that this influx of money has continued to compress cap rates, which for some properties approach 3%.
Professor Shilling pointed out that during prolonged periods of low economic growth and low interest rates the inclusion of commercial real estate is of great benefit to any investment portfolio.
Increasing correlation between asset classes due to lower interest rates and the trend towards a flat yield curve has produced a scenario for portfolio managers where there is “nowhere to hide”. It is increasingly difficult to achieve diversification using only developed market assets. He argues that more effective diversification can be achieved through investments in emerging markets assets.
Distinguished Speakers Series: Barry Sternlicht
Barry Sternlicht was the featured guest at the Distinguished Speakers Series held on Nov. 21 at the Standard Club. Sternlicht is the Chairman & Chief Executive Officer of Starwood Capital Group, a private investment firm he formed in 1991 focusing on global real estate, hotel management, oil and gas, energy infrastructure, and securities trading.
Using an inordinate number of slides Sternlicht gave a sweeping account of just about everything that related to the global economy. His remarks covered a range of investment topics including; the domestic housing market, New York City property prices, currencies, quantitative easing, oil prices, global real estate valuations, and the 2015 outlook for the U.S. and global markets.
A subset of Sternlicht’s presentation comments included:
- The top 1% are getting richer in all markets. This subgroup of the investing population is no longer willing to solely invest in domestic or global markets. Instead, these investors are now buying up real assets in prime locations – South Americans investing in Miami, Asians investing in New York, Russians investing in London, etc. These global buyers are pushing higher purchase prices in these ‘world class’ cities. As a result, buyers looking for reasonably priced real estate will have to look to ‘second tier’ cities.
- The U.S. government deficit will continue to grow despite the spending bill passed at the start of 2014. Entitlements – Medicare, Medicaid, and Social Security will increase the deficit dramatically over the next decade. To combat this the retirement age will be raised, and benefits will be reduced.
- The movement of populations from high tax states to low tax states will accelerate as more baby boomers retire. This will drive real estate growth in those low tax states and provide for slow or even negative growth in high tax states.
- Growth in retail rents is and will continue to be bifurcated. Luxury retail malls will continue to outperform in terms of high occupancy rates, and growth in rents. Properties that are not at the A level will likely exhibit slow or flat growth in rents.
- The Euro zone and Japan will institute their own form of quantitative easing. This will cause the dollar to rise against the Euro and Yen. The U.S. has promoted a weaker currency over the past several years with lower interest rates and growth in the money supply. The stagnating economies in Europe and Japan will push policy makers to weaken their own currencies in an attempt to reflate their respective economies with increased exports. Even so, a greater currency war will be fought over the next several years with many nations fighting to have a weaker currency.
- The Federal Reserve will keep interest rates lower for a longer period due to a lack of any inflation on the horizon and lower energy prices. In addition U.S. yields are higher than in Europe and Japan, which will cause flows into the U.S. market, keeping the long end of the curve depressed.
Sternlicht ended his presentation by taking questions from the audience and sharing details of his latest hotel and apartment project – the ultra-luxury Baccarat Hotels and Resorts development in midtown Manhattan. This development underscored several of the points Sternlicht made earlier – premium properties commanding outsized rents, and investing in world-class cities for outsized returns.