Magazine article Real Estate Issues

What's New in Asset Allocation?

Magazine article Real Estate Issues

What's New in Asset Allocation?

Article excerpt

The use of asset allocation tools in the risk management and return enhancement of real estate portfolios has, at long last, come into its own. Investment advisory and real estate research and strategy firms provide institutional investors with rigorous quantitative methodologies to analyze the structure of a portfolio and assess the likelihood its returns are achieved with the least amount of risk possible. Sophisticated institutional investors apply the tools now and others will follow over time.

While the adoption of this approach to portfolio construction and management is laudable, there is never a spare moment to savor the accomplishment. A major complication to the portfolio design problem has been introduced called the "quadrants" approach to real estate. The quadrants approach seeks to broaden the traditional definition of real estate to include all the ways real estate is expressed in the investment arena. This article will explain the sense of the quadrants and discuss how the concept both complicates and enriches our thinking. In recent papers I have explained the concept of the quadrants approach to investing.(l) The intuition is recounted here.

The Sense Of The Quadrants

Traditionally real estate has, at least in the institutional investment community, been narrowly defined as assets traded in the private markets. Insurance companies allowed for the notion that both private debt and private equity could be accommodated within that definition. However, pension funds held that real estate equaled private equity. This traditional idea is now being challenged and explored for two primary reasons.

The first reason to broaden the definition of real estate is because the market where real estate assets trade does not determine the ultimate value of the investment. The ultimate value is determined by the real estate itself. For example, if a REIT was to liquidate, the value of the shares would instantly revert to the value of the underlying real estate. The management premium or discount and the impact of the stock market would evaporate as an influence on the share value. Thus, real estate is really what you are buying when you buy a RET. A further example is a CMBS issue. If push comes to shove, particularly for the BB and lower tranches, and the real estate underlying the mortgages becomes distressed, the value of the position would be fully dependent upon the value of the real estate.

Thus, the trading market and the structure of the investment layered on top of the asset serve to alter the timing of cash flows and perhaps to recut the riskiness of cash flows. This does not alter the importance of the underlying real estate. The trading market creates temporal shifts in the performance of the asset and adds influence to its valuation. Consequently, the trading market where an asset is priced and transacted should not cause us to overlook that real estate continues to drive the asset's ultimate performance.

The second reason to broaden real estate's definition is that all real estate is, to a greater or a lesser degree, comprised of both debt-like and equity-like behaviors.(2) The leases represent the cash flows most synonymous with the debt market as leases are contractual cash flows derived from differing credits. This is precisely analogous to a bond. The unleased portion of a building, and/or the space in the building at the end of the lease term is characterized as pure residual equity. The value has no contractual obligations attached to it; this part of the value is 100 percent exposed to the conditions in the market. A speculative multitenant office or industrial building is a good example of an entire property which is characterized as pure equity.

Every building, with the exception of one with a AAA credit tenant on a triple net lease, is exposed to both these behaviors in differing degrees. All real estate is a hybrid. Until now real estate investors have not paid appropriate attention to this extremely important reality. …

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