Skyler MacGowan, 250634552 Geography 4460 Term Paper Due April 5th, 2016

Institutional Allocation to Real Estate – An Evolving Landscape

Table of Contents Executive Summary……………...………………………………………………………..1 1.0 Preface………………...…………………………………………………………….....2 2.0 Factors Behind the Increased Institutional Allocation to Real Estate…..……………..3

2.1 Macro Environment – Changing Interest Rates……………………………….4 2.2 Increased Demand for Assets of Offering Stable Income Growth……………5 2.3 Increase Returns……………………………………………………………….5 2.4 Structural Changes in the Real Estate Investment Environment……………...7

3.0 Real Estate Allocation Between Types of Institutional Investors..………….………..8 4.0 The Future Role of Real Estate in Institutional Portfolios……………………………9

4.1 Conclusion…………………………………………………………………...10 Bibliography……………………………………………………………………………..12

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Executive Summary

This paper examines some of the reasons behind the significant increase in institutional allocation to real estate investments that has occurred since the early 1980s. I also analyse whether this increase has been observed homogenously across all types of institutional investors. Finally, I consider the future role of real estate assets in institutional portfolios. While traditional reasons for investing in real estate (diversification, inflation protection, and liability matching) remain important, four other factors have played a major role in contributing to the increased institutional portfolio weightings towards real estate investments. These are:

1) Decreased interest rates 2) Increased need for current income 3) Increased availability and interest in opportunistic real estate investments 4) Structural changes in the real estate investment environment

There have been significant disparities in the extent to which real estate allocation has increased among specific types of institutional investors. Real estate allocation is highest in pension funds where it constitutes approximately 20% of their asset mix. Conversely, smaller institutional investors (family offices and wealth managers, for example) typically allocate much less to real estate. The reasons for these disparities are primarily due to the variances in investment objectives, risk tolerance, and capital accessibility among different types of institutional investors. Most literature suggests institutional allocation to real estate will continue to increase in the future, albeit at a somewhat lesser pace due to the expected rise in interest rates. Although precise predictions are difficult, most commentators forecast real estate will constitute 15-20% of institutional portfolios by 2030, with some recent estimates in the range of 20-30%.

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1.0 Preface

Since the 1980s, there has been a consistent trend of increasing institutionali allocation to

real estate investments (Figure 1). Specifically, over the past 35 years institutional

allocation to real estate has increased from just 2.1% in 1980 to 8.8% in 2013, reaching

about 11% by 2015.1 What are the reasons behind this change? Have they been observed

homogenously across all types of institutional investors? Will this trend continue going

forward? Through a review of recent literature, this paper strives to answer these

questions and in so doing provide insight into an asset class that is playing an

increasingly important role in the global investment climate.

Figure 1: Asset Allocation of All Institutional Investors Since 19802

i In this paper, reference to “institutional investors” refers to those investors in a North American context.

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2.0 Factors Behind the Increased Institutional Allocation to Real Estate

The historic rationale for investing in real estate centered upon diversification as a means

of improving risk-adjusted returns, inflation protection, and matching long-duration

liabilities with future cash inflows.3 While these traditional benefits to real estate

investment endure, as demonstrated by Figure 2 they are not presently the most important

reasons why institutional investors invest in the asset class. Therefore, they are not the

focus of this paper. Instead, I examine the top three current reasons institutional investors

are investing in real estate and how these factors have contributed to the increased

institutional allocation to real estate that has taken place since 1980.

Figure 2: Current Motivators for Institutional Investors’ Allocation to Real Estate1

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2.1 Macro Environment – Decreased Interest Rates

Bond yields have decreased substantially in the past two decades, with current rates being

approximately one-third of what they were at the turn of the twenty-first century (Figure

3). As a result, bonds as an investment class are no

longer able to keep pace with institutional

investors’ liquidity needs, forcing them to

look elsewhere for sources of current

income. The predictable long-term income

streams from the contractual revenues

obtained through real estate investment

have proved a viable substitute for the

income lost through decreased bond yields.4 Additionally, the availability of cheap debt

facilitates real estate development, meaning that there is an increasingly wide-array of

opportunities available to real estate investors in this low interest rate environment.1 As

Figure 4 illustrates, rising interest

rates would significantly

impact the investment

strategy of the majority

(59%) of institutional real

estate investors. This implies

that just as decreased interest

rates have contributed

Figure 3: Falling Bond Yields4

Figure 4: Effect of Interest Rates on Institutional Allocation to Real Estate1

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significantly to increases in real estate investment, the anticipated rise in interest rates

could decrease investors’ enthusiasm with this asset class going forward.

2.2 Increased Demand for Assets of Offering Stable Income Growth

The problems associated with the decreasing yields from fixed income investments are

compounded by the increasing liquidity requirements of institutional investors,

particularly pension funds.4 Their increasing liquidity requirements have been driven

largely by the growing number of retirees drawing on accrued pension liabilities due to

the ageing population typical of most developed countries.5 Of particular concern are the

liabilities associated with the Baby Boom generation (ages 52-70), the majority of whom

who will retire in the next 10-15 years.5 Also, as the most recent financial downturn in

2008 is still in recent memory, the presence of a stable income stream to weather future

market cycles is a priority for institutional investors.4

2.3 Increase Returns

As mentioned, one of the major reasons traditionally cited for making an allocation to

real estate was the diversification it provided. Essentially, real estate’s reduced cyclicality

relative to bonds and equities meant that it was perceived as a safe investment, effective

in increasing a portfolio’s risk-adjusted return.3 While real estate’s diversification

benefits endure, today’s institutional investors also appreciate the asset class’s ability to

provide well-rewarded opportunistic investments. Indeed, as illustrated by Figure 5,

institutional investors in real estate currently favour value-add and opportunistic

investment strategies over core investments.

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When making value-add and opportunistic investments in real estate, investors strive to

capitalize on three main types of premiums. The increased willingness of current

investors to take these risks is due in large part to the significant reduction in rates of

return on alternative investment classes that has occurred since 1980.1

1) Illiquidity: The illiquidity of direct real estate investment relative to publicly traded

securities provides a strong risk premium.1

2) Emerging Markets: The increasing integration of global capital markets means that

current real estate investors have access to a wide-array of high-risk investment

opportunities in emerging markets that were previously unavailable.1

3) Asset Mispricing: For a few different reasons (i.e. appraisal smoothing, fewer listed

transactions relative to bonds and equities), pricing errors of real estate assets are

relatively common.6 These pricing errors provide an opportunity for astute real estate

investors to take a risk on what they perceive to be an undervalued asset.1

Figure 5: Risk Tolerance of Institutional Investors for Real Estate Investments2

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2.4 Structural Changes in the Real Estate Investment Environment

Real estate’s rise in institutional portfolios has been enabled largely by the lifting of

various barriers to investment in the asset class.2 Some of these historical barriers include

an inadequate regulatory framework surrounding real estate investment, a relative lack of

transparency and liquidity, as well as limited investment vehicles available to access

possible real estate investments.2 With time however, various developments have

significantly reduced these barriers and doing so has played a major role in the increased

institutional allocation to real estate that has occurred since 1980.2 Some of the key

developments that have increased the accessibility to real estate investments include:

1) 1982: Creation of the National Council of Real Estate Investment Fiduciaries

(NCREIF). NCREIF launches its index of institutional real estate returns,

providing a critical institutional benchmark.2

2) 1986: To address real estate’s role as a tax shelter, targeted tax reform creates

an even playing field for tax-exempt (institutional) investors.2

3) Late 1980s and early 1990s: Creation of real estate opportunity funds in the

late 1980s show the strong investment returns available through real estate. As

a result, there is a proliferation of comingled real estate funds in the 1990s,

increasing institutional accessibility to the asset class.7

4) 1992: Beginning of rapid growth in the equity REIT market, as decreased debt

availability caused by the 1986 tax reform led many owners to public markets

for their capital requirements.2 The rise of REITs permitted smaller-cap

investors to invest in real estate, further increasing the asset class’s

accessibility.

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5) Early 2000s: Rise of third-party real estate data providers (i.e. CoStar, Real

Capital Analytics) results in increased data availability and research into the

asset class.2

6) 2010-Present: Maturing of sovereign wealth funds, helping stimulate

continued growth of global capital flows to real estate investments.2

3.0 Allocation to Real Estate by Type of Institutional Investor

As demonstrated by Figure 6, the increasing institutional allocation to real estate has not

been observed homogenously across the different types of institutional investors. The

primary reason for these differences is due to the variation in investment objectives and

risk tolerance of different institutional investors.3 For example, while the steady source of

income generated by real estate investments is highly valued by pension funds, this

Figure 6: Allocation to Real Estate by Type of Institutional Investor3

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characteristic is not nearly as important for the typical wealth manager looking to

maximize capital appreciation. The different investment objectives of institutional

investors are also illustrated by the specific type of real estate investment they prioritize.

For example, as pension funds really value the income stream generated by real estate

they invest primarily in core assets.8 Conversely, endowments are more concerned about

maximizing their returns and hence allocate more to value-add and opportunistic real

estate investments.8

Also, although the accessibility of real estate investment has increased significantly in

recent years, many real estate investments still involve very significant capital

expenditures that are only accessible to the largest institutional investors.8 This is

reflected in Figure 6 which shows real estate allocations are generally highest among the

largest institutional investors (i.e. pension funds, foundations, and endowments) and

lowest among the smaller ones (i.e. family offices and asset managers).

4.0 The Future Role of Real Estate in Institutional Portfolios As discussed, the majority of institutional investors indicated that a rise in interest rates

would significantly influence their allocation to real estate investments. Therefore, some

analysts predict the expected rise in interest rates that will occur as central banks stop

flooding markets with liquidity in the wake of the financial crisis will decrease the

current enthusiasm for real estate investments.9 Also, there is speculation that the increase

in competition for real estate assets will soon start to reduce the asset class’s upside

potential.9 Essentially, the argument is that the significant increase in real estate

investment that has taken place over a relatively short time period has resulted in an

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overly optimistic perception of the asset class, not reflective of its underlying

fundamentals.9

Despite these arguments, most researchers predict institutional allocation to real estate

will continue to increase in the foreseeable future.9 Although interest rates are expected to

rise, the general consensus is that such growth will be relatively modest, with rates of

return on fixed income investments unlikely to come close to pre-2000 levels anytime

soon.4 Furthermore, to the extent fixed income yields do go up, so too will the demand

for the inflation protection capability provided by real estate. Also, the opinion that there

is an overly optimistic perception of real estate assets is not widespread. Indeed, most

literature finds that if anything, real estate assets continue to be undervalued because

despite recent improvements there is still relatively little information on real estate assets

compared to bonds and equities.6

4.1 Conclusion

The ongoing increase in accessibility to pursue higher-risk real estate investment

opportunities in emerging markets is likely to continue in the foreseeable future.4

Therefore, the trend of institutional investors allocating capital to the asset class for its

upside potential is likely to continue.4 Additionally, even with a rise in interest rates,

ageing populations in most developed countries will cause institutional investors

(especially pension funds) to continue to invest heavily in real estate for its predictable

income stream.9

As a result, institutional allocation to real estate assets is likely to continue to increase

going forward, although perhaps at a lesser rate due to the expected rise in interest rates.

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Indicative of this, recent studiesii predict institutional real estate allocations of 20-30% by

2030, with more conservative estimates suggesting real estate allocations of 15-20% by

that time.9 Also, due to their differing investment objectives and risk tolerance, future real

estate portfolio weightings will likely continue to vary significantly depending on the

specific type of institutional investor.

ii For example, in its 2013 study entitled “Real Assets: The New Essential”, Brookfield Asset Management writes, “we expect this trend (towards increasing real estate allocation) to accelerate materially over the course of the next decade, with allocations to real estate reaching 20% to 30% of portfolios by 2030, with some institutional investors allocating upwards of 50% to the asset class.”3

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Bibliography 1) BlackRock, Incorporated. (September 2014). The Ascent of Real Assets: Gauging

Growth and Goals in Institutional Portfolios. New York, NY: McCombe, M. Botein, M. Sperber, M. Barry, J.

2) Commercial Real Estate Development Association. (Spring 2015). Real Estate Takes Its Place as the Fourth Asset Class. Cornell University. Ithaca, NY: Funk, D.

3) Kennedy Associates Real Estate Counsel, Inc. (2002). Making and Allocation to Real Estate. Toronto, ON: Lindahl, D.

4) Brookfield Asset Management. (2013). Real Assets: The New Essential. New York:

NY. 5) Congress of the United States, Congressional Budget Office. (2003). Baby Boomers’

Retirement Prospects: An Overview. Purdue University. Holtz-Eakin, D. 6) European Business School. Real Estate Risk in Equity Returns, Empirical Evidence

from US Stock Markets. Wiesbaden, GER. Gaston, M. Johanning, L. 7) Higgins, D. (2007). Comingled Four Quadrant Property Funds: Creating an

Investment Framework. University of Technology, Sydney. 8) Massachusetts Institute of Technology. (2011). Alternative Investment Opportunities

in Real Estate for Institutional Investors. Harper, J. 9) PricewaterhouseCoopers. (2016). Emerging Trends in Real Estate: Canada and the

United States. Washington, D.C. Kelly, H.