Various Risk-Adjusted Performance Measures are Equally Effective for REIT Analysis
From “Does the Composition of the Market Portfolio Matter for Performance Rankings of Post-1986 Equity REITs?,” by Justin D. Benefield, Randy I. Anderson, and Leonard V. Zumpano, published in Journal of Real Estate Portfolio Management, July–September 2007.

Three researchers, Justin D. Benefield of College of Charleston, Randy I. Anderson of The Anderson Group, and Leonard V. Zumpano of University of Alabama, compare measures of risk-adjusted REIT investment performance, including the Sharpe ratio, Jensen's alpha and Treynor index. The authors computed them against several benchmarks to determine whether they yield consistent results. Benefield, Anderson and Zumpano conclude that the choice of benchmark does not affect measures of risk-adjusted performance.

"As REITs become more accepted as an alternative asset class, issues surrounding their performance take on more importance for investors of all types.

Clearly, the rankings provided by the various market indexes are very similar. In other words, REIT performance rankings are robust."

Editor's note: The chart shows one measure of risk-adjusted performance—the Sharpe ratio, measured as average annual excess total return divided by standard deviation of monthly returns—for 719 equity investment benchmarks: five U.S. REIT indexes (shown in green), 17 global listed property indexes, 10 commodity indexes, 158 U.S. stock indexes and 529 global stock indexes. Risk-adjusted returns for U.S. REITs have been far superior to risk-adjusted returns for most other equity investments over the past 15-plus years, with Sharpe ratios between 3.15 (FTSE NAREIT U.S. REIT Index) and 2.50 (FTSE NAREIT All-REIT Index), compared to representative Sharpe ratios of 2.21 for global listed real estate (FTSE EPRA/NAREIT Global Index, shown in yellow), 1.84 for U.S. stocks (Dow Jones Wilshire 5000 Index and S&P 500 Index, both shown in white), 1.40 for international stocks (MSCI EAFE Index, shown in orange), and 0.52 for commodities (S&P GSCI Index, shown in red).

Source: NAREIT data

Real Estate Provides Unparalleled Portfolio Diversification Power

From “Will Private Equity and Hedge Funds Replace Real Estate In Mixed-Asset Portfolios? (Not Likely),” by Shaun A. Bond, Soosung Hwang, Paul Mitchell and Stephen E. Satchell, published in Journal of Portfolio Management, special issue, September 2007.

Four researchers, Shaun A. Bond and Stephen E. Satchell of Cambridge University, Soosung Hwang of GSA Capital and Paul Mitchell of Paul Mitchell Real Estate Consultancy, investigated whether alternative investments are capable of providing the same portfolio diversification power that real estate produces. They found that alternative assets were virtually irrelevant to optimal portfolios already including real estate.

"We investigate in detail the risk and return characteristics of real estate and a selection of alternative assets, along with the benefits that arise from diversification and the role of these assets in an institutional investor's portfolio. We consider core asset classes as the traditional investment sectors favored by large institutional investors. These include domestic and foreign equities, corporate bonds, gilts including index-linked, commercial real estate and Treasury bills.

The alternative asset classes have attracted institutional investors for some time, but they are not traditionally considered an essential component of the asset mix. These include private equity, hedge funds and infrastructure and commodity funds.

When the four alternative assets are added to the portfolio mix, not including real estate, the results are limited. However, when real estate is added to a mixed asset portfolio, portfolio risk is reduced dramatically.

The analysis clearly shows the importance of real estate as the principal hedging instrument in portfolio formation, and justifies the recent increase in this asset class.

Encouragingly for investors, the historical evidence provides strong support for the current trend toward high and increasing allocations to real estate.

Real estate has a significantly better risk-hedging characteristic than other asset classes. As to whether these benefits could be derived by substituting other alternative assets for real estate, the emphatic answer is that no other asset class can deliver the same level of portfolio hedging benefits as real estate."

Traditional Measures of Direct Real Estate Investment are Flawed

From “Illiquidity and Pricing Biases,” by Zhenguo Lin and Kerry D. Vandell, published in Real Estate Economics, Fall 2007.

Economists Zhenguo Lin of Fannie Mae and Kerry Vandell of UC-Irvine analyzed the effects of “marketing-period bias” and “liquidation bias” on the measured returns and volatility for direct real estate investments. They found that true returns are likely to be much lower—and true volatility much higher—than popular benchmarks suggest.

“This article demonstrates the potential pricing biases in traditional real estate valuation methodologies that implicitly assume real estate assets can be sold immediately. The assumption of immediate execution may be reasonable in the financial market where the time to trade an asset is trivial. However, it is certainly not valid in the direct real estate market where the marketing period is not only uncertain but also substantial.

Our results suggest that ignoring the existence of a finite and sometimes significant marketing period in real estate can cause the true underlying market return to be much lower than the observed transaction-based return and the underlying market risk to be much higher than the observed transaction-based risk. We conclude that traditional methods of estimation of real estate return and risk not only understate real estate risk, but also overstate real estate returns.”