By Gil Menna

Onstitutional investors have long recognized the benefits of owning an interest in real estate assets. These benefits include portfolio diversification, current income, relatively stable returns and the potential to hedge against inflation. Traditionally, individual investment in real estate assets were limited to direct purchases of a fee interest in a property, purchase of an interest in a partnership that invested in real estate assets, or purchase of REIT shares. As the size of this asset class has grown, numerous products have been developed to permit direct and indirect investment in real estate EBITDA.

Any discussion of the changing face of real estate as an asset class must begin with a definition of what is included in the asset class. Though it is often broadly defined, Goodwin Procter’s view is that an investment in a real estate asset is a direct or indirect investment in the cash flows provided by owning, developing or operating real estate assets, and/or the cash flows related to the residual value associated with these assets upon expiration of the near-term income stream.

In the U.S., the primary opportunity for individuals to invest broadly in real estate equity securities has been through REITs and REOCs. In 1985, there were 82 listed real estate companies with a market capitalization of approximately $7.5 billion, and that increased to 197 companies with a market capitalization of approximately $330 billion in 2005, according to NAREIT. Investors can also obtain property and market diversification, as well as foregoing the need to perform their own detailed analysis of the underlying assets, by buying shares of real estate focused mutual funds. According to Morningstar, the number of dedicated open and closed-end mutual funds that invest primarily in real estate assets has grown from 134 in 2000 to 287 in 2005.

The increase in funds investing in real estate has raised liquidity for the asset class, and has led to the development of additional products that permit investors with specific needs to invest in real estate. For example, investment banks have securitized the cash flows generated by real estate assets, allowing investors to purchase specified cash flows derived from the underlying portfolio of real estate assets. The first collateralized debt obligation (CDO) backed solely by commercial real estate assets appeared in 1999. According to Citigroup, commercial real estate CDO issuance was approximately $14.5 billion in 2005.

Also in 2005, numerous other real estate-related securities were issued and used as collateral for a variety of CDOs. Synthetic CDOs now are being created that allow investors to purchase a derivative security that simulates the cash flows of a referenced real estate asset. Recently, the Chicago Mercantile Exchange (CME) announced that in the second quarter of 2006 it will begin trading futures and options based on indices of home prices. Futures and options trading of commercial real estate indices on the CME will likely follow and provide additional opportunities for individuals to invest.

As the asset class becomes more available through globalization and increased product availability, an interesting dynamic of both opportunity and risk is present. There is still the fundamental question of whether too much capital (regardless of its source) is chasing too few opportunities (regardless of their location).

Investors also need to consider whether the current dynamic will change when and if interest rates rise. According to JP Morgan Asset Management, historically there has not been a meaningful correlation between interest rates and REIT share prices—the correlation coefficient between the 10-year Treasury yield and REIT securities was -0.16 over a 28-year period. Presumably, this relationship is not changing even though we are entering a new era of product availability for the asset class.