By Phil Brit

At $4.6 trillion, income-producing commercial real estate—both indirect and direct—is a major component of the global investment universe, and investors increasingly are globalizing their real estate allocations. The spread of the REIT approach to real estate investment makes it easy and efficient for investors around the world to invest in other regions. At a time when many investors are diversifying abroad, the findings of a new Ibbotson Associates study, commissioned by NAREIT, serve as a reminder that a global real estate investment portfolio should be anchored with a significant allocation to North American real estate.

Ibbotson explored optimal global real estate allocations by creating and comparing the performance of optimal portfolios based on two different methodologies: one that constructed portfolio performance using historical investment returns for various asset classes, and another that projected future portfolio performance using forward-looking, expected investment returns.

Once investors realize that they can have better performance through diversification, they’ll look at other countries and at different asset classes. —Jerry Moskowitz FTSE Group Americas

“In the late 1990s and early 2000s, worldwide diversification didn’t make sense because world markets moved together,” says Jerry Moskowitz, managing director of FTSE Group Americas. “Now there’s more of a divergence. Once investors realize that they can have better performance through diversification, they’ll look at other countries and at different asset classes. One of the truisms in finance is that proper diversification leads to better returns.”

Ibbotson’s historical analysis of data for the period 1990 to 2005 showed the addition of global real estate allocation improved returns of global portfolios, with nearly all of that increase coming from U.S. real estate investment, according to Thomas Idzorek, Ibbotson Associates’ vice president of research and product development, and co-author of the study.

“The forward-looking analysis indicated that North American real estate should continue to be approximately half of the total real estate allocation in an optimized global portfolio and serve as a core component of the global market portfolio,” Idzorek says. “As compared with the optimized portfolio based on historical data, future allocation to European and Asian real estate should increase. The forward-looking optimizations include significant allocation to Asian and European real estate. As always, the key is diversification.”

Real Estate Boosts Historical Portfolio Returns

Ibbotson created its historical models by charting risks and returns for various asset classes for the 1990 to 2005 period and constructing optimized portfolios of moderate risk (defined by a volatility level of 10 percent) with and without global listed real estate. The real estate asset class was represented by the FTSE EPRA/NAREIT Global Real Estate Index, with its North American, European and Asian indexes.

The researchers found that the optimized real estate allocation by region placed the bulk of investment in North America, because of its superior returns and lower volatility, with little allocation to Europe and none to Asia.

“You can pick up 100 to 150 basis points through diversification, which is great for an investor,” Moskowitz says.

Modeling the Future

The future performance of global real estate is unlikely to be the same as the past. Consequently, Ibbotson constructed estimates of future investment returns for each asset class by blending historical returns with expected future returns. Importantly, the future return calculations took into consideration the historical levels of risk and correlation for each asset class and geographic region, based on the assumption that, over time, higher levels of risk will be commensurate with higher returns.

In Ibbotson’s unconstrained, forward-looking optimizations, allocation to global real estate range from 15 percent to 24 percent at the moderate-risk level. The allocation, however, were diversified among the world’s real estate markets.

“Approximately half of the real estate allocation—12.1 percent of the total portfolio—still went to North America,” says Michael Grupe, executive vice president of research and investor outreach at NAREIT. “However, one-third of the forward-looking real estate allocation—7.8 percent of the total portfolio—went to Europe and 3.4 percent of the total portfolio went to Asian real estate.”

Additionally, Ibbotson’s forward-looking expected returns are more conservative when compared with historical investment performance. Including global real estate, Ibbotson projected a 9.60 percent average total return for the optimal forward-looking portfolio, down from the 10.98 percent average annual return of the optimal historical portfolio.

“Ibbotson’s forward-looking results point to the growing importance of the European and Asian real estate markets for global investors—but also to the continuing importance of the North American market and the overall importance of real estate investment in a global allocated long-term portfolio,” Grupe says. “However, they also may indicate that, going forward, investors may be required to assume more risk to achieve returns comparable to historical ones.”