Having a Real Estate Investment Option Is Critical to Portfolio Returns and “Utility”

From “Investing for the Long-Run in European Real Estate,” by Carolina Fugazza, Massimo Guidolin, and Giovanna Nicodano, published in Journal of Real Estate Finance and Economics, 2007.

Three Italian economists, Carolina Fugazza of the Center for Research on Pensions and Welfare Policies, Massimo Guidolin of the St. Louis Federal Reserve Bank, and Giovanna Nicodano of the University of Turin, use an innovative technique to calculate optimal portfolio allocations. They find that real estate is critical not just as part of a diversified investment portfolio, but also as a contributor to "expected utility."

"We calculate optimal portfolio choices for a long-horizon, risk-averse European investor who diversifies among stocks, bonds, real estate and cash, when excess asset returns are predictable. We find that real estate ought to play a significant role in optimal portfolio choices, with weights between 10 percent and 30 percent in most cases.

Real estate has a considerable importance for both the size of optimal portfolio weights and welfare: the compensatory variation required by an investor to do without real estate is easily in excess of 100 basis points per year. Our robustness checks suggest that these estimates are probably only a lower bound.

The costs of restricting the available asset menu to financial securities only, thus ignoring real estate—are large. This means—that especially under long planning horizons, including real estate in the asset menu should represent a primary concern for all portfolio managers."

REITs Use Bank Financing to Take Advantage of Investment Opportunities, Increasing Stock Values

From “Investment, Liquidity and Private Debt: The Case of REIT Credit Facilities,” by Robert D. Campbell, Erik Devos, and Andrew C. Spieler, an unpublished working paper, October 2006.

Three finance professors, Robert Campbell and Andrew Spieler of Hofstra University and Erik Devos of Ohio University, examined how REITs use bank lines of credit (LOC), and whether bank financing announcements improve stock prices. They found that bank financing increases REIT stock prices and that REITs will not have much difficulty repaying the credit.

"Traditional firms are more likely to use LOC to manage short-term cash flow, accounts payable and seasonalities in their particular industries, but less likely to use LOCs to fund long-term capital acquisitions. Because the primary investment for REITs is real estate, the expected level of transparency is greater and the associated cash flows are less seasonal. Therefore, the need for discretionary and transitory funding is smaller for REITs than for non-REITs.

On the other hand, REIT managers themselves generally extol the virtues of LOC because it provides managers with significant flexibility in their decision-making and discretionary choices, allowing them to avoid the lengthy process of issuing public debt or equity and to take advantage of opportunities as they arise.

Our findings suggest that REITs enter credit facilities when they have large investments to fund. The ratio of net investments to total assets is significantly higher in years where credit facilities are arranged, relative to other years. We also find that cash flow ratios are somewhat higher in LOC years, and that operating cash flow as a ratio is significantly higher in LOC years. This suggests that REITs will have relatively little problem repaying their credit facilities."

Real Estate Is an Effective Hedge Against Inflation

From “The Asymmetric Response of Equity REIT Returns to Inflation,” by Marc W. Simpson, Sanjay Ramchander and James R. Webb, forthcoming in Journal of Real Estate Finance and Economics, 2007; and “The Inflation Hedging Characteristics of U.S. and U.K. Investments: A Multi-Factor Error Correction Approach,” by Martin Hoesli, Colin Lizieri and Bryan MacGregor, forthcoming in Journal of Real Estate Finance and Economics.

In two separate papers, independent research teams, one from the U.S., Marc W. Simpson, Sanjay Ramchander and James R. Webb, and the other from the U.K., Martin Hoesli, Colin Lizieri and Bryan MacGregor, confirm that real estate provides a hedge against inflation. The two teams examined the question as to whether the role of real estate as an inflation hedge is myth or fact. Both groups concluded that real estate is an effective hedge against inflation.

"If the values of real assets rise with inflation, then REIT returns should increase correspondingly with the general price level.

Previous studies have documented evidence of a negative relationship between REIT returns and inflation. This result is counterintuitive in that the price of real assets should rise when inflation rises.

This study documents an asymmetry in the response of equity real estate investment trusts (EREIT) returns to inflation. What this means is that EREIT returns are shown to rise when inflation rises as expected and to also rise when inflation decreases as previous studies documented. The counterintuitive results of previous studies have been shown to be an artifact of the methodology they employ, which implicitly assumes symmetrical responses in EREIT returns to inflation."

For U.S. and U.K. markets, the long-run models all included expected inflation with a significantly positive coefficient. Adjustment was relatively slow—which provides confirmation for the argument that short-run analysis based on high frequency return data characteristic of research failing to show hedging ability was unlikely to detect hedging qualities of assets.

The results provide a broad confirmation of prior empirical and theoretical work on the relationship between asset returns, inflation, real output and monetary shocks. They demonstrate that, in both the U.K. and the U.S., public market asset returns are linked in the long run to anticipated inflation but not to unexpected shocks in inflation, once the impact of real and monetary variables is considered."