Direct RE

Advantages

1. Competitive Returns: Over multi-year horizons, property’s total returns (rental income + capital growth) often exceed bond returns.

   • Example: IPF data from the 1990s onwards showed real estate yields outpacing gilts in stable periods.

2. Low Correlation: Property correlates less with equities than gilts, improving diversification.

   • Supported by Norges Bank (2015), which found property boosted Sharpe ratios.

3. Steady Income: About 50% of property returns are from contractual rental income, providing stability compared to the fixed coupon from gilts.

4. Inflation Hedge: Over the long term, property rents and asset values tend to rise with inflation, offering partial protection (IPF 2011).

5. Control: Direct ownership allows active decisions like refurbishments and tenant mix, unlike passive equity or bond holdings.

Disadvantages:

1. High Transaction Costs: Stamp duty, legal fees, and brokerage erode net returns, particularly with short holding periods.

2. Illiquidity: Property sales take months; unlike tradable bonds or equities.

   • Example: Commercial real estate market froze during the 2008 GFC.

3. High Management Time: Active management demands significant time (“95/5 rule”: most effort goes to the worst-performing assets).

4. Specific Asset Risk: Tenant defaults and location risks require diversification across sectors/regions, needing large capital.

5. Appraisal Bias: Appraisal-based valuations smooth real volatility, potentially misrepresenting risk. (Highlighted by Garay & Lee.)

6. Large Lot Size: Real estate is lumpy; significant capital is needed to achieve diversification, unlike easily scalable bond investments.

Conclusion: In the long run, direct property often outperforms gilts due to stable income and capital growth, but investors must account for illiquidity, management complexity, and high costs.

Definition:

Hedge if:

(1) Real returns > inflation

(2) Returns respond to inflation period-by-period

1. Data Issues

• Expected vs. unexpected inflation hard to separate → distorts results

• Returns = rental income + capital growth

  • Capital values: Appraisal smoothing hides short-run volatility

  • Lease structures weaken inflation link:

    • Upward-only reviews delay inflation pass-through

    • Step/fixed rents disconnect from actual CPI

    • EU CPI indexation helps (e.g., Germany 3–5% thresholds)

• IPF (2011): Weak short-run response, but long-run alignment

2. Period Variation

• 1970s: Strong inflation hedge

• 2010s: Weak linkage due to low inflation & QE

• Sectors/countries vary

  • CBRE/NCREIF: Prime retail & industrials > secondary offices/retail

3. Methodological Differences

• Correlation: High (~0.7 historically), lower post-2000

• Regression: Inflation explains some variation, not all

• VaR: Captures downside during inflation shocks

• Co-integration: Long-term link despite short-term divergence

• IPF (2011): Highlights mixed results depending on method

4. Missing Variables

• Inflation ≠ sole driver

  • GDP growth, interest rates, and RE cycles more impactful

  • Stagflation: High inflation + low growth = weak RE returns

• Hoesli (2008): GDP stronger predictor than inflation

Conclusion

• Short-term: RE is a weak/unreliable hedge

• Long-term (5–10 yrs): Partial protection via income & capital

• Best in prime sectors (e.g., Central London retail, industrials)

• RE is imperfect but reasonable long-run hedge, influenced by GDP, leases, occupancy