Direct Real Estate

Introduction: The IPF (1994) report states that property can deliver higher returns and lower correlationcompared to equities than gilts or cash. This suggests that property may improve a mixed-asset portfolio’s risk–return profile more efficiently than these fixed-income assets.

Advantages

1. Competitive Returns: IPF data from 1990s onwards often showed RE yields that could outpace gilts in stable economic periods

1. Low Correlation with equities and bonds

   1. relies on local market factors like regional supply-demand imbalances and tenant dynamics

   2. Diversification effect reduces portfolio volatility

      1. Norges Bank (2015) found that adding RE improved Sharpe ratios of mixed-asset portfolios

2. Steady Income: ~50% of TR, stable due to long-term lease contracts

   1. Supports portfolio resilience, especially during periods of market volatility

   2. especially attractive compared to the fixed coupon of gilts

3. Inflation Hedge: In the long run, rents and asset values tend to rise with inflation,

   1. IPF (2011) concluded that direct RE offers a reasonable long-term inflation hedge, despite short-term mismatches

4. Control over decisions like refurbishments, tenant mix, leverage or location focus

   1. Allows proactive management to respond to market changes, unlike passive equity or bond holdings

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

2. Illiquidity: RE sales can take months, making quick portfolio rebalancing difficult, especially compared to equity and gilts, which are quickly traded on the market

   1. Example: During the 2008 GFC, commercial RE markets froze, highlighting illiquidity risks compared to tradable securities like bonds.

3. High Management Time, whereas equity and gilts are effectively buy-and-hold

   1. "95/5 rule: 95% of management effort concentrated on 5% of the assets (RE)

4. Specific Asset Risk, like tenant defaults, vacancy periods, or location obsolescence

   1. Diversification requires large-scale capital commitments

5. Appraisal Bias can underestimate volatility & misrepresent asset’s risk (Garay & Lee)

6. Large Lot Size: Real estate is lumpy. Developing diverse property holdings requires significant capital. Gilts, in contrast, can be bought in small portions.

Conclusion: In the long run, direct RE often outperforms bonds or cash, partly due to stable income & capital appreciation. The relatively low correlation to equities benefits a multi-asset portfolio. However, one must account for illiquidity, higher frictional costs, and cyclical/management complexities. Net effect of property is often positive if portfolio is large enough to spread specific risk and if investor’s horizon is sufficiently long.

Real Estate is a Hedge Against Inflation if:

• 1st Concept (Positive Real Returns): returns must exceed inflation over time, to preserve purchasing power

• 2nd Concept (Short-run inflation linkage): returns should respond quickly to inflation movements, not just in the long run

Reasons for Conflicts

1. Data Issues:

   1. Expected vs. unexpected inflation

      1. Not separating might under-/overstate true hedging ability

   2. Considering rental income growth and capital gains

      1. Capital value: Appraisal smoothing can understate short-run movements

      2. Lease structures (delay, disconnect, hurdle)

      3. IPF (2011): Over multi-decade periods, property rents and capital values tend to align with inflation, even if short-run reactions are weak

2. Results vary by decade, sector, and country

   1. Different Periods: strong hedge (1970s), vs none (2010s)

   2. CBRE/NCREIF: Prime sectors (Central London retail) consistently outperformed inflation, while secondary sectors (weaker retail, suburban offices) often failed to fully hedge inflation, even over long periods

3. Methodology

   1. Different methods can yield varied results (IPF 2011) provides thorough analysis

      1. Correlation: Simple relationship, historically higher correlation (~0.7) but weakened over the last 20 years

      2. Regression analysis: Explains how much inflation drives RE returns

      3. VaR (Value at Risk): Measures downside risk during inflationary periods.

      4. Co-integration: Tests whether RE and inflation move together in long term despite short-term fluctuations

         1. Hoesli (2008): positive long-term link between RE returns & inflation, but GDP growth often drives return stronger than inflation alone

4. Missing Variables (that should be considered)

   1. Interest rates, cyclical RE supply & demand could overshadow inflation link. During economic slowdowns, even if inflation is high, RE might not perform

• Short term: Real estate is a weak and unreliable inflation hedge

• Long term: over 5-10 years, direct RE offers partial inflation protection mainly through income growth and capital appreciation

• Some sectors (e.g., Central London retail, industrials) have historically outperformed inflation more consistently than others (secondary offices, retail outside prime areas)

• Most studies suggest real estate is an imperfect but reasonable inflation hedge over extended horizons.  Investors should not rely on property as a pure hedge

• Performance depends heavily on GDP growth, occupancy rates, and lease terms.