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C ommercial real estate is the most commonly held alternative asset class, following only equities and fixed income in its share of the typical institutional portfolio. Thanks to its risk-return profile, real estate can offer significant diversification benefits to a portfolio. Real estate offers a stable income stream from rent, as well as inflation protection and expected capital appreciation over the long term given its limited supply and constantly growing demand.
Real estate investments can be made in two ways. Traditionally, investors buy assets through private markets (either directly or through a pooled vehicle) or take stakes in unlisted funds. Direct ownership, in particular, presents high barriers to entry, as it requires significant capital outlay and structuring experience specific to the asset class. Combined with high transaction costs and illiquidity, these hurdles can be significant for small investors and make private real estate suitable mainly for large institutional investors that have long investment horizons. Even large institutional investors may be discouraged by liquidity concerns and monitoring costs that are significantly higher for private real estate than for equities. From 1998 to 2011, U.S. institutional investors experienced average costs of 22.9 bps for U.S. large- capitalization (large-cap) stocks, 55.5 bps for U.S. small-cap stocks, and 44.3 bps for non-U.S. equities compared with average costs of 112.6 bps for private real estate (Beath [2014]).
The public market offers a second route for investing in real estate. Listed companies that have property portfolios, such as real estate investment trusts (REITs), generally offer daily liquidity and lower transaction costs. The securitized nature of public markets also makes it easy to diversify even a relatively small portfolio. However, accessing real estate through equity markets also comes with disadvantages: leverage, higher volatility, and a high equity market beta.
Indexes exist for measuring both direct and listed real estate. Direct real estate indexes measure the value of physical properties based on infrequent appraisals. Listed real estate indexes, on the other hand, are based on daily stock prices and can be calculated in real time. Correlations between these two types of indexes generally have been low, 1 leading some experts to question how much linkage exists between these two avenues for accessing real estate exposure and whether real estate securities are more...