Real Estate as a Strategic Asset Class The Benefits of Illiquid Investments Real estate, a key asset class in a portfolio, can offer stable income returns, partial protection against inflation, and good diversification with other investments in the portfolio. An efficient real estate portfolio should include varied regions, sectors and investment strategies. While most investors still have a major home bias in their real estate portfolios, the trend toward a heavier international focus has been on the rise for some years. The ongoing near zerointerest rate environment in most industrialized nations poses a variety of challenges to private and institutional investors, as traditional fixedincome investments do not provide the desired yield levels as they did in the past. In light of that, the benefits of real estate investments, such as low correlation to other asset classes and the relatively stable and attractive returns, are more prominent than ever. Moreover, the real asset element structured in real estate provides investors with stability in the current environment, which is subject to a number of uncertainties. Less is More: Private Equity Investments` Benefits David Swensen, the Chief Investment Officer at Yale University since 985 and one of the world s most appreciated investors, realized decades ago that liquidity is an undesirable feature which should be avoided in a significant part of the portfolio. Insisting on liquidity results in lower returns, a heavy price paid by the investor. The Yale Model is thus characterized by relatively heavy exposure to private equity compared to more traditional portfolios, dedicating about 20% of the portfolio to real estate. Since 978, the real estate component of Yale s portfolio has yielded an annual average return of.6%. The inefficiency embedded in the private equity markets creates opportunities for identifying mispriced assets, bearing a potential of higher returns compared to the capital markets. Liquidity concession in a significant part of the portfolio suits sophisticated investors endowed with a long term view and ability to stand strongly at times of turmoil in the markets. One must keep in mind that private equity investments, like real estate, do have liquid elements within them, such as distributions originated in rent as well as realizations. How to Invest in Real Estate? Investors seeking successful investments in real estate have to cover a wide range of specialist functions that are needed for implementing the real estate strategy and managing international real estate portfolios. Since most investors do not have these specific resources, an alternative way to invest is via indirect real estate investment vehicles, customized real estate mandates, or property clubs. Investing through tradable vehicles such as REITs is also an option, but the fact that these are liquid investments, that don t have the benefit of illiquidity premium and also highly correlated to the stock market, must be taken into account.
Why Invest in Real Estate? Portfolio Diversification From a portfolio standpoint, the low correlation with other asset classes is definitely an important argument for investing in real estate. This means that by adding real estate to an existing portfolio of equities and bonds, investors can gain diversification benefits. In other words, similar portfolio returns can be generated with a lower risk, or higher returns can be generated with the same risk. Correlation of price changes (all indices in local currency) Calculated on the basis of price indices for quarterly figures, starting from December 3, 2000 MSCI WORLD 0year US government bonds Global REITs/ real estate equities Direct investments in office real estate, global MSCI WORLD 0.6 0.8 0.3 0year US government bonds 0.34 0.5 Global REITs/real estate equities 0.35 Direct investments in office real estate, global Source: PMA, Datastream, Credit Swiss Diversifying the portfolio between tradable assets such as stocks and bonds in different regions is no longer as efficient as it used to be. In a global universe, when interest rate trends and countries economic shifts immediately affect other countries, the diversification effect becomes significantly lower and even nonexistent. Diversification for the sake of risk reduction still exists effectively as long as the correlation between the assets in the portfolio is not whole, and even better if it is low or negative, as it is between real estate and bonds. Relatively High, Stable Cash Flow Returns In a macroeconomic environment of continued low interest rate levels, the advantage of real estate investments, generating relatively high, stable yields, stands out. Looking at global real estate investment returns, it is notable that while returns from changes in capital values typically have cyclical fluctuations, the income yield was 5%7% and is therefore a stable component of the total returns achieved. Global Real Estate Returns in % (in local currency) 5 0 5 0 200 2002 2003 2004 2005 2006 2007 2008 2009 200 20 202 203 5 0 5 Income Return Capital Value Growth Total Source: IPD, Credit Swiss 2
Hedge Against Inflation As rental contracts are typically indexed to inflation, real estate investments offer partial protection against rising inflation. The link to inflation can differ depending on the country: Continental Europe: In many continental European countries, rents are indexed directly to the Consumer Price Index (CPI), as it is in Switzerland. Germany has a rent review once inflation crosses a certain threshold. Another option is partial indexing, as is the case in Italy, for instance. There, 75% of the inflation will impact the rent. United Kingdom: Rents are adjusted to inflation or the market typically every five years, whereby rents can only be increased to positive inflation. US: Commercial real estate rents are generally increased annually at a fixed percentage of 2 3%. Australia: Leases for shopping malls usually include an annual increase either a fixed rate of 45% or the rate of inflation plus another.0.5%. There are various options for rent prices in office and industrial space, including fixed increases, based on the rate of inflation or a current market analysis. A Global Portfolio The global market for commercial real estate in 20 was approximately USD 26.6 trillion, and by 202 it will grow by 83% to USD 48.7 trillion. In 20, the Swiss real estate market accounted for only % of the global real estate market, at USD 284 billion. In addition to a geographic distinction of markets, proper diversification of real estate investments also includes examination of business sectors on which the local economy is based. For instance, markets can be distinguished by whether they are mainly driven by commodities, finance, or government sector. The first category includes cities such as Brisbane, Perth, Calgary, and Santiago de Chile. Markets that largely depend on the financial industry are typically London, New York, and Tokyo, while the commercial real estate demand in cities such as Berlin and Washington D.C. depends stronger on the public sector. The formation of such industry clusters allows us to identify key drivers of each real estate market, to avoid any problematic segments, and to diversify across various industries. 3
Using Diversification to Reduce Risk Risks that affect a real estate portfolio can be divided in two: SYSTEMATIC RISKS which can t be reduced by diversification. It is important to note that the globalization process has led to similarities and compatibility in the market cycles of different markets, thus radicalizing this risk. NONSYSTEMATIC RISKS such as demographic changes, inflation, vacancy rates, construction costs, financing costs, etc. These risks, at the market level or the property level, can be reduced by implementing a global portfolio strategy. The potential for diversification depends on the return correlation among the various markets; investing in markets characterized by low or negative correlations would be more efficient. The following table shows, for example, that while the returns of assets in NY and London often move in similar ways (high positive correlation), holding real estate in Hong Kong and some European countries (Germany, Italy, Netherlands, Spain) reduces risk as the combination is characterized by low and even negative correlation values. Estimated Correlation Matrix for Annual Total Returns on Office Space for Selected Countries (990203) France Germany Ireland Italy Netherlands Spain UK USA Japan Australia Hong Kong Singapore France 0.56 0.65 0.6 0.52 0.74 0.66 0.75 0.74 0.56 0.27 0.39 Germany 0.48 0.44 0.49 0.63 0.4 0.28 0.48 0.05 0.08 0.39 Ireland 0.39 0.67 0.78 0.52 0.6 0.6 0.46 0.06 0.29 Italy 0.57 0.7 0.33 0.40 0.38 0.40 0.3 0.2 Netherlands 0.77 0.36 0.57 0.32 0.50 0.8 0.40 Spain 0.42 0.59 0.59 0.49 0.3 0.24 UK 0.7 0.50 0.65 0.4 0.37 USA 0.65 0.76 0.28 0.58 Japan 0.52 0.24 0.43 Australia 0.9 0.54 Hong Kong 0.45 Singapore * Total returns on national level correspond to the weighted total returns of each leading city; Historical returns and financial market scenarios are no guarantee of current or future performance. Last data point: March 204. Source: PMA, Credit Suisse. 4
How to Invest in Real Estate? Investing in real estate can be done in several ways, including investment in the equity segment, the debt structures, publicly accessible vehicles and private investment opportunities. PRIVATE Equity Direct investments with mandates or property clubs Nom listed real estate funds and funds of funds Debt Direct mortgages Private real estate debt fund PUBLIC Real estate equities REITs Listed real estate funds Bonds from real estate companies Mortgage REITs Mortgage backed securities (CMBS/RMBS) Private Investments Direct investments in real estate assets requires a high equity threshold as well as a wide range of skills, competencies and resources in order to thoroughly analyze the asset and the market. Investing via a real estate investment specialist enables a lower equity threshold whereby due diligence is the specialist s responsibility. Investing this way is better done with a local real estate manager with a long proven track record that includes times of crisis. Investing through a fund or Fund of Funds can also provide the investor with broader diversification. Publicly Listed Real Estate Investment Vehicles Investing in real estate companies equities and bonds, as well as in Real Estate Investment Trusts (REITs), provide investors with liquidity and low investment thresholds but also embedded volatility, as they are highly correlated to the markets. In fact, only long term holdings of these kind of investments will simulate private real estate investments in a portfolio. Therefore, sophisticated investors would prefer the premium embedded in a long term nonliquid investment. In a memo published by CitiGroup, the bank s investment division states that investors harm their long term returns by over focusing on assets that are too liquid and can be turned into cash at virtually any time. According to their estimation, investors shouldn t be afraid of locking their money for months or years in assets such as real estate, defined as less liquid. These nonliquid assets have the potential of achieving higher yields and can be integrated in investment strategies that are not available in the public markets. 5
Real Estate Investment Strategies The following graph shows the major real estate investment strategies, classified by Risk/Return Profiles. The particular characteristics of our strategies may change according to the market environment and may overlap in specific cases. Choosing the investment style depends on the investor s objectives and expectations as well as one s view on the markets. Private equity real estate is an inefficient market, where information isn t exposed to everyone, thus the investor should aspire to identify the managers specific qualifications and ability to produce excess returns given the inherent risk involved in the investment. Income Security Growth Oriented High Return/Opportunistic All markets including emerging, development and speculative development markets, Return Enhanced/Value Added Major and secondary, leverage higher than 60% upside potential, and shorter holding period markets, leverage 5565% Core Major, developed markets, stable, yielding assets, and long holding periods, leverage under 50% Risk PROFIMEX is the private equity real estate arm of BambergerRosenheim Ltd., established in 969. We have been adding value to the business community for 47 years with integrity, respectability and full transparency. Over the past 7 years, PROFIMEX and its private and institutional investors, together with global JV partners, have invested in assets with a total gross value of over $45 billion. Since its inception and as of December 3, 204, PROFIMEX has generated an IRR reflecting an average annual return of 2.93% PROFIMEX LTD. 0 Zarhin Street P.O.B 55 Ra anana 4300 Israel Tel: + 97297774444 Fax: + 97297774400 p rofimex@ profimex.com www.profimex.com 6