Shift in Institutional Real Estate Portfolio Allocations

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Most economic news during the past four years surrounds the failure of real estate as a stable investment; ironically, stocks may not be the preferred investment alternative due to volatility risk. Northpoint Capital Management, a private equity investment firm focused on real estate, anticipates an increase in both private and public non-traded real estate allocations in an environment where double-dip recession and inflation fears prevail.

If inflation takes hold of the American economy, real estate assets are a great investment as long as they are not tied to revolving or high interest bearing debt.

Real estate’s tarnished reputation could soon evolve into a stable investment despite poor macro-economics in the United States. Northpoint successfully navigated the recent real estate downturn by having the discipline and foresight to halt acquisitions early enough to avoid problematic asset performance. Northpoint now projects new opportunity in real estate. But who can take advantage of these opportunities and how might real estate’s new risk profile alter portfolio allocations?

The phrase “cash is king” answers that question. Real estate investors with access to large amounts of cash and who avoid debt are probably best positioned to benefit from what could be a significant shift in portfolio allocations into real estate. Institutions are flush with cash. Currently, US pension funds alone hold approximately $5 trillion in assets.

Naturally, limited lending restricts business growth and investment; especially in capital intensive industries like real estate. Banks' near freeze on lending has been a popular topic recently. For example, David Weidner, a Wall Street Columnist for MarketWatch, wrote over two years ago that “banks need to stop the charade, ignore the political and public pressure and admit they're not lending.” Just more than a year ago Todd Zywicki, a Law Professor at George Mason University, wrote that “despite constant urging by Washington for banks to increase their lending, credit conditions remain tight.” The same tight lending continues to restrict business growth today.

Although interest rates are at an all-time low and even if debt became easier to obtain, anything other than fixed rate mortgages could be dangerous in an inflationary environment. Historically, a period of low interest rates has been followed by high rates and monetary inflation. According to calculations based on the Consumer Price Index for the Bureau of Labor Statistics, from about 1950 to 1970, inflation and the Federal Fund’s Effective Rate remained, on average, under five percent. From 1973 to 1982, inflation increased to as high as 13.5 percent and was on average approximately nine percent. During the same years, the Federal Fund’s Effective Rate increased to as high as 16.40 percent and remained on average nine percent through 1990. The 30-year fixed home mortgage and other US treasury and capital market rates experienced a similar increase. From 1990 until 2010, the inflation rate has remained, on average, under three and a half percent and interest rates have been correspondingly low. There are many factors that can affect these rates but it would be foolish to ignore historically corresponding trends and time periods.

If inflation takes hold of the American economy, real estate assets are a great investment as long as they are not tied to revolving or high interest bearing debt. Rent may increase in sync with interest rate hikes but it’s hard to speculate if occupancy will remain the same or increase; it may decrease which could trigger mortgage defaults. Regardless, as recommended by Dirk Wiedmann who is head of investments at Rothschild, investors should hold “real assets – such as commodities, gold and property – which are likely to rise in value in line with inflation.

Currently, pension funds allocate approximately 8% - 12% of their portfolios into the real estate asset class. Of that allocation, about 10% is invested into publicly traded REITs and other real estate equities subject to stock market volatility. Institutions such as pensions, endowments, and other similar organizations have recently experienced little other than unpredictable volatility from most investments linked to the stock market, which begs the question, will investors increase their allocations to conservative real estate through private equity funds and other investments not subject to volatility? Even though non-traded investments are less liquid, if they can generate sufficient dividends, they may become the preferred alternative to volatile equities and low-yield bonds.


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John Plocher
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