Historical Trends in Real Estate & Other Asset Classes
The lingering COVID pandemic, paired with geo-political concerns and a rising interest rate environment, have produced volatility in the market in 2022. As of July, the annual inflation rate has risen to a 40-year high of 9.1%. In response, the Federal Reserve is expected to continue to raise interest rates, currently surpassing 2% after a historic low of less than 1% in early 2020. Interest rates are now projected to exceed 3% by year-end.
At the same time, public market investments have faced a tough year, with the return of a public 60/40 portfolio yielding a ~17% loss through the first half of 2022.
For reference, the five worst-performing years in history range from a 14% loss to a 27% loss for the Great Financial Crisis in 2008 and the Great Depression in 1937, respectively. The goal of this balanced, long-term portfolio is to achieve annualized returns of 7%. However, in 2022, even a 7% gain wouldn’t beat inflation.
Real estate, on the other hand, has typically outperformed public equities in times of economic volatility. When the market optimism suffers, and most portfolios shrink, real estate tends to stay on the rise.
What does this mean for you as a potential investor?
In this article, we’ll explore key trends across asset classes over time and why we believe it may be an opportune time for investors to consider reallocating a portion of their portfolios to alternatives (alts), such as private commercial real estate (CRE).
About Risk-Adjusted Returns & Volatility
Before we dive into any specific numbers, let’s take a moment to review the concept of risk-adjusted returns. Your understanding of these is key to making the most out of a volatile market.
The Sharpe ratio measures how much excess return an investment generates per unit of volatility. It is one good way to measure risk-adjusted returns, compare time periods across the same asset class, or compare two different asset classes during the same period.
Why the Sharpe Ratio Matters
It turns what could be seen as an intangible — risk — into a mathematical expression investors can use to assess whether an investment is worth it. Essentially, how much risk are you taking on to achieve potentially higher returns?
You can compare the Sharpe ratio of one investment (or investor) to the market or asset class as a whole to see if they truly outperformed their peers, or simply benefited from the same volatility (risk), knowing that since significant risk was involved, their results could have easily gone the other way.
By doing so, you can compare market-impacting events across history — such as the higher than usual inflation we’re experiencing in 2022 compared to the 1970s.
It’s important to get the most useful information out of your formal Sharpe ratio analysis or other risk-adjusted return comparisons. To accomplish this, choose a consistent time window basis or a similar timeframe.
Because of the preciseness of a Sharpe calculation, it is usually very useful to investors as a standalone measurement. This means you can skip combining investments, a typical aspect of portfolio review. Instead, the denominator is the standard deviation only for that investment rather than the adjusted standard deviation that comes from creating a portfolio.
Limitations of the Sharpe Ratio
It’s important to recognize Sharpe ratio is not a perfect measure for alternative investments, since alts don’t usually experience normal distributions as conventional investments do. In other words, statistically speaking, numbers can get skewed, especially over a longer time window.
For this reason, the standard deviation may be different from that of a normally distributed stock, etc. With that said, this is still one of the best stand-alone measures you have to compare investments across time and asset classes (stocks vs. alts).
Calculating the Sharpe Ratio
You express the Sharpe ratio as the periodic (annual) excess return per percentage point of (annualized) volatility or standard deviation. A higher Sharpe ratio investment is generally better when comparing two or more investments, as it implies it adds more excess return per the same percentage point of volatility relative to those other investments, provided the calculation (timeframe) is consistent.
To calculate the Sharpe ratio,
- Numerator
- Subtract the risk-free return (e.g. U.S. Treasury rate) from the average return generated by the individual investment over a certain timeframe (e.g. 1 year)
- The residual is the numerator to the Sharpe Ratio calculation.
2. Denominator
- Calculate the average variance in incremental periods of time, such as months or years.
- Square (multiply it by itself) each average variance to a get number for each time increment.
- Add them up.
- Divide the total by the number of increments (e.g., 24 months or five years).
- Get the square root of that quotient.
- The square root or standard deviation represents volatility and is the denominator to the Sharpe Ratio calculation.
3. Divide the numerator by the denominator to get your Sharpe ratio, expressed in decimals.
You could also use a Sharpe Ratio Calculator, or better yet, work with a company that offers simplified CRE investing and does these calculations for you.
Recent Asset Class Performance
That brings us back to commercial real estate. To find out how real estate may perform in today’s inflationary environment, we need to understand how it has performed historically in the context of risk vs. return.
In the 15 years ending December 2020, a traditional 60/40 portfolio yielded an annualized return of 5.8% with 10.4% volatility. You can compare this to a similar portfolio including 60% alts yielding an annualized return of 8.1% at 7.8% volatility.
For reference, today’s 10-year U.S. Treasury rate is at ~3.26%. If we do a quick Sharpe ratio calculation, we can see the potential impact of adding alternatives:
(5.8–3.26)/10.4 = 0.24
vs
(8.1–3.26)/7.8 = 0.62
Alts, or alternative investments, include non-conventional investments not directly tied to cash, equity, or income, such as venture capital, commodities, and real estate.
Note: This 15-year period includes the Great Financial Crisis and the start of the COVID pandemic, two periods of great volatility.
On a risk-adjusted return basis (which we acquire by calculating the Sharpe ratio), private real estate has significantly outperformed global stocks, represented by the MSCI World, and most other private capital strategies within this timeframe.
In fact, global stocks realized the lowest return at 6.7% annualized and the highest volatility at 17.6% in the 15 years ending Dec. 2020, representing a low Sharpe ratio, something investors generally want to avoid.
You can further visualize this below.
Although the MSCI performance is from a different timeframe given the availability of data and resources to EquityMultiple, we believe the overall trends should still hold true.
Commercial Real Estate During 1973–1983 Inflation
Stocks, bonds, and other conventional assets tend to suffer as inflation rises. The cost of living is going up, and the average person has to prioritize spending — generally, food, then shelter. Residential home prices can also decline as more people are paying higher rent vs. saving to buy a home. If you own commercial real estate, that means you’re likely to receive higher rent on your commercial real estate investment.
It is, however, important to realize that as inflation rises, the costs to manage and maintain a commercial building go up. Rent goes up because those costs are being passed on to the people benefiting from living there, the tenants. This may happen during an annual rent review or a CPI indexation escalator clause in the lease agreement, which allows you to adjust rent in line with agreed-upon measures of inflation. This happens across CRE asset classes: retail, industrial, office, and storage units.
To see this phenomenon historically, let’s look at inflation vs. rent from 1973–1983, with which our current inflation is competing, but has not yet surpassed. On the left, you see the inflation rate rising with rent rates nearly keeping pace, providing an almost perfect hedge against inflation.
As rent more or less kept up with inflation, the value of real estate itself rose at a greater rate than inflation.
This can happen for several reasons, many of which apply today:
- Rising material costs and supply chain issues can lead to fewer new buildings being built.
- How renters utilize space changes and becomes more efficient.
- Rising interest rates can make it harder for some to invest, so existing buildings become more valuable.
- Increased costs can spark innovation that cuts costs over the longer term.
This represents the return on investment of commercial real estate.
The Bottom Line
When comparing historical returns of alternative assets such as real estate to traditional investments, investors should remember that all assets experience volatility. However, the long-term benefits of investing in real estate are clear.
If you have not already done so, you may want to consider investing in real estate, which can help limit the impact of volatility on your portfolio as it provides a hedge against inflation. That said, commercial real estate may not be right for everyone. Your own investing goals and personal risk tolerance should serve as your North Star.
If you would like to learn more about portfolio allocation strategies, please consult our recently published Guide to Alternative Investments, and feel free to contact our Investor Relations Team with any further questions.
Sources: Bloomberg, U.S. Treasury, U.S. Bureau of Labor Statistics, New York University Research, Morningstar, CAIA Association (2022), Burgiss (Dec. 2020)
This material is confidential and has been prepared solely for the information of the intended recipient and may not be reproduced, distributed, or used for any other purpose or shared with anyone in any form or format. This has been prepared for you by EM Advisor, LLC (“EM”), an SEC registered investment advisor. Information within this report may have been provided by third-parties and, while EM believes this information to be accurate, EM has not independently verified such information. Reference to registration with the Securities and Exchange Commission (“SEC”) does not imply that the SEC has endorsed or approved the qualifications of the firm or its respective representatives to provide any advisory services described on the report or that the Firm has attained a level of skill or training. Investments in securities are not FDIC insured, are not bank guaranteed and may lose value. Investing in securities involves risks, and there is always the potential of losing money when you invest in securities.
Additionally, investments may not achieve stated social, environmental, or similar objectives. Before investing, consider your investment objectives and EM charges and expenses. EM advisory services are designed to assist clients in achieving discrete financial goals. They are not intended to provide financial planning with respect to every aspect of a client’s financial situation, they do not incorporate investments that clients hold elsewhere, and they do not provide tax advice. Past performance does not guarantee future results, and the likelihood of investment outcomes are hypothetical in nature. Nothing in this presentation constitutes an offer, solicitation of an offer, or advice to buy or sell securities in jurisdictions where EM is not registered.
EM’s Form ADV can be found here: https://adviserinfo.sec.gov/firm/summary/314402.
Originally published at https://www.equitymultiple.com on September 12, 2022.
