Ratel Investments
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Why Invest in Real Estate

Many financial advisors recommend that their clients hold approximately 20% of their financial assets, excluding their primary residence, in income producing real estate in order to have a well balanced investment portfolio. Direct ownership of commercial real estate has historically provided investors with both capital preservation and wealth creation. These benefits include:

Capital Preservation through Financial Diversification:
Both modern portfolio theory and empirical evidence suggest that asset diversification is critical to the preservation of capital and, ultimately, the long-term performance of an investment portfolio. Diversification through proper asset allocation is the single most important step in creating a top performing investment portfolio; studies attribute almost 90% of a portfolio’s return strictly to asset allocation.1 For diversification to be effective, the performance of various asset classes must have low correlation. Public equity and fixed income investments historically have been impacted by similar macro economic cycles: changes in global interest rates and volatility in world financial markets. In contrast, the performance of real estate markets has been driven by more regional, less directly correlated variables such as local job creation and population growth, zoning laws and the supply/demand balance of competing properties.  Further, real estate revenue streams are less correlated to the returns provided by equity and fixed income investments because they are tied to leases whose expiration is typically staggered over months and years; thus the leases reflect a weighted moving average of historical and current market rents.

The National Council of Real Estate Investment Fiduciaries (NCREIF) is an organization that represents private real estate owners. NCREIF conducted a study of private real estate as compared to most major equity and debt markets. As illustrated below, the low correlation of the NCREIF Index to other market indices indicates that real estate provides capital preservation through diversification. For example, a one point move in the Standard & Poor 500 (SP500) results in a small 8.4% movement in the NCREIF Index:  thus, private real estate appears almost uncorrelated with the SP500.

Return Correlation: Stocks, Bonds and Real Estate

(January 1983 - December 2006)

 StocksRealEstateBonds
 SP500Russell 2000Russell
Value
EAFENAREITNCREIFLehman
Gov’t
Lehman
Aggregate
10 Year
Treasury
91-Day
T-Bill
SP500 100.0%
Russell 2000 75.1% 100.0%            
Russell Value 49.7% 83.8% 100.0%          
EAFE 53.5% 42.7% 29.4% 100.0%          
NAREIT 25.5%  63.3% 79.0% 20.2% 100.0%        
NCREIF 8.4% -13.4% -11.3% 21.9% 3.4% 100.0%        
Lehman Gov’t 24.7% 14.3% 6.6% -0.5% 13.4% -16.3% 100.0%    
Lehman Aggregate 28.8% 21.3% 8.2% 1.3% 17.2% -15.1% 98.7% 100.0%    
10 Year Treasury 21.0% 6.1% -6.3% 6.5% 1.6% -10.8% 56.8% 62.1% 100.0%  
91-Day T-Bill 27.1% -0.9% -14.6% 1.0% -6.5% 6.6% 57.0% 60.8% 91.4% 100.0%

Note that in the chart above, a 100% correlation implies that a change in one market index results in the exact same magnitude change in a second index.  A zero correlation indicates that a movement in one market index has no impact on the second market index.&nbsp Finally, a negative correlation reflects that the movement of one market index is replicated in the opposite direction in the second market index.

Increased Return with Lower Volatility
Numerous studies support the benefit of real estate assets in an investment portfolio.  For example, as illustrated below, a National Council of Real Estate Investment Fiduciaries (NCREIF) study found that an investment portfolio that includes 20% real estate assets delivered superior returns with lower risk when compared to the same portfolio without real estate.

Portfolio Comparison: January 1997 – June 2004

Note:  Assumes investment of $100,000 on January 1, 1997 in each portfolio depicted above.  All investment proceeds and earned interest are reinvested annually.  Stock returns are based on SP500 results provided by Standard & Poors, cash investments assume the average three month government T-bill rate based on information from the U.S. Federal Reserve, bond returns are based on the Lehman Aggregate Bond Index and private real estate returns are based on data provided by NPI – NCREIF.

Additionally, a 2007 NCREIF study, shown below, illustrates that real estate lowers volatility without adding incremental risk to an investment portfolio.  Private real estate has the highest Sharpe ratio; this implies that private real estate provides higher return than the other assets examined for the same risk.

Real Estate Returns & Volatility Compared to Stocks and Bonds
(1Q 1982 - 4Q 2006)

  Volatility
(Std.Dev.)
Sharpe
Ratio

PRIVATE REAL ESTATE:

NCREIF Property Index

6.0%

0.604

 

S&P 500

15.5%

0.579

STOCKS:

Russell 2000 Stock Index

17.9%

0.435

 

NAREIT - Equity REIT

15.2%

0.684

BONDS:

Lehman Gov’t Bond Index

7.2%

0.514

Source: National Association of Real Estate Investment Trust, National Council of Real Estate Investment Fiduciaries, Standard & Poor’s. Index returns do not reflect the fees and expenses of an actual investment and do not represent actual investment daims.

The dynamics underlying the superior returns associated with ownership of commercial real estate assets is based on the inefficiency of real estate markets, in particular for properties requiring value add, when compared to the public equity and bond markets.  There are fewer participants, and both the search costs and transaction costs are high.  Additionally, real estate assets are individual and unique: pricing tends to be imprecise and based on asymmetry of information.  These inefficiencies, in part, are why private real estate assets have been shown to increase the return of an investment portfolio.  Further, the presence of real estate assets has the additional benefit of lowering an investment portfolio’s volatility. 

Current Income and Tax Benefits
Private commercial real estate investments offer the potential for not only capital appreciation, but also current income in the form of recurring cash flow.  As illustrated below, the income yields for directly owned commercial real estate investments have historically performed favorably when compared to the current income yields for equity and fixed income investments. 

Today’s current low interest rate environment has even further reduced the current yields of fixed-income securities.  In contrast, the majority of Ratel’s investments generate recurring cash flow of 7-11%; see the Performance section of this web site for details on Ratel’s returns.

Non-Cash Tax Benefits:  In addition to higher yielding cash flow, real estate investments also generate non-cash tax depreciation benefits that can be used to offset the taxes associated with a property’s cash flow.  Because of the legal structure Ratel utilizes when investing in a property, we are able to pass through 100% of the depreciation benefits to our investors on a pro rata basis.  This depreciation can generate approximately 3-5% in annual, non-cash tax benefits for each dollar invested in a commercial real estate investment.   Thus, the cash flow that is distributed to an investor on a recurring basis is typically partially tax sheltered. 

Directly Held Real Estate versus a Real Estate Investment Trust (REIT)

While the underlying assets of a REIT are commercial real estate properties, these publicly traded securities are often used by investors as as a substitute for directly held commercial real estate assets in a financial portfolio.  Unfortunately, REITS do not provide many of the benefits of directly owned commercial real estate.

Diversification:  Similar to most publicly traded securities, REITS demonstrate a historic correlation to other public debt and equity markets.  As illustrated in the chart below, the NAREIT Index, a grouping of REIT stocks, has a 25% correlation with the SP500.  In contrast, directly owned real estate, represented as the NCREIF Index, demonstrates a low, 8.4% correlation to the same public debt and equity markets.  

Return Correlation: Stocks, Bonds and Real Estate

(January 1983 - December 2006)

 StocksRealEstateBonds
 SP500Russell 2000Russell
Value
EAFENAREITNCREIFLehman
Gov’t
Lehman
Aggregate
10 Year
Treasury
91-Day
T-Bill
SP500 100.0%
Russell 2000 75.1% 100.0%            
Russell Value 49.7% 83.8% 100.0%          
EAFE 53.5% 42.7% 29.4% 100.0%          
NAREIT 25.5%  63.3% 79.0% 20.2% 100.0%
NCREIF 8.4% -13.4% -11.3% 21.9% 3.4% 100.0%        
Lehman Gov’t 24.7% 14.3% 6.6% -0.5% 13.4% -16.3% 100.0%    
Lehman Aggregate 28.8% 21.3% 8.2% 1.3% 17.2% -15.1% 98.7% 100.0%    
10 Year Treasury 21.0% 6.1% -6.3% 6.5% 1.6% -10.8% 56.8% 62.1% 100.0%  
91-Day T-Bill 27.1% -0.9% -14.6% 1.0% -6.5% 6.6% 57.0% 60.8% 91.4% 100.0%

Tax Impact:  Directly held real estate investments, such as those provided by Ratel, typically generate recurring cash flow that is often partially tax sheltered by the depreciation generated by the property and shared with investors.  Additionally, the gain on sale for real estate assets, after depreciation recapture, is currently taxed at the lower long-term capital gain tax rate of 15% (Federal rate), assuming the property is held for at least one year.  Further, one can periodically refinance a directly held real estate investment and return capital appreciation on a tax sheltered basis.  In contrast, a REIT is legally considered a security for tax purposes.  An investor in a REIT cannot use depreciation to shelter the dividend income.

Volatility:  Bailard, an institutional investment advisor, examined 24 years of REIT returns and compared the results to NCREIF returns (institutionally held private real estate).  As shown in the chart below, REITs have experienced three times as many negative years as private real estate; further, the magnitude of REIT’s volatility is greater than directly owned private real estate which offers far greater return consistency.

Yield:  Bailard also compared 24 years of REIT returns to institutionally held private real estate.  NCREIF, the private real estate index, reports their performance without the benefit of leverage while REIT returns used in the study included the actual in-place debt.  To adjust for this material discrepancy leverage, Bailard assumed a very conservative 35% debt level for NCREIF assets.  Bailard concluded that from 1978 to 2002 REIT returns were virtually identical to NCREIF returns at 13% annually.  If one were to assume a more traditional level of leverage, say 60% for the NCREIF portfolio, then directly held real estate would materially out perform REITs for the period in question.

FeesREITs carry significant transaction costs, typically between 6% and up to 12% of an investor’s original investment is often lost to fees.  In contrast, Ratel’s fees are lower and largely performance based.  Ratel’s fees which are not performance-based are generally less than .5% per year.

Footnote 1:
  • Source: “Determinants of Portfolio Performance II: An Update” by Gary P. Brinson, Brian D. Singer and Gilbert L. Beebower, Financial Analysts Journal May/June 1991