Real estate, as represented by the National Association of Real Estate Investment Trusts Index, has been the best-performing asset class over the past 20 years, from 1996 through 2015.
This is surprising to many investors who still live in a 60/40 stocks and bonds world. Real estate beat out stocks, bonds, diversified portfolios, commodities and cash to be the top-performing asset class.
Although publicly traded real estate exhibited higher returns, it also is characterized by higher volatility. This higher volatility, which is a proxy for risk, must be considered in investment decision-making.
The Sharpe Ratio is perhaps a better indicator of returns because it takes into account the volatility or standard deviation of returns. Therefore, investors should also seek to invest in assets that have the highest Sharpe Ratio.
A higher Sharpe Ratio indicates a higher return per each unit of risk. Fortunately, the other investable universe of real estate, private real estate, delivers exactly this.
Private core real estate is much less volatile, and its correlations are considerably lower to equities and every other asset class.
The chart below shows the risk and return profiles of various asset classes over the 20 years from 1993 to 2013.
Core real estate, as represented by the National Council of Real Estate Investment Fiduciaries Property Index, tends to have similar volatility to corporate and government bonds with a higher return over the long term. The reasons vary, but core real estate uniquely possesses both stock and bond characteristics.
A stockholder gains from rising stock prices just as a real estate equity investor gains from rising property values. Absent a default, a bondholder receives a contractual income stream.
20-Year Return and Risk Profile Across Major Asset Classes
Source: Thomson Reuters Datastream; www.treasury.gov
Data from the third quarter of 1993 to the second quarter of 2013. The indices used for each asset class are: core real estate, NCREIF Property Index, listed REITs, FTSE NAREIT Equity REITs Index; government bonds, Bank of America Merrill Lynch Treasury Master; corporate bonds Baa-rated, Barclays US Aggregate Corporate Intermediate; large- capitalization stocks, Russell 1000 index; small-cap stocks, Russell 2000 Index; commodities, S&P GSCI Commodity Index. The risk-free rate is the 10-year U.S. Treasury note yield.
Let's look at the effect of adding private real estate to a traditional investor portfolio. Consider a Portfolio A consisting of bonds (40%) stocks (50%) and T-bills (10%).
Over the 20 years ended in 2014, this portfolio would have earned annual returns averaging 8.23%, with a standard deviation of 9.86% for a Sharpe Ratio of 0.61, as shown in the table below.
By investing 10% of the portfolio in real estate, while reducing exposure to stocks and bonds, this portfolio could have achieved higher risk-adjusted returns as shown in Portfolio B and a higher Sharpe Ratio of 0.68.
20-Year Return and Risk Profile in a Diversified Portfolio
Data from 1995-2014. The indices used for each asset class are: S&P 500; Barclay's U.S. Aggregate (Bonds); Bank of America/Merrill Lynch 3-month U.S. Treasury Bill; and NCREIF NPI (CRE).
Furthermore, as shown in Portfolio C, investing 20% of the portfolio in real estate, while further reducing exposure to stocks and bonds, achieves higher risk-adjusted returns (8.54%) and a higher Sharpe Ratio of 0.75.
Over various real estate and economic cycles, core real estate's Sharpe Ratio has been higher than both stocks and bonds.
This shouldn't be surprising, given its equity and bond-like features explained earlier. This makes core real estate perhaps the most valuable asset class.