For many pension funds struggling with underfunded liabilities and investment portfolios that are generating low fixed income yields and highly volatile equity returns, real estate represents an attractive investment option. In Canada, real estate has transitioned from an alternative investment to a mainstream asset class because of its consistent performance and its ability to generate the long-term, stable cash flows needed to meet pension obligations.
Real estate is currently trading at returns that represent a significant premium to bond yields and with significantly lower volatility than stocks. Over time, the value of real estate has tended to grow with inflation and reflect GDP growth. As a result, investors get the benefit of both solid current income returns and the opportunity for potential value increases.
The driving force behind real estate’s increasing popularity has been its long term performance relative to other major asset classes. The table below illustrates the returns from real estate over the past 15 years compared to stocks and bonds based on their industry-specific benchmarks.
Risk-Adjusted Returns, 15-Year History, 1997Q1 – 2011Q4 (click on image to enlarge)
Over the 15-year period, real estate generated the most attractive total rate of return (11.8%) and the highest cash component (7.8%). The picture gets even better when risk is factored in. Using the Sharpe ratio as a measure, real estate has experienced not only the best absolute return, but also the lowest volatility and the highest risk-adjusted return. This superior risk protection is reinforced when an alternate measure of risk –the number of quarters in which the return was negative – is considered. Over the period, real estate had only four (out of 60) negative quarters, while bonds and stocks recorded 15 and 21 negative quarters respectively.
Add to this the fact that real estate returns are not highly correlated with those of stocks and bonds, and the case for introducing real estate to an investment portfolio as an important diversification tool becomes even more compelling.
Canada’s market
Despite a slowing global economy dogged by risk and uncertainty, Canadian real estate markets remain healthy and robust. This holds true both for leasing markets for tenants and capital markets for investors.
Canadian real estate is dominated by a small number of urban centres. The top ten cities account for almost 50% of the nation’s population, employment and GDP. The three largest centres (Toronto, Montreal and Vancouver) alone represent nearly 36% of the total, while the western cities of Calgary and Edmonton are among the fastest growing.
Within the major cities, leasing markets for all four major property types (office, industrial, retail and apartments) are strong, characterized by low vacancy rates and rising rents. In many of these cities the tight markets and prospects for growth are stimulating a wave of new construction projects.
On the investment market side, 2011 was one of the most active years ever for Canadian real estate. The $24 billion of transactions completed was below the peak levels of 2007, but was still well above the $19 billion 10-year average. Historically low interest rates and healthy leasing fundamentals have driven capitalization rates to cyclical lows and property values to near all-time highs. Despite the historically high real estate prices, investment returns remain at an attractive spread over Government bond yields.
Like all asset classes, the short term performance of real estate is shaped by cyclical forces. Leasing markets depend on supply and demand, driven by the strength of national and regional economies. Property investment markets respond to competitive returns available from other assets and the cost of capital, particularly long term interest rates. But for institutional investors focused on long term performance, real estate’s key attributes –solid income yields, opportunity for capital appreciation, low volatility, and diversification benefits – make it an attractive core component of any investment portfolio.
Stephen Taylor is President and Chief Operating Officer, Morguard investments Limited