Despite recent market turmoil, real estate continues to play a key role in asset allocation strategies. However, it requires investors to rethink their approach to gain an edge in the current environment. For example, an investor whose real estate exposure is limited to the United States has ignored roughly 60% of global market capitalization as measured by the FTSE EPRA/NAREIT Global Index.

Given that markets, companies and investors continue to shift toward a global orientation, rebalancing domestic allocations to capture the benefits associated with a well-diversified global real estate portfolio makes both tactical and strategic sense.

“Investors need to be cognizant of the short-term challenges the ongoing credit crunch poses, but adding an international component to a real estate portfolio potentially could lower risk while enhancing real returns net of inflation,” says Philip S. DeSantis, senior investment product manager at Northern Trust.

The Case for Going Global

“Global real estate as an asset class has provided investors with significant returns during the past 15 years both on real-return and risk-adjusted bases,” adds Andrew C. Smith, CFA, chief investment officer at Northern Trust Global Advisors in Stamford, Conn.

In fact, global real estate outperformed major stock indices for the 15-year period ended June 30, 2008. The FTSE EPRA/ NAREIT Global Index provided an annualized return 2.76 percentage points higher than the S&P 500 during the period.

“The implementation of a global real estate strategy can provide an investor with significant diversification benefits relative to other traditional asset classes,” Smith says. “For example, a global real estate portfolio has offered a low correlation of roughly 0.50 to such commonly used benchmarks as the S&P 500 Index. Since real estate is a hard asset driven by rental incomes and capital appreciation, adding global real estate to a mix of financial assets such as equities and fixed income can lower total portfolio risk.”

Although most institutional investors recognize the low correlation real estate offers at the portfolio level, the incremental benefits compared to a stand-alone domestic strategy become more obvious with the addition of new geographies. “North American property returns have had correlations of less than 0.50 versus both the Asian and European regions, while many countries tend to price independently from each other,” Smith says. “This unique diversification benefit represents more than a function of expanded opportunities across multiple real estate markets; it reflects local economies positioned in different phases of the economic cycle.”

Further, diversifying real estate portfolio investments across multiple economies may be even more important in the coming years. “Projected GDP growth for the United States is expected to be lower than that of competing nations, especially in the Asian region, where Hong Kong continues to demonstrate strong growth coming out of China,” DeSantis says. “Because of the fundamental drivers behind real estate, having the ability to gain exposure to property markets in different countries is important. In doing so, investors may reduce market-specific risks. This underscores the thesis for reallocating to a global strategy.”

In addition, income is the primary contributor to total returns in real estate over the long term. For investors with defined liabilities, income streams with greater certainty can carry a higher intrinsic value as market volatility rises and capital market expectations in the United States remain depressed.

“A diversified global real estate portfolio potentially provides a hedge against inflation in an economic environment in which modest interest rates persist with rising prices. This hedge results from diversified yields from rental and leasing incomes across the globe,” Smith says. “The ability to invest in multiple local economies within a portfolio could potentially provide a more stable stream of income over the long term.”

The Growth of Overseas REITs

Historically, investing directly in foreign real estate could be a cumbersome process. Investment strategies were limited to direct investment in individual properties or private equity structures. Although direct allocations to overseas properties provided investors with more control over portfolio assets, this approach also required significant capital to minimize property and geographic-specific risks.

“It was very difficult to get broad global exposure in real estate across 20 to 25 countries,” DeSantis says. “Typically, investors had to invest directly into a private limited partnership, which was not only expensive but requires a very large capital base reserved for only a small segment of the investment population,” he adds.

One approach that facilitates an investor’s diversification into global real estate markets is the use of real estate investment trusts (REITs). “An indirect, or securitized, global strategy can potentially provide returns comparable to direct investments while increasing liquidity, risk efficiency and transparency,” DeSantis says. “These are all critical factors when expanding the investment universe to include international real estate markets.”

REITs also are familiar vehicles for many institutional investors, who have used the trusts to invest in U.S. real estate while avoiding the management headaches of direct investment.

“A decade ago, REITs existed in only five countries,” DeSantis says. “Since 2001, France, Germany, Hong Kong, Japan, Singapore, South Korea and the United Kingdom have all passed REIT legislation. Today, more than 20 nations host several hundred publicly traded REITs. That growth has been fueled by rapid expansion of REIT legislation and initial public offerings for securitized real estate.”

During the same time, capitalization of the FTSE EPRA/ NAREIT Global Index has also grown, totaling $793 billion at the end of 2007. “That expansion was propelled by the continued integration of world financial markets, increased cross-border flow of capital and investor appetite for a globally mixed asset base,” Smith says.

An Efficient Approach

“Perhaps the most attractive feature of indirect property investing is the efficiency gained from accessing local expertise across multiple countries and sectors at a fraction of the cost of direct property investing,” Smith adds. “Becoming a local expert is difficult for practitioners and investors. Zoning, tax laws, data quality and cultural differences all can impede the ability to make informed investment decisions.” As a result of these hurdles, management fees and transaction costs resulting from using direct intermediaries can be as high as 2% to 7% annually. That can significantly diminish returns over the long term.

Investors also enhance their liquidity by indirectly investing in global real estate. “Owning an indirect investment valued daily enables investors to dynamically manage portfolio exposure without competing with tradeoffs, such as high transaction costs or lock-up periods,” DeSantis says. “The flexibility to tactically raise cash or re-allocate across other asset classes can be very costly with global direct investments, especially during a political or financial crisis like the one we have experienced.”

Indirect investment in global real estate also can help minimize risks related to arcane tax structures, single-country currencies and a lack of performance transparency.

Assessing the Risks and Rewards

The current market environment presents both challenges and opportunities for investors who are evaluating their long-term strategic asset allocations. “Ongoing risk aversion in the equity markets has resulted in meaningful declines across many global indices, including real estate,” DeSantis says. “As of June 30, global real estate markets as measured by the FTSE EPRA/NAREIT Global Real Estate Index were down nearly 14% year-to-date on the heels of a 6.96% decline in 2007. But the negative impact on performance in 2007 could have been more severe by a factor of 2.5 were it not for such burgeoning markets as Hong Kong, which bubbled up nearly 50%.”

“Investors should be cautious about increasing their real estate allocations because of the limited visibility today due to the credit crisis,” he adds. “But if investors have a long-term investment strategy, shifting globally could be a smart move. And if investors are committed to a 10% real estate allocation, there is a strong case for incorporating global exposure.”

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