Real estate has served as a lighthouse in many investors’ portfolios

The case for adding real estate to a mixed-asset portfolio has never been stronger. In response to massive volatility in their portfolios in recent months, investors are asking two fundamental questions of their two largest asset classes:

• Can stocks hold their value and produce the same kinds of returns in the future that they have produced over the last twenty years?

• With falling interest rates, can fixed-income instruments produce the same cash yields in the future that they have earned over the past twenty years?

An affirmative answer to either of these questions is less certain than ever before. As a result, more investors are rethinking their asset mix and many are considering the addition of real estate for the first time, while others are expanding their allocations to real estate.

Before an investor pursues a real estate strategy, however, it is important to understand the financial behavior of this Â'third asset classÂ'. Moreover, capital market demand for real estate and real estate fundamentals are now moving in opposite directions — a situation that cannot last indefinitely.

Buildings are certainly not immune from the financial pressures on tenants, but they do have a prior claim on their tenants’ earnings. This senior claim insulates real estate from the earnings volatility felt by rent-paying firms and stockholders in the broader equity market.

During periods of uncertainty, investors are willing to pay more for contractual earnings relative to speculative earnings. This is why the capital markets are favoring real estate, even though fundamentals are weak. Real estate does not have the volatility that stocks often exhibit and it can earn higher yields than bonds of equivalent credit risk and duration.

But, as a low-correlated asset class, it also marches to its own rhythm and cannot be expected to perform in quite the same way as either stocks or bonds. Real estate has now out-performed other major asset classes in Europe in nine of the last 10 quarters.

This is a highly unusual state of affairs. The point is that real estate is simply different. It is this difference that reduces the risk of the overall portfolio and therefore improves riskadjusted returns over time for investors.

Cross-border capital flows in European real estate appear to be more after higher yields than in pursuing a pure goal of diversification.

In the United States the hotel and lodging industry was hurt more than any other in the aftermath of 9/11. If opportunistic returns are to be found anywhere in the United States, it will be here. The public markets have already priced in a recovery in the hotel sector, but the private markets have not. Also the flex and distribution sectors have had their share of difficulties.

In Asia, the strength of the Seoul office market today is surprising and how rapidly it has recovered after the Asian crisis of 1997.

In general, real estate investors are pleased with the performance of European, Asian and American real estate relative to the turbulent waters of the stock market. By preserving its value and sending forth a steady income stream, real estate has served as a lighthouse in many investors’ portfolios.

(source: Market Watch, LaSalle Investment)

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