Property returns exhibit serial correlation, meaning past returns can somewhat predict future ones. This characteristic impacts comparisons between private and public property returns.
This serial correlation hides risks from private CRE equity, leading to potential overallocation in portfolios.
Property models explain over 80% of historic levered and unlevered property (NPI) returns, using variables like lagged REIT returns, BBB CMBS returns, NOI growth, and past property returns.
This report examines the relationship between private and public property investments, focusing on commercial real estate (CRE). It highlights the differences in how public and private markets are priced, affecting risk and returns. Private real estate markets rely on appraisals and are slower to react to public market changes, which makes their returns smoother (serially correlated), unlike publicly traded assets such as REITs or stocks, which are more volatile and efficient.
Key Points on Market Characteristics:
Public vs. Private Markets: Public markets (like stocks and REITs) are more liquid, efficient, and transparent, whereas private markets are illiquid and slower to reflect price changes.
Serial Correlation: Private property returns show serial correlation, meaning past returns are more predictive of future returns. This masks the true volatility of private real estate, often making it seem less risky than it is.
Models and Data Analysis:
The report compares S&P 500, equity REITs, and private property (leveraged and unleveraged) returns over time. Key findings include:
Public Markets: No significant correlation between past and future returns for public assets like the S&P 500 and REITs.
Private Markets: There is strong correlation in private property returns, with past returns predicting up to 64% of current leveraged property returns.
NOI Growth:
Net Operating Income (NOI) growth directly impacts property returns. The relationship is complex, but models that incorporate NOI growth, lagged REIT returns, and other factors explain a large portion (83.9%) of property returns. This helps investors predict property performance by factoring in both income and appreciation.
Leveraged vs. Unleveraged Property:
Leveraged Property: Higher risk due to debt (loan-to-value ratios of 50-60%), but also higher returns.
Unleveraged Property: Less risky, but with returns more closely aligned to income growth and fundamentals.
Conclusion:
Key Drivers of Property Returns: REIT performance, BBB CMBS returns, lagged returns, and NOI growth are the key drivers of property returns.
Investment Strategy: To gain insights into private property returns, investors can look at the performance of other quadrants, such as public market indicators.
Future work will explore the interrelationship of the four quadrants and offer further insights into the optimal asset allocation for CRE investors.
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