Real Assets Reporter Fall 2016

A version of this article was published in the Spring 2016 edition of PREA Quarterly, a publication of the Pension Real Estate Association.

Is the commercial real estate cycle in its later stages? A key market signal indicates that it may be; the NCREIF Property Index notched

26 quarters of consecutive growth, and appreciation outpaced income in 14 of those quarters, including 8 of the last 10 (Exhibit 1).

Knowledge. Experience. Integrity.

CALLAN INSTITUTE Real

Assets Reporter

Spotlight: Boom in Commercial Real Estate May Be EndingJamie Shen

Summer/Fall 2016IN THIS ISSUE pg. 1 Spotlightpg. 4 Real Estate Reviewpg. 6 Characteristics and Datapg. 8 Periodic Table vs. Inflation

After the Global Financial Crisis (GFC), Callan developed our

proprietary Real Estate Indicators tool to anticipate commercial

real estate cycles better. We identified seven indicators based

on spreads in real estate and fixed income markets that, com-

bined with an understanding of prevailing market dynamics,

have helped signal when the institutional commercial real estate

market is overheated or attractive. One of these indicators is the

spread between the NCREIF Appreciation and Income quar-

terly returns; a situation in which appreciation outpaces income

over a prolonged period of time may indicate the asset class

has become overpriced, increasing the risk of a reversion to the

mean. For core real estate, more than two-thirds of the long-term

returns are expected to come from income. -2%

0%

2%

4%

6%

Income Return Appreciation Return Total Return

2010 2011 2012 2013 2014 2015 2016

Exhibit 1: NCREIF Property Index Returns

Source: National Council of Real Estate Investment Fiduciaries

2

Callan’s Real Estate Indicators

Callan developed our exclusive Real Estate Indicators as a method of forecasting the stages of the real estate cycle. The indicators were created in consultation with clients, who asked whether there was a way to warn them about market corrections, and came in the wake of the Global Financial Crisis.

Callan’s Real Assets Consulting Group identified seven indicators—based on spreads in real estate and fixed income markets—that, combined with an understanding of prevailing market dynamics, have helped signal when the institutional real estate market is overheated or cooled. The metrics are fairly broad. Some are directly related to real estate, such as income and appreciation return. Others are indirectly related, such as Treasury rates. Our research found that based on their relative relationship historically, they did a valuable job of forecasting the real estate cycle to help guide investors’ plans.

Five years ago, the indicators signaled it was an attractive time to

be investing. Today, the results are mixed. Support for real estate

investing generally comes from this era’s historically low interest

rates, which have made real estate attractive for investors on a

relative basis. But even the indicators that consider Treasuries are

less attractive than they were five years ago.

Beyond the indicators, Callan looks at core open-end fund contri-

bution queues, redemption queues, and distributions as additional

important market signals. Over the past six months, we have seen

a marked increase in redemption requests and lower overall contri-

butions (Exhibit 2). We believe this is mostly attributable to rebal-

ancing as investors reach or exceed their real estate allocations.

Collectively, the core open-end fund universe still has over $3 bil-

lion available to invest; however, this is down $6 billion from just

three quarters ago.

While real estate fundamentals have continued to improve—as

evidenced by lower vacancy rates and higher rents—net operat-

ing income growth is starting to slow and new construction activity

has increased.

Indi

cato

r Spr

eads

NCREIF Income vs. NCREIF AppreciationCap Rates vs. 3-Month TreasuryCap Rates vs. 10-Year Treasury10-Year Treasury vs. 6-Month TreasuryNAREIT Total vs. NCREIF Total ReturnNAREIT Dividend vs. 10-Year TreasuryBaa Bond vs. 10-Year Treasury

2010 2011 2012 2013 2014 2015 2016

Wide Spread: blue blocks signal quarters when spreads were the widest (top quartile)

Narrow Spread: red blocks are periods when spreads were nar-rowest or inverted (fourth quartile)

3rd Quartile: yellow blocks mark quarters when spreads narrowed

2nd Quartile: green blocks define quarters when spreads were less wide

Quartile Results

Exhibit 2: Entry and Exit Queues

One way to gauge the real estate market is by the amount of capital flowing into and out of core open-end funds. Based on those flows, core real estate is losing steam, as institutional investors reach their target allocations and concerns about pricing emerge.

$0

$2,000

$4,000

$6,000

$8,000

$10,000

$12,000

Core Fund Redemption Queues Core Fund Contribution Queues

2008 2011 2012 2013 2014 2015 20162009 2010

($m

m)

Source: Callan

3Knowledge. Experience. Integrity.

Armed with this information and our Indicators, we have taken a

cautionary tone with our clients—many of whom are also bumping

up against their real estate allocations—and are tempering expec-

tations. Because our clients are long-term strategic investors in

the asset class, our advice to them has changed on the margin

over the past five years to reflect our continued focus on managing

portfolio risk.

A program that implements these points should be better posi-

tioned for a downturn and will have a stronger chance of providing

clients with a sound risk-adjusted return even if the market contin-

ues to perform well.

Callan’s Recommendations

Given our view of the current market environment, we are advising our clients to:

• Sell any investments that are non-strategic;

• Focus on income and stability of income;

• Limit leverage;

• Avoid or limit speculative development;

• Focus remaining capital with proven managers and proven strategies that endure throughout the cycle;

• Encourage closed-end fund managers to wind up lingering funds;

• Avoid strategies that rely on prolonged future rent growth to improve the returns.

4

Real Estate Review Kevin Nagy

In the U.S., the strong performance of REITs was attributed to

investors in search of yield. After the Brexit vote cast doubt on a

Fed rate increase, global bond yields compressed 25 bps, mak-

ing high-yielding REITs more attractive. Data centers (+20.59%),

industrial (+15.38%), and infrastructure (+15.33%) were the best-

performing sectors. Self-storage (-5.76%) suffered a sharp fall from

grace and was the worst performer in the second quarter after being

the strongest performer in the first. Strong data center performance

was driven by robust tenant demand and less economic sensitivity.

Conversely, self-storage assets with more acute economic sensitiv-

ity struggled due to fears of slowing growth. As of June 30, U.S.

REITs were trading at a 7.1% premium to net asset value (NAV),

contrasting sharply with U.K. REITs, which were trading at a 21.6%

discount to NAV.

The NCREIF Property Index gained 2.03% during the second

quarter, the lowest return since the first quarter of 2010, recording

a 1.19% income return and a 0.84% appreciation return. Industrial

(+2.90%) and retail (+2.17%) topped property sector performance

for the quarter while hotels (+1.46%) brought up the rear. The West

region was the strongest performer, up 2.46%, while the East was

the worst at 1.73%. Transaction volume hit $9 billion, which repre-

sents a 25% increase over the second quarter of 2015. Appraisal

capitalization rates increased to 4.60%, up from an all-time low

of 4.55% last quarter. Occupancy rates also increased and hit a

15-year high at 93.2%. All property types have seen occupancy

increase for the year, though retail was down 20 bps for the quarter.

The preliminary return for the NFI-ODCE Index was 1.91%, com-

prising a 0.90% income return and a 1.01% appreciation return.

This marks a decrease of 5 bps from last quarter’s return and a

new low since 2010. The U.S. real estate market has become

increasingly attractive and has captured nearly 30% of global

capital allocations in 2016. Investors are flooding into the U.S.

due to low government bond yields globally, uncertainty caused

by the Brexit vote in late June, and concerns about China’s slow-

ing growth. According to Preqin, which provides data on the alter-

native assets industry, the amount of dry powder for real estate

investing globally increased to $234 billion in the quarter, up 11.4%

from year-end 2015.

The FTSE EPRA/NAREIT Developed REIT Index (USD) over-

came the shock of Brexit and gained 3.74% in the second quarter,

while U.S. REITs tracked by the FTSE NAREIT Equity Index

surged ahead 6.96%.

Exhibit 3: Rolling One-Year Returns

-60%

-40%

-20%

0%

20%

40%

60%

80%

100%

120%

REIT Database Global REIT DatabasePrivate Real Estate Database

02 0396 97 98 99 00 01 04 05 06 07 08 09 10 11 12 13 14 15 16

Source: Callan


Exhibit 5: NCREIF Transaction and Appraisal Capitalization Rates

Exhibit 4: NCREIF Capitalization Rates by Property Type

0%

3%

6%

9%

Appraisal Capitalization RatesTransaction Capitalization Rates

06 07 08 09 10 11 12 13 14 15 16

Source: NCREIFNote: Transaction capitalization rate is equal-weighted.

0%

3%

6%

9%

IndustrialApartment RetailOffice

06 07 08 09 10 11 12 13 14 15 16

Source: NCREIFNote: Capitalization rates are appraisal-based.

Real Estate: The Long-Term View

Real estate can provide inflation protection, diversification, and

growth in the portfolio. However, certain types of investments

may be volatile, illiquid, or come with high fees. Trends support-

ing investment in real estate include:

• Moderate economic growth

• An aging population that will need to work longer and will

require accommodative housing

• Echo boomers with a desire for independence, individualiza-

tion, and an urban setting

• Expanded demand for core globally

• Expansion of the middle class in China, Brazil, and India,

coupled with urbanization

Risks and issues to consider include:

• Changes in consumer (tenant) demand

• Future increase in cost of capital

• Market size and depth for emerging markets

• Manager risks in Asia and Europe

• Competitiveness of capital relative to other sources

• Unforeseen taxes in non-U.S. markets

Institutional investors can access real estate via direct owner-

ship, commingled funds, open-end funds, REITs, or debt instru-

ments. As with any investment, a careful assessment of risks,

opportunities, and investment vehicles is essential.

Uncertainty over the Brexit vote—and its surprising result—had a

tremendous effect on real estate in the U.K. compared to continen-

tal Europe. According to Cushman & Wakefield, investment volume

in the U.K. was down 25% year-to-date compared to 2015, versus a

10% increase in the rest of the EU.

CMBS issuance for the quarter was $10.8 billion, down sharply from

the second quarter of 2015 ($26.0 billion) and first quarter of 2016

($19.3 billion). The decline was attributed to continued concerns

over economic instability, including the Brexit vote; only $800 million

in CMBS was issued in June.

6

Real assets play a key role within institutional portfolios as diver-

sifiers, sources of income, sources of manager value-add, and

potential hedges against inflation (Exhibits 6 and 7). In addi-

tion to core real estate, real assets encompass investments with

exposure to the real economy (as opposed to the financial econ-

omy) such as timber, infrastructure, and commodities, as well

as inflation-linked strategies. Each of these sub-asset classes

provides a different exposure to inflation and economic growth,

leading to a range of correlations with public equity and fixed

income markets (Exhibit 8).

In high or rising inflation scenarios, real assets can provide a

hedge against losses from short- or intermediate-run underperfor-

mance by equities and bonds. In low-inflation environments, real

assets provide diversification benefits. Some, like commodities,

are well-suited to play the diversification role while contributing

only modestly to total portfolio return; others, such as core real

estate, can both diversify risk and augment returns. Because real

assets include a wide spectrum of strategies and approaches, we

expect an equally wide distribution of returns (and risk) over time.

Real Asset Characteristics and Data Eugene Podkaminer, CFA

Their use of leverage, and the inherent illiquidity of some real asset

classes, also drives the expected returns demanded by investors

while increasing risk.

Investors need to have a thorough understanding of the risks of

real assets. For instance, the hazard of investing in real estate

is poorly represented by the volatility of return streams gener-

ated by an annual valuation process. The actual volatility of

real estate returns experienced in 2008, 2009, and 2010 was

not represented in the smoothed return history available prior

to 2008, suggesting that it could never happen. And the artifi-

cially low correlation of those smoothed returns with stocks and

bonds suggested a greater diversification benefit than real estate

actually offered. Diversification works only when investors can

rebalance by selling high and buying low, and they can only do

so when they can sell the investment that has run up to buy the

investment that has declined.

Because of all these factors, investors need to set realistic

expectations for real assets given the framework of a generally

low return environment across the capital markets.

Real Asset StrategyPeripheral Strategy

Inflation Protection

Diversifica-tion Growth Illiquid High Fees

High Imple-mentation

RiskInvestable

Index

Private Markets

Real Estate X X X X X

Timberland X X X X X X X

Farmland X X X X X X X

Infrastructure X X X X X X X

Energy X X X X X X X

Public Markets

REITs X X X X

Natural Resource Equities X X X X

Commodities X X X

Listed Infrastructure X X X X X

MLPs X X X X X

Exhibit 6: Real Assets – Primary Strategies and Key Characteristics

Source: Callan


Exhibit 7: Callan Database and Index Returns* for Periods Ended June 30, 2016

10-Year Historical

Second Quarter Year 3 Years 5 Years 10 Years 15 Years

Standard Deviation

Sharpe Ratio

Callan Real Estate Database (median) 2.17 11.86 13.09 12.23 4.89 7.36 11.24 0.36NFI-ODCE (value wtd-net) 1.91 10.80 11.97 11.66 5.19 6.95 8.70 0.48

NCREIF Property 2.03 10.64 11.61 11.51 7.40 8.91 6.00 1.06

NCREIF Farmland 1.25 9.68 12.79 15.19 14.04 14.37 5.61 2.32

NCREIF Timberland 1.09 3.49 7.77 6.72 6.40 6.85 4.91 1.09

Callan Global REIT Database (median) 2.96 10.87 9.50 9.24 5.56 10.14 23.32 0.19EPRA/NAREIT Developed REIT 3.74 12.57 8.95 8.63 5.00 9.81 23.61 0.17

Alerian MLP 19.70 -13.11 -5.38 3.24 9.48 11.58 21.23 0.40

DJB Global Infrastructure 7.44 3.22 8.46 9.61 9.12 – 15.71 0.51

Bloomberg Commodities 12.71 -13.48 -10.63 -10.89 -6.46 -0.89 20.56 -0.36

Barclays TIPS 1.71 4.35 2.31 2.63 4.75 5.49 5.46 0.68

Consumer Price Index (CPI-U) 1.22 1.01 1.06 1.32 1.74 2.04 2.19 0.32

S&P 500 2.46 3.99 11.66 12.10 7.42 5.75 16.46 0.39

Barclays Aggregate 2.21 6.00 4.06 3.76 5.13 5.08 3.27 1.25

*Returns less than one year are not annualized.

All REIT returns are reported gross in USD.

Sources: Alerian, Barclays, Bloomberg, Bureau of Labor Statistics, Callan (database groups), Dow Jones, NCREIF, Standard & Poor’s, The FTSE Group

Exhibit 8: Correlation Table – 10 Years Ended June 30, 2016

Callan Real Estate Database 1.00NFI-ODCE (val wtd-net) 0.93 1.00

NCREIF Property 0.96 0.98 1.00NCREIF Farmland 0.12 0.07 0.09 1.00

NCREIF Timberland 0.27 0.19 0.23 0.63 1.00Callan Global REIT Database 0.22 0.15 0.20 -0.04 -0.17 1.00

EPRA/NAREIT Dev REIT 0.23 0.16 0.20 -0.05 -0.17 1.00 1.00Alerian MLP 0.06 -0.08 -0.02 -0.03 -0.26 0.51 0.51 1.00

DJB Global Infrastructure 0.26 0.18 0.24 0.05 -0.14 0.85 0.85 0.73 1.00Bloomberg Commodities 0.23 0.16 0.21 -0.08 -0.13 0.51 0.50 0.63 0.66 1.00

Barclays TIPS 0.06 -0.04 0.04 -0.27 -0.03 0.12 0.11 0.21 0.25 0.36 1.00CPI-U 0.27 0.19 0.25 -0.47 -0.24 0.21 0.23 0.43 0.31 0.61 0.34 1.00 0.03 0.83

S&P 500 0.31 0.22 0.26 0.09 -0.16 0.86 0.85 0.63 0.85 0.53 -0.07 0.25 1.00 -0.34Barclays Aggregate -0.20 -0.18 -0.17 -0.13 0.10 0.04 0.04 -0.10 0.06 -0.12 0.59 -0.27 -0.27 1.00

Callan Real

Estate DB

NFI-ODCE

(val wtd-net)

NCREIF Property

NCREIF Farm

NCREIF Timber

Callan Global

REIT DB

EPRA/NAREIT

Dev REIT

Alerian MLP

DJB Global Infra-

structure

Bloom-berg

Comm

Barclays TIPS

CPI-U S&P 500

Barclays Agg

All REIT returns are reported gross in USD.

Sources: Alerian, Barclays, Bloomberg, Bureau of Labor Statistics, Callan (database groups), Dow Jones, NCREIF, Standard & Poor’s, The FTSE Group

8

Callan Periodic Table of Real Asset Investment Returns Relative to Inflation

This chart depicts annual returns (and 10-year returns in the last column) for select real asset indices ranked from best to worst. The

intent is to demonstrate the strong case for diversification as well as illustrate performance relative to inflation (CPI-U).

NCREIF Timberland18.43%

Alerian MLP

35.85%

EPRA/NAREIT Dev REIT28.65%

DJB Global Infrastructure

16.34%

NCREIF Farmland14.47%


16.26%



Alerian MLP

27.58%



8.80%NCREIF Farmland15.90%

Alerian MLP

76.41%

Bloomberg Commodities

16.67%



16.01%



Alerian MLP

8.74%NCREIF Property15.85%


NFI-ODCE (value wtd-net)

15.26%


14.96%

NCREIF Property10.54%


15.89%




14.84%


34.24%




9.79%


12.92%


11.45%


13.95%

NCREIF Timberland

6.92%Alerian MLP

12.72%


18.72%


12.46%

Alerian MLP

13.88%

NCREIF Timberland

7.76%


NCREIF Timberland10.48%



5.55%Barclays TIPS

11.63%


Barclays TIPS

11.41%



13.75%

Barclays TIPS

6.98%

NCREIF Timberland

9.68%

Alerian MLP

4.80%




11.08%

NCREIF Timberland

9.52%


Barclays TIPS

6.31%

Barclays TIPS

13.56%

Alerian MLP

4.80%


Barclays TIPS

3.64%

NCREIF Timberland

4.97%

Barclays TIPS

3.93%2007 CPI

4.08%2008 CPI

0.09%2009 CPI

2.72%2010 CPI

1.50%2011 CPI

2.96%2012 CPI

1.74%2013 CPI

1.50%2014 CPI

0.76%2015 CPI

0.73%10 Years 2015

CPI 1.86%EPRA/NAREIT

Dev REIT-6.96%

Barclays TIPS

-2.35%

NCREIF Timberland

-4.76%

NCREIF Timberland

-0.16%

NCREIF Timberland

1.58%


-1.14%

Barclays TIPS

-8.61%


-17.04%



-7.49%NCREIF Property-6.46%

NCREIF Property-16.86%

EPRA/NAREIT Dev REIT-5.82%


-9.58%

Barclays TIPS

-1.44%NFI-ODCE

(value wtd-net)-10.70%


-30.40%


-13.37%


-14.40%DJB Global

Infrastructure-36.36%


-24.70%Bloomberg

Commodities-36.61%

Alerian MLP

-32.59%Alerian MLP

-36.92%EPRA/NAREIT

Dev REIT-47.72%

Sources: Alerian, Barclays, Bloomberg, Bureau of Labor Statistics, Callan, Dow Jones, NCREIF, The FTSE Group


Jay Kloepfer

Capital Markets Research

Strategic investment planning, asset allocation

Jamie Shen

Practice Leader, Alternative Investments Consulting and Real Assets Consulting

Real estate, agriculture

Lauren Sertich Real Assets Consulting

Real estate, real estate securities, timber

Avery Robinson, CAIA

Real Assets Consulting

Real estate, infrastructure, emerging managers, minority-, women-, and disabled-owned firms

Sally Haskins


Real estate, Asia

Jonathan Gould, CAIA


Real estate, infrastructure

Michael Bise

Private Equity Research

Private energy, minerals/mining

Eugene Podkaminer, CFA

Capital Markets Research

Strategic investment planning, asset allocation

Brett Cornwell, CFA

Global Manager Research

Master limited partnerships, commodities, TIPS

Gary Robertson

Manager, Private Equity Research

Private energy, minerals/mining

Kevin Nagy, CAIA


Real estate, real estate securities, Latin America

Real Assets Research Team

10

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Certain information herein has been compiled by Callan and is based on information provided by a variety of sources believed to be reliable for which Callan has not necessarily verified the accuracy or completeness of or updated. This report is for informational purposes only and should not be construed as legal or tax advice on any matter. Any investment decision you make on the basis of this report is your sole responsibility. You should consult with legal and tax advisers before applying any of this information to your particular situation. Reference in this report to any product, service or entity should not be construed as a recommendation, approval, affiliation or endorsement of such product, service or entity by Callan. Past performance is no guarantee of future results. This report may consist of statements of opinion, which are made as of the date they are expressed and are not statements of fact. The Callan Institute (the “Institute”) is, and will be, the sole owner and copyright holder of all material prepared or developed by the Institute. No party has the right to reproduce, revise, resell, disseminate externally, disseminate to subsidiaries or parents, or post on internal web sites any part of any material prepared or developed by the Institute, without the Institute’s permission. Institute clients only have the right to utilize such material internally in their business.

The Real Assets Reporter newsletter offers Callan’s data and insights on real estate and other real asset

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please contact your Callan consultant or the appropriate member of the research team at 415.974.5060.

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If you have any questions or comments, please email [email protected].

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Real Assets Reporter Fall 2016

Real Estate

Transcript of Real Assets Reporter Fall 2016