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Endowment Spending and Purchasing Power Preservation (IV): Real Estate

Potential Benefits of Real Estate Investments

Similar to the return patterns of other real assets, real estate returns also have low correlations with traditional investment vehicles, which adds a diversification benefit. Secondly, as real estate investment returns are directly linked to the rents, its income tends to increase faster in inflationary environments, allowing investors to maintain its real returns and potentially absolute returns. Beyond that, imagine that an investor owns ten one-bedroom apartments and each generates a monthly cash inflow of $3,000; real estate investing enables investors to quickly build up a nice income. Furthermore, during the period of depreciation, the feds allow real estate owners or investors to deduct a portion of the property value from their income. Since rental income is considered passive income, it is not subject to self-employment taxes. In the U.S., investing in real estate around April 15th of each year brings even more opportunities – investors can depreciate rental property, deduct mortgage interest, and write off maintenance and other associated expenses of managing the asset.

The Investor Report by Pension Real Estate Association released in August 2013 uncovered that in the calendar year 2012, 33.9 percent of the reporting investors had greater-than-ten percent of their assets allocated to private real estate investments. The survey participants are public and private retirement plans, endowments, and foundations. It is worth noting that the Yale Endowment has a 22 percent long-term policy allocation to real estate, which significantly exceeds the average endowment’s commitment.

Private Real Estate Equity Allocations by PREA Members

Exhibit 5.2 Private Real Estate Equity Allocation by PREA Members

Types of Real Estate Investments

Real estate investments can be categorized in different ways.

  • Based on nature, mortgage is a debt instrument as opposed to the equity category.
  • Investors can choose to invest in the domestic real estate market, or international market. In Asia, investor sentiment has grown increasingly uncertain, with concern over fading global economic prospects tempered by ongoing strength in asset pricing and persistently compressed yields. Additionally, the difficulty in sourcing good returns has indicated that investors have become more adventurous in seeking out yield with secondary locations.
  • People talk about single-family homes, townhouses, condominiums, manufacture housing, which belong to the broad residential category; on the other hand, we have office buildings, retail space, industrial centers, hotels, and apartment buildings, i.e., commercial real estate. According to the Investor Report, in 2012, office properties remained the top property type for investors with 27.9 percent of holdings, but multi-family properties moved into the second spot, approximately 20.2 percent whereas retail slipped to 20.1 percent. In the past two years, office property was the worst-performer.
  • An important form of public real estate investment vehicle in the U.S. is Real Estate Investment Trusts (REITs). In practice, most institutional investors, in particular endowments and foundations, prefer to gain the asset class exposure via private real estate investments, which are physical, direct, and non-exchange-traded. Pension funds have historically invested in either private real estate funds or direct ownership of physical properties. Generally speaking, private real estate investments have the potential to generate higher returns, and they are less affected by investor euphoria. Besides, private real estate investments are lower-correlated with the broader equity markets. Finally, they also allow investors to capitalize more on the private real estate managers’ knowledge and skills. However, the tradeoffs are illiquidity, higher fees, and less transparency.
  • Beyond the core real estate market, the so-called primary real estate market, as real estate sectors have entered the expansion phase, endowments and foundations are willing to take some more risk by venturing towards secondary real estate market and tertiary real estate markets.

Private Real Estate Valuation

There are three primary approaches to private real estate valuation:

1)       Cost approach. The assumption of this approach is that the value of the property is the same as the construction cost or replacement cost. It requires professional background and knowledge of the industry and material costs in particular.

2)       Sales comparison approach is more accepted when valuing residential real estate. It typically involves selecting properties with similar characteristics in the same real estate market that have recently experienced transactions.

3)       Income capitalization approach can be used if the investor knows what the prevailing capitalization rate is in the given market for that particular type of property. He can then simply divide the income generated by the property by the capitalization rate and come up with the value of the property.

Private Real Estate Investment Styles

  • Core real estate is an unleveraged, low-risk strategy with predictable cash flows. It invests in stable, fully-leased, and multi-tenant properties within diversified metropolitan areas.
  • Value-added real estate is a medium-to-high-risk strategy. It is structured to buy a property, restructure and improve it, and then sell it at an appropriate timing for gain.
  • Opportunistic real estate is a high-risk strategy because the properties such as raw land and those in development will require a high degree of enhancement. Opportunistic real estate category also includes mortgage notes and niche property sectors.

Exhibit 5.3 Private Real Estate Investments by Strategy


In the U.S., institutional investors held 4.1 percent of all assets in real estate investments at year-end 2012. Investments in core real estate captured 50 percent of the total allocation. A study by James D. Shilling and Charles H. Wurtzeback, using data from National Council of Real Estate Investment Fiduciaries (NCREIF) property database demonstrated that while value-added and opportunistic real estate investments have higher returns than core real estate investments. The superior returns are driven primarily by market conditions and the use of cheap debt rather than by risk exposure.


Understanding the differences among various categories and styles of real estate investments will provide investors with a better understanding of the breadth of investment opportunities. It will help to refine an asset allocation framework as to how much to allocate to real estate assets, and more practically, how much to allocate within the portfolio and how to optimize it.


Portfolio Allocation with and within Real Estate


Typical public and corporate pension funds have an average allocation of approximately 4 percent to real estate assets, with individually weighted averages of 1.3 percent to public real estate and 3.1 percent to private real estate.


Overall, institutional investors’ allocation to the asset class is no greater than 15 percent of their portfolio to real estate assets, and it may depend on various factors, including analytical capabilities and tolerance for illiquidity. In the U.S., larger endowments and foundations’ portfolios tend to have greater allocation to real estate. The National Association of Real Estate Investment Trusts (NAREIT) recommends a breakdown of 1/3 REITs, ½ core private real estate, and 1/6 opportunistic private real estate investments.


The investments in real estate made by endowments and foundations have been increasingly moving away from the “naïve diversification” asset allocation approach; instead, they have been seeking an optimal diversification starting with a target portfolio equivalent to the market portfolio based on the capital asset pricing model (CAPM). If adopting a mean-variance optimization approach, since the framework is a single period model and it does not consider transaction cost, it is not ideal for real estate investments, since they are held over long periods of time and the transaction costs are substantial. It does not reflect the experience of the investors either.


In reality, many investors and investment advisors use such framework as a starting point. As a second step, they adjust the weights according to respective investment objectives and constraints. It is widely agreeable that given the unique features of real estate investments, such as income tax advantages, illiquidity disadvantage, the asset allocation decision within this category should be made on a case-by-case basis.


Final Thoughts


  • The first thing that investors should be aware before making an allocation to real estate is that the transaction costs are significant when compared to other asset classes. It is also costly to operate and manage because it is tangible and requires ongoing maintenance. Besides, legal issues may come into play when investors become owners of property; they become liable for damages to others who come onto the property.
  • Investors should also have a good sense about the state of the market when they make the investment, and consider how the property will perform as it moves through investment market cycles and leasing market cycles.
  • Another major challenge of real estate investment is to assess conflicting risks, such as illiquidity. Private real estate is highly illiquid, taking years to trade at competitive prices. This can raise serious issues for cash management, risk measurement, and portfolio risk management.
  • Real estate is a highly heterogeneous asset, in terms of location, use, design, lease provisions, income streams, etc. this heterogeneity is particularly troublesome in the due diligence process. Compared with most other asset classes, it requires even more specialized analysis and managerial skills.
  • Another unique feature is the so-called “lumpiness.” Real estate investments cannot be easily bought and sold in sizes or quantities that meet both transaction parties’ needs.
  • The price of real estate offered for sale vary widely from true its economic value due; investors with poor-quality information should realize that transactions in relatively inefficient markets will systematically generate inferior returns.
  • The last consideration is related to leverage. In 2003, 88.5 percent of real estate investment managers indicated they used leverage; by the year-end 2012, the leverage level has little changed, and approximately 88.7 percent has used leverage.


  1. Investor Report by Pension Real Estate Association, August 2013
  2. Emerging Trends in Real Estate Asia Pacific 2012
  3. Is Value-Added and Opportunistic Real Estate Investing Beneficial? If So, Why? James D. Shilling and Charles H. Wurtzebach JRER  Vol. 34  No. 4 – 2012

One response to “Endowment Spending and Purchasing Power Preservation (IV): Real Estate”

  1. Wow such a helpful webpage.

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