Defining the pattern and sources of return for commercial real estate as a distinct asset class is important, but investors typically hold portfolios of properties that differ markedly from the broad asset class1.
Real estate investors often employ significant amounts of leverage, may concentrate their holdings in a few properties or locales, or take on higher-risk development projects. These activities, alone or together, can transform a low-risk, income-oriented portfolio into a high-risk, appreciation-oriented holding, with important implications for asset allocation. Generalizing about real estate as an asset class may be inadequate when advising clients about their specific holdings or overall financial plans.
We have devised a framework for assessing leverage, concentration, and development activity to help investors see how these factors can alter a portfolio’s risk/return characteristics (see below). Our analysis applies to all real estate investments, whether they are held directly, via REITs, or through private investment funds.
The Alchemy of Leverage
Turning Steady Income into Growth Opportunity
For many, leverage is an absolute necessity of property ownership. In commercial real estate investing, leverage offers a number of unique advantages2.
- Enhanced return potential. As long as the cash flow on the property exceeds the cost of the loans, investors are able to leverage their returns. Real estate equity should always be priced to offer an extra return – a risk premium over and above the cost of mortgage financing.
- Base of diversification. Buying a diversified portfolio of commercial properties requires capital. By gaining access to borrowed funds, investors can acquire a collection of properties without consuming the majority of their net worth.
- Source of long-term financing. With many other asset classes, leverage is fickle since investors face margin calls – and thereby forced sales – if their holdings drop quickly in the face of short-term market stress. Commercial mortgages tend to be long-term in nature, giving the real estate investor the ability to ignore near-term volatility.
1 Market indexes tend to have characteristics that ensure some predictability around future returns, such as broad diversification, high occupancy rates, or above-average asset quality. In our analysis, we focus on a diversified array of fully leased properties within warehouse, office, apartment, and retail.
2 REITs also employ leverage-and for the same reasons as direct investors – but the amount is a given and not within the control of the individual investor.