Explain the concept of economic geography. For commercial real estate, does economic geography ignore property type? 2. In commercial real estate, the correlations by market type/cluster are very...

Explain the concept of economic geography. For commercial real estate, does
economic geography ignore property type?
2. In commercial real estate, the correlations by market type/cluster are very high.
What data can we use to work around this potential pitfall?
3. Explain the relationship between public and private markets in commercial real
estate. What makes this rather unique? How could we use this to our advantage?
4. Explain the difference in cash flows between swaps and forward contracts.


Problem Set #2 Name_________________________ Risk and Portfolio Management 1. Explain the concept of economic geography. For commercial real estate, does economic geography ignore property type? 2. In commercial real estate, the correlations by market type/cluster are very high. What data can we use to work around this potential pitfall? 3. Explain the relationship between public and private markets in commercial real estate. What makes this rather unique? How could we use this to our advantage? 4. Explain the difference in cash flows between swaps and forward contracts. Microsoft Word - Rational Differences Between Public & Private.doc Rational Differences Between Public and Private Real Estate May 2004 Research Philip Conner Vice President US Office Tel 973.734.1339 [email protected] Robert Falzon, CFA Managing Director Global Real Estate Private Equity US Office Tel 973.734.1443 [email protected] Prudential Real Estate Investors (US) 8 Campus Drive Parsippany, NJ 07054 USA Tel 973.683.1745 Fax 973.734.1319 Web www.prudential.com/prei E-mail [email protected] Two ownership markets – public and private – compete for commercial real estate. Although real estate has been traded in the private markets since before the creation of any organized exchanges, the dramatic growth of the REIT market since 1993 has enhanced the status and influence of the public market. In today’s environment, the public market is as important as the private in shaping trends in the industry. Furthermore, investors have a genuine choice between public and private vehicles to gain exposure to real estate. While the objectives of public and private real estate vehicles are often similar, and the underlying assets in which they invest may be the same, the performance characteristics of the vehicles themselves can differ dramatically, particularly over relatively short time horizons. As the historical returns of REITs and private real estate demonstrate, the two markets are not perfectly aligned. The most important difference between the two markets, however, is the significantly higher volatility of the public markets. The differences between public and private real estate investment performance are frequently attributed to inherent flaws in private market benchmarks, such as the NCREIF Property Index (NPI). Many believe that these “flaws” are caused by deficiencies or inefficiencies in measuring private market investment performance. To be sure, some of the criticisms of private real estate benchmarks are valid, and limitations exist as to how a benchmark like NCREIF’s should be utilized. But the “flaws” in private market benchmarks have become a scapegoat to explain any and all performance disparities between the two markets. The differences between these markets are important and rational. In this paper, we advance two hypotheses, the sentiment theory and the marginal investor theory, to explore the sources of the public market’s higher volatility. The public and private markets are often subject to different and differing degrees of powerful sentiment gyrations. At times, these forces cause the public and private markets to deviate from each other in their implicit pricing of underlying assets. Furthermore, the different investor constituencies – private real estate investors are almost exclusively Prudential Real Estate Investors (US) 2 long-term investors, while investors in public securities may be both long and short term – clearly define the two markets. As a result, the public market provides greater liquidity along with higher volatility. The private market provides more stability, but with less liquidity. Key Performance Characteristics Analysts and investors typically evaluate investments (or asset classes) using three key performance characteristics: return, volatility and correlation. For real estate investments of all types, these attributes are partly determined by the fundamentals of the underlying assets, which include property-specific features, such as property type and quality, and market-specific features, such as vacancy rates, rents and local market practices. However, the nature and structural characteristics of the vehicles and markets (public and private) in which the assets are owned and traded also affect return, volatility and correlation. Exhibit 1 shows the historical returns for US public equity REITs and private real estate investments. Although the magnitude of return differences varies from year to year and over the different time intervals, it is clear that public and private real estate investments historically have performed differently. Over the longer term, however, the returns have been more comparable. The generally higher historical returns for REITs are due, at least in part, to REITs tending to use 30% to 50% leverage, while the NPI is unleveraged. Many REITs also generate additional earnings from property management and other tenant services that are not reflected in the NCREIF returns. Exhibit 1: Calendar Year and Compound Annual Returns Public Real Estate Private Real Estate Difference (bps) 1990 -15.4% 2.3% (1,770) 1991 35.7% -5.6% 4,130 1992 14.6% -4.3% 1,890 1993 19.7% 1.4% 1,830 1994 3.2% 6.4% (320) 1995 15.3% 7.5% 780 1996 35.2% 10.3% 2,490 1997 20.3% 13.9% 640 1998 -17.5% 16.2% (3,370) 1999 -4.6% 11.4% (1,600) 2000 26.4% 12.2% 1,420 2001 13.9% 7.3% 660 2002 3.8% 6.7% (290) 2003 37.2% 9.0% 2,820 3-Year Return 17.5% 7.7% 980 5-Year Return 14.4% 9.3% 510 10-Year Return 10.7% 9.9% 80 Sources: NAREIT; NCREIF; Prudential Real Estate Investors Remarkably, the return series reveal several years during which public real estate investment returns were negative while private returns were positive, or vice versa, but not a single year since 1990 when returns for both public and private real estate were negative. 3 Exhibit 2 shows the rolling four-quarter returns for US public equity REITs and private real estate since 1990. It clearly shows the most important difference between the performance characteristics of the private and public markets: the significantly higher volatility of public REIT returns versus private real estate returns. Exhibit 2: Rolling Four-Quarter Returns Reveal Volatility of Public Returns Public and Private Real Estate - Rolling Four-Quarter Total Returns -30% -20% -10% 0% 10% 20% 30% 40% 50% M ar -9 0 Se p- 90 M ar -9 1 Se p- 91 M ar -9 2 Se p- 92 M ar -9 3 Se p- 93 M ar -9 4 Se p- 94 M ar -9 5 Se p- 95 M ar -9 6 Se p- 96 M ar -9 7 Se p- 97 M ar -9 8 Se p- 98 M ar -9 9 Se p- 99 M ar -0 0 Se p- 00 M ar -0 1 Se p- 01 M ar -0 2 Se p- 02 M ar -0 3 Se p- 03 Public Real Estate Private Real Estate Sources: NAREIT; NCREIF; Prudential Real Estate Investors Annual public market returns have varied much more dramatically from year to year than private real estate returns (see Exhibit 3). Since 1990, private property returns ranged from as low as – 5.6% in 1991, at the bottom of the early-’90s real estate market crash, to as high as 16.2% in 1998, with an annual standard deviation of 6.2%. Annual returns for public REITs, in comparison, have ranged from as low as –17.5% in 1998, the peak year of private real estate returns, to as high as 37.2% in 2003, with an annual standard deviation of 17.1%. Exhibit 3: Investment Performance Volatility 1990-2003 1994-2003 Public Real Estate 17.1% 16.5% Private Real Estate 6.2% 3.2% Sources: NAREIT; NCREIF; Prudential Real Estate Investors Admittedly, some of the difference in volatility may be due to weaknesses in the NPI, such as smoothing due to staggered appraisals, which artificially understate the true volatility of the assets. But even with such weaknesses in the private benchmark, investment performance and, by implication, the pricing of the underlying assets has differed significantly in the public and private real estate markets. Further, these episodes of misalignment can persist for a surprisingly long time – much longer than the appraisal lag explanation would support. 4 Exhibit 4, which shows the correlations between public and private real estate and other major asset classes from 1990 through 2003 (using quarterly data), highlights two important aspects of public and private real estate returns. First, as the different return series for public and private real estate suggest, the correlation between the two markets is quite low. In fact, over the 1990- 2003 period, public and private real estate returns in the US were negatively correlated. Second, the correlations between public real estate and the other major asset classes are generally much higher than the correlations between private real estate and stocks and bonds. As shown, public equity REITs are more highly correlated with small cap stocks, particularly small cap value stocks. Exhibit 4: Public Real Estate Returns More Highly Correlated with Other Asset Classes Public Real Estate Private Real Estate S&P 500 Small Cap Growth Small Cap Value 7-10 Yr Govt./ Credit Bonds Public Real Estate --- -0.07 0.43 0.55 0.73 0.13 Private Real Estate -0.07 --- 0.00 -0.14 -0.13 -0.15 S&P 500 0.43 0.00 --- 0.84 0.68 -0.07 Small Cap Growth Stocks 0.55 -0.14 0.84 --- 0.76 -0.09 Small Cap Value Stocks 0.73 -0.13 0.68 0.76 --- 0.05 7-10 Yr Gvt./Credit Bonds 0.13 -0.15 -0.07 -0.09 0.05 --- Average 0.35 -0.10 0.38 0.38 0.42 -0.03 Sources: NAREIT; NCREIF; Ibbotson Associates (Wilshire small cap growth and value stock