Published July/August 2014
REIT: There has been increased focus recently on how to measure the performance, volatility and diversification benefits of illiquid assets. Can you briefly describe the problem and the solution developed in your recent collaborative research?
GOETZMANN: Private equity investments have gained in popularity among institutional investors over recent years. This is due in part to the great success enjoyed by endowments such as Yale and Harvard, which were early investors in non-marketable assets. These assets present a problem for valuation and risk measurement. The lack of market prices forces investors, regulators and auditors to rely on appraisals rather than transactions prices. Appraised price series are typically smoother than market price series although not necessarily less risky. Appraisal valuation masks the variation of market prices.
REIT: And what did your empirical results suggest regarding the performance and volatility specifically of private equity real estate investments?
GOETZMANN: My co-authors (Andrew Ang, Binxu Chen and Ludovic Phalippou) and I developed a method of estimating the systematic and total risk of commercial real estate investment based on cash flows in and out of limited partnership real estate funds. The data used in our research paper include real estate funds employed by U.S. pension funds. We found a few key issues of interest to real estate investors.
First, the volatility of our private equity real estate index was 17 percent per year, much higher than that of an appraisal-based index and similar to the volatility of a REIT index. This suggests that the appraisal-based indices are unreliable for risk measurement.
We also found that the CAPM beta for unlevered property investment was .77, indicating a systematic risk exposure less than the equity market. The beta on a REIT index was also less than one. We estimated an average private equity-specific factor for real estate funds to be negative during the period of our study – i.e., we found that these funds, on average, did not contribute positively to performance when benchmarked against a REIT index.
REIT: Before the liquidity crisis you did some fascinating research on how institutional investors make their real estate investment decisions. I was particularly struck by the finding that, as of late 2004, nearly half of the investors surveyed considered it unlikely that real estate prices would crash in the next 10 years. How do you think institutional decision making on real estate investing may have changed since then?
GOETZMANN: Yes, Ravi Dhar (Yale School of Management professor) and I surveyed a large sample of institutional investors at that time. Some fraction of them held no real estate at all – evidently burned by prior crashes. Interestingly, those who did invest in real estate identified liquidity risk, the lack of reliable valuation data and the risk of making a poor investment as the three largest risks. The risk of a crash was way down on the list.
Although real estate investing is nearly as old as private property itself, the cyclical nature of the returns continues to be a problem for the formation of reasonable investor expectations. Booms continue to attract new cash flows, just as busts drive investors away from the asset class. Certain institutional investors have come to understand this and have made long-term commitments to property investing that include the capacity to adjust to periodic downturns.
It may be, however, that agency considerations make direct property investing infeasible for some types of institutions.
REIT: You’ve analyzed both how the residential mortgage-based securities market may have contributed to the 2008 crisis and how an early commercial mortgage-backed securities market may have contributed to the 1929 crisis. Separate research by Tim Riddiough of the University of Wisconsin contrasts the stock exchange-listed REIT model with the MBS model and suggests that REITs may actually have moderated the recent downturn in commercial property markets. Is your research consistent with that story?
GOETZMANN: REITs have proven to be an important source of capital during periods of contraction in the real estate market. They saved the real estate market after the credit crunch of 1990, reinvigorating it with public market flows. Because REITs are less tied to the institutional structure of the banking industry, they are less subject to its systemic shocks.
In my study of the skyscraper bond market in the early 20th century, I found that the SEC made a regulatory decision to shut down public real estate markets – closing New York’s real estate exchange permanently. This transformed the development market in many cities into one dominated by private capital and family businesses rather than an open and transparent public capital market.
Broader access to real estate investment in the U.S. only revived with the distribution of tax shelter property investments in the 1950s, the creation of REITs in 1960 and the authorization of REITs as corporations in 1976.
REIT: Are REITs part of your investment portfolios?
GOETZMANN: I invest in REITs through a diversified REIT mutual fund and have done so for many years – as long as I have been involved in real estate research.
William N. Goetzmann is professor of Finance & Management Studies and director of the International Center for Finance at Yale University, where he has authored or co-authored more than 100 published articles, most of them on investing in assets as varied as commercial real estate, single-family housing, hedge funds and art.