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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
5Knowledge. Experience. Integrity.
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
7Knowledge. Experience. Integrity.
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%
DJB Global Infrastructure
16.26%
EPRA/NAREIT Dev REIT20.40%
NCREIF Farmland18.58%
Alerian MLP
27.58%
EPRA/NAREIT Dev REIT15.89%
DJB Global Infrastructure
8.80%NCREIF Farmland15.90%
Alerian MLP
76.41%
Bloomberg Commodities
16.67%
NCREIF Farmland15.16%
DJB Global Infrastructure
16.01%
NCREIF Farmland20.93%
NCREIF Farmland12.64%
Alerian MLP
8.74%NCREIF Property15.85%
EPRA/NAREIT Dev REIT38.26%
NFI-ODCE (value wtd-net)
15.26%
NFI-ODCE (value wtd-net)
14.96%
NCREIF Property10.54%
DJB Global Infrastructure
15.89%
NCREIF Property11.82%
NCREIF Property7.76%
NFI-ODCE (value wtd-net)
14.84%
DJB Global Infrastructure
34.24%
NCREIF Property13.11%
NCREIF Property14.26%
NFI-ODCE (value wtd-net)
9.79%
NFI-ODCE (value wtd-net)
12.92%
NFI-ODCE (value wtd-net)
11.45%
NFI-ODCE (value wtd-net)
13.95%
NCREIF Timberland
6.92%Alerian MLP
12.72%
Bloomberg Commodities
18.72%
DJB Global Infrastructure
12.46%
Alerian MLP
13.88%
NCREIF Timberland
7.76%
NCREIF Property10.98%
NCREIF Timberland10.48%
NCREIF Property13.33%
NFI-ODCE (value wtd-net)
5.55%Barclays TIPS
11.63%
NCREIF Farmland15.84%
Barclays TIPS
11.41%
NCREIF Farmland8.79%
DJB Global Infrastructure
13.75%
Barclays TIPS
6.98%
NCREIF Timberland
9.68%
Alerian MLP
4.80%
NCREIF Farmland10.35%
EPRA/NAREIT Dev REIT5.39%
Bloomberg Commodities
11.08%
NCREIF Timberland
9.52%
NCREIF Farmland6.33%
Barclays TIPS
6.31%
Barclays TIPS
13.56%
Alerian MLP
4.80%
EPRA/NAREIT Dev REIT4.43%
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%
Bloomberg Commodities
-1.14%
Barclays TIPS
-8.61%
Bloomberg Commodities
-17.04%
EPRA/NAREIT Dev REIT0.05%
Bloomberg Commodities
-7.49%NCREIF Property-6.46%
NCREIF Property-16.86%
EPRA/NAREIT Dev REIT-5.82%
Bloomberg Commodities
-9.58%
Barclays TIPS
-1.44%NFI-ODCE
(value wtd-net)-10.70%
NFI-ODCE (value wtd-net)
-30.40%
Bloomberg Commodities
-13.37%
DJB Global Infrastructure
-14.40%DJB Global
Infrastructure-36.36%
Bloomberg Commodities
-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
9Knowledge. Experience. Integrity.
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 Assets Consulting
Real estate, Asia
Jonathan Gould, CAIA
Real Assets Consulting
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 Assets Consulting
Real estate, real estate securities, Latin America
Real Assets Research Team
10
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11Knowledge. Experience. Integrity.
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
investment topics. Callan’s real assets consulting practice offers extensive manager research; a dedi-
cated and experienced team; and a solutions-focused, customized approach. For real assets inquiries,
please contact your Callan consultant or the appropriate member of the research team at 415.974.5060.
Editor – Stephen R. Trousdale
Designer – Jacki Hoagland
If you have any questions or comments, please email [email protected].
About CallanCallan was founded as an employee-owned investment consulting firm in 1973. Ever since, we have
empowered institutional clients with creative, customized investment solutions that are uniquely backed
by proprietary research, exclusive data, ongoing education and decision support. Today, Callan advises
on $2 trillion in total assets, which makes us among the largest independently owned investment consult-
ing firms in the U.S. We use a client-focused consulting model to serve public and private pension plan
sponsors, endowments, foundations, operating funds, smaller investment consulting firms, investment
managers, and financial intermediaries. For more information, please visit www.callan.com.
About the Callan InstituteThe Callan Institute, established in 1980, is a source of continuing education for those in the institu-
tional investment community. The Institute conducts conferences and workshops and provides published
research, surveys and newsletters. The Institute strives to present the most timely and relevant research
and education available so our clients and our associates stay abreast of important trends in the invest-
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