Given the prospect of rising interest rates in the U.S. and elsewhere, and the challenges of finding opportunities overseas, many real estate entrepreneurs are looking for ways to protect their portfolios. “Real estate has attracted significant investment, leading to high valuations, and some clients are expressing concerns about the potential for declining values in a rising interest-rate environment,” says Marc DiLorenzo, chief operating officer at The Citigroup Private Bank. Indeed, as the threat of rising interest rates to U.S. real estate becomes increasingly real, investors should consider ways to lower their risk exposure, according to experts at Wharton and The Citigroup Private Bank.


Portfolios of Real Estate Entrepreneurs


The Citigroup Private Bank’s typical high net worth client has a net worth of at least $25 million, and many have made their fortunes in real estate, according to CEO Damian Kozlowski. They are typically entrepreneurs, real estate developers and financial sponsors like private equity firms. The Citigroup Private Bank’s clients tend to concentrate their investments in a single asset class. “We build our business around that investment behavior,” he says.


What’s in a typical real estate client’s portfolio? Three things, according to Kozlowski: concentration (relatively few asset types make up a large proportion of net worth); correlation (those holdings tend to behave similarly); and illiquidity (investments are locked up for many years). “Even when they get out of whatever their primary holding is, they reinvest in assets that behave similarly,” Kozlowski says. For example, when entrepreneurs sell their companies, they might reinvest their proceeds in the stocks of the companies they sold to. Also, portfolios’ illiquidity makes them too inflexible to allow for quick responses to macroeconomic shifts. Put it all together, and structuring portfolios that have inherently counter-balancing characteristics as responses to so-called “event risks,” like interest-rate increases, becomes critical.


Another characteristic of real estate entrepreneurs is the aggressive use of leverage with floating-rate loans. “Historically, if you’ve been willing to take the risk of playing the short end of the yield curve by taking out consecutive short term mortgages or adjustable rate mortgages, you actually have done better,” says Wharton real estate professor Todd Sinai. “But it’s riskier. It’s not risk-adjusted better, but in a lower, long-term interest rate environment, there’s nothing to say that people shouldn’t be taking out adjustable rate mortgages.” 


The Challenges of a Real Estate-Heavy Portfolio


All this doesn’t mean that real estate isn’t an attractive asset class. David Rosenberg, head of U.S. investment solutions for The Citigroup Private Bank, says real estate will remain an important asset group in his ideal portfolio for high net worth investors because real estate currently offers “reasonable returns, reasonable cash flow and a limited amount of risk relative to other assets.” But he also believes that investors need to recognize that real estate is subject to event risks — such as interest-rate spikes — and an absence of symmetry, or a “skewness” in the distribution of returns. “When you invest in real estate with an understanding of that distribution distinction, you are better prepared to diversify around it.”


Rosenberg also says investors should pick good managers who provide diversified portfolio offerings, even if the investor is intimately familiar with real estate. “If you are a small investor — and that includes people with a net worth of $25 million — and you want to put, say, 10% or 15% in real estate, you still don’t have enough capital to self-select your own portfolio,” he says. That’s why real estate entrepreneurs should turn to experienced real estate fund managers and adopt an asset-allocation strategy that accounts for real estate’s unique characteristics.


However, building such an efficient portfolio presupposes an ability to compare risks and returns across different asset groups. The historical data most widely used in the real estate industry are compiled by the National Council of Real Estate Investment Fiduciaries (NCREIF), a not-for-profit industry association in Chicago. Its members include real estate investment managers, institutional investors, accountants, consultants, appraisers and academicians. At the end of 2004, the index compiled by NCREIF covered 4,152 properties with a market value of $145.44 billion.


In a 2004 paper titled, “Real Estate Returns in Public and Private Markets,” Wharton professor of real estate and finance Joseph Gyourko points to some limitations in the NCREIF index, especially when it displays an “extremely low volatility” in returns. He notes that the information from the NCREIF series is not transaction-based and “as such, does not represent the true performance of arm’s-length trading of properties.” In his paper, Gyourko demonstrates that the very low volatility of real estate returns as measured by the NCREIF index reflects measurement error.


That error is rooted in the fact that the index records volatility in capital values only in the fourth quarter of a year. According to Gyourko, “While it is quite reasonable to believe that the net rental flows on a widely diversified portfolio of well-leased, institutional quality properties are very stable from quarter to quarter, the absence of appraisals each period obviously under-represents the volatility of the capital gain component of total return.”


Gyourko points to the pitfalls of relying too much on the NCREIF index in the design of investment portfolios, noting that the low volatility of returns leads to “artificially favorable portfolio implications, as the covariance of this real estate series with stocks and bonds is artificially low.” In a standard asset-allocation model, he adds, that would have the effect of assigning a significant portfolio share for appraisal-based real estate. But in practice, that is not the way investment managers typically have viewed real estate’s place in portfolios. He says that with commercial real estate’s share of the investable universe estimated at about 10%, “one does not have to be a committed believer in efficient markets” to conclude that a significantly higher allocation to real estate is too high.


Overcoming Faulty Data


Citigroup has addressed similar concerns over the last several years through its own research, as part of its Whole Net WorthSM asset-allocation methodology. According to Nicolas Richard, head of Strategic Asset Allocation at Citigroup Global Wealth Management, Citigroup has employed a variety of methods to correct several significant shortcomings in the historical data of the returns, risks and correlations of different asset classes. He names some of the technical challenges addressed by Whole Net Worth regarding alternative assets such as real estate: using artificial appraisal valuations for illiquid assets; making the most of short track records; survivorship bias (when investments that have failed to survive during a period under study are excluded from the data examined, skewing the results); and selection bias (when incorrect sampling excludes relevant groups of securities or entities, which again creates misleading results).


Richard and his team try to get around “staleness” in the underlying components of indexed returns. Staleness occurs in the case of real estate, private equity, distressed debt or other illiquid assets, which do not allow fund managers to provide accurate monthly returns to index providers. The resulting infrequency of valuations creates artificially low volatility in returns. Another imponderable is the so-called “fat tail” risk, where an asset class may not be volatile but still presents significant downside event risk. According to Richard, this could happen “when in one month out of 20 you get really, really bad returns.” Only by incorporating all of these characteristics of real estate can you build efficient portfolios and truly understand their risks, he says.


Investment Strategies for Real Estate-Heavy Portfolios

So what strategies should real estate entrepreneurs consider now, given the prospect of rising interest rates in the U.S. and elsewhere? Perhaps the most important strategy is sensible asset allocation. Asuka Nakahara, Wharton real estate professor and associate director of the School’s Zell/Lurie Real Estate Center, says high net worth investors make “half their money” as soon as they decide how to allocate their assets. But he also isn’t willing to blindly follow the market, saying he wouldn’t try to chase “a hot market” just as he would not ignore what many may describe as “a cold market.” In today’s real estate euphoria, he sees an “eerie similarity” to the dot-com bubble of the late 1990s, “when if you had not bought Internet stocks you would have felt foolish.” His simple tip: “You can never make a mistake taking a profit in real estate.”


Citigroup’s Rosenberg, however, thinks it is critical for high net worth investors to be better prepared for interest-rate shocks. The main plank of his strategy is to design portfolios with assets that have opposite return distributions over a period of time. “According to our research work, what you need are other asset classes that offer investors the ability to buy into a positively skewed distribution,” he says. In essence, this means steering clear of negative returns. He says such assets tend to have “equity-like characteristics,” examples of which are directional hedge funds and leveraged buyouts. Rosenberg explains that unlike hedge funds that try to cut out all the beta risks, directional hedge funds retain some exposure to the equities market. “Their equity characteristics and their positive exposure to the market give directional hedge funds and LBOs varying degrees of equity exposure, so that gives you a positive skew in the portfolio,” he adds.


Rosenberg says these asset groups carry event risks, but historical-return distribution curves show they are positively skewed. While real estate investments could face a negative event risk at some point over a cycle, he says, LBOs could have a positive event risk at some other juncture; over time, the two could cancel out each other. Investors could also dip into a range of derivative products that allows them to trade returns for liquidity and stabilized debt-service obligations.


Rosenberg goes about designing investment portfolios with a keen eye on liquidity. Many high net worth clients come to him with sizable pre-existing real estate or other holdings that may be relatively illiquid, so the challenge is to balance those with instruments that have more liquidity. Of course, a lot depends on the investor’s degree of willingness to tolerate illiquidity and other objectives, including safety and growth in value. “Based on the success of many of our real estate entrepreneurs, we do not try to tell our investors what to do,” Rosenberg says. “These individuals are among the more independent type of investor out there.” Even so, he persuades them to take the excess cash flows from their properties and invest them in assets that diversify their risks.


Ajay Badlani, head of the U.S. Analytical Lab for The Citigroup Private Bank, says one way to mitigate the event risks that real estate investments carry is to include assets in your portfolio, such as equities, that have a low correlation to real estate. The potential downside risk of the portfolio can be diminished further by buying protection, such as put options on equities.


“What’s clear is that the more tools investors have at their disposal, the better they can position real estate-rich portfolios,” Badlani says.