From a small northwestern observatory…

The National Association of Real Estate Investment Trusts (NAREIT) recently commissioned Morningstar to study the role of securitized real estate in the well-balanced portfolio, with a particular eye to the investor attitudes regarding risk, as well as the actual performance of markets.  Both of these two concepts — risk and investor attitudes — are less well understood than researchers seem to think.  In the first, market models assume a degree of normalcy in the distribution of market returns.  However, empirical evidence seems to contradict this, and in fact market volatility is significantly greater (and of greater magnitude) than models would predict.

In the second case — investor attitudes — traditional models suggest that rational investors react to “up” markets in the same way as “down” markets.  More recent behavioral models recognize the fallacy in this — rational investors relish “up” volatility, but loathe down markets.

The results of the research were published in an excellent new research piece from NAREIT titled “The Role of Real Estate in Weathering the Storm” (click on the title for a copy of the paper).  Some high-points from the study:

• Since 1929, the S&P 500 has had 10 months with declines of 15.74% or more — which is eight more than would be predicted by a normal distribution.
• Recent studies by James Xiong of Ibbotson Research show that the log-normal distribution fails to account for this down-side volatility.
• From 2000 – 2009 (often called the “lost decade”), the cumulative return on large-cap stocks was negative 0.95%.

Morningstar then crafted portfolios under the “theoretical” model (normal distribution) versus a more realistic model of volatility, with alternative structures for risk-averse investors and more risk-tolerant investors.  Investment returns were measured over the period 1990 – 2009, which notably included the recent market melt-down.

Under normal distribution assumptions, an optimum risk-averse portfolio would allocate about 6% to securitized real estate and theoretically enjoy a return of 7.6%.  Under more realistic volatility assumptions, the risk-averse portfolio would allocate 14% to securitized real estate and would have returned 8.2%.

A more risk-tolerant investor would have allocated 18% to 20% in securitized real estate, and would have enjoyed a return of 9.7%, with volatility (standard deviation of portfolio returns) of 10%.

The most striking finding of the study was the consistent role played by securitized real estate in all four of the models (normal versus non-normal, risk-averse versus risk-tolerant) and particularly thru the market melt-down.  While this may seem counter-intuitive, given the roller-coaster ride of REIT prices, investors need to realize that REIT shares paid relatively high dividends through this period, thus ameliorating the downward price movements.  In short, the gains from real estate holdings pre-meltdown, coupled with the dividends, more than made up for the price bounce over the past few years.  Further, REIT prices have rebounded better post-recession than have other S&P shares.