Commercial real estate is priced to produce superior risk-adjusted returns compared with investments in both fixed income and public equities in coming years. This article will present two different frameworks to assess and validate this claim.
Framework #1: Mean reversion of returns
Asset class returns are volatile but tend to be mean-reverting over sufficiently long time-horizons. Two of its most important implications are: 1) investors should hold diversified portfolios to reduce portfolio volatility; and 2) investors should regularly rebalance their portfolios back to their target asset allocation, a form of programmatic contrarianism.
In 2020, the top-performing asset classes were US equities, Japanese equities and global investment grade corporate credit. These investments not only outperformed other asset classes but were also significantly higher than their own ten-year average total returns.
By contrast, global REITs were the worst-performing asset both compared with investment alternatives and with their own long-term returns, followed by core US real estate as reflected by NCREIF’s National Property Index (NPI). Given that downgrades in appraised values tend to lag changes in market conditions, 2020 performance was likely worse than the most recent figures suggest. The same is true of the all-property RCA CPPI index, which showed prices increasing in line with the ten-year average: the value is inflated by the lack of trades for all but the most resilient properties. The upshot is that in the years ahead, returns for the first group of assets are likely to slow down while commercial real estate returns accelerate.
Cross-asset returns: 2020 versus ten-year average (%)