In Black’s new research paper titled “Real Estate in the Investment Portfolio,” he takes a look at the standing research to compile a comprehensive study of real estate as a diversification tool for the institutional investor. Black notes that his research is meant for financial professionals “who want to know more about the benefits of adding real estate to a mixed portfolio of investments.” According to the paper, actual investments in the U.S. totaled about $70 trillion in early 2000, with real estate and real-estate-backed assets making up approximately $30 trillion of “this investable capital, which also included stocks and bonds.” Black adds that real estate has a balancing effect on a portfolio, due to its negative or low positive correlation with stocks, making it a key part of a diversified portfolio.

Certainly, investment mix has long been considered an appropriate way to manage and mitigate risks across a portfolio. In his research, Black notes that this spin on investing, or modern portfolio theory, began with researcher Harry Markowitz in the early 1950s, with Markowitz providing statistical evidence for diversifying investments. This early research also provides the modern-day tool for actual measurement of the benefits of diversification, with the objective of the investor being that of achieving a target rate of return and mitigating risk, or maximizing “the return on the portfolio subject to a target level of risk. To do this, the investor uses mean-variance portfolio analysis.” Essentially, mean-variance portfolio analysis involves evaluating risk based on the expected value and the variation of possible outcomes.

Even in the best of situations, warns Black, any investment strategy comes with risk, and as the level of risk increases, so does the investor’s expectations for higher rates of return. Generally, says Black, a portfolio can be constructed to deal with volatility. Investment A might be selected, as it is expected to rise by one dollar, for instance, when investment B falls by one dollar, in a given economic situation or market scenario. Black does note that “it is virtually impossible to find investments that are perfectly negatively correlated. However, investments can be found that have negative correlations [of] less than -1, [or] say, -0.5.”

After giving a backdrop on the proper investment strategy, based on one’s level of risk/reward, Black takes a look at the existing data collected on commercial real estate. He analyzes data and research based on the NCREIF Index (NPI)—an index from the National Council of Real Estate Investment Fiduciaries that tracks the returns in direct real estate investments. According to the paper, the NPI “represents a value-weighted aggregate of private U.S. real estate properties held by tax-exempt pension funds, reported with no mortgages.” Development properties are not included in the data. However, the index is “broken down into sub-indexes of apartment, hotel, industrial, office and retail properties."

Black does note the limitations of the NPI, including: (a) quarterly, and not weekly, updating; (b) primarily using appraised, and not merely sale or market, prices; and (c) the exclusion of data on smaller or more local commercial properties that might not be considered investment-grade. Nonetheless, he argues that the reliable and long-term collection of this data does make up for some of the concerns. The prior research based on the NPI, indicated that while real estate didn’t outperform stocks and bonds over a 23-year period, when adjusted for risk, “real estate outperforms both stocks and bonds.” More importantly, the results indicated that real estate served as a partial inflation hedge.

In the paper, Black makes the needed distinction between publicly-traded REITs and private real estate investment. He notes that publicly-traded REITs generally perform differently than private real estate investment, and that previous studies suggest publicly-traded REITs are more volatile and more closely resemble the movement of “the S&P 500 than will private real estate investments.  Simply, private real estate has better covariance with the stock market, helping to smooth the volatility of a mixed asset portfolio better than publicly-traded REITs.” But, he also writes that “the returns for publicly-traded REITs have a lower risk for the reward than the stock market as a whole,” especially when compared to the S&P 500 and treasury bonds. Despite the acknowledged diversification benefits, research indicates real estate remains underrepresented in mixed asset portfolios, says Black.

The paper draws on the standing research in the field to address the needed balance of publicly-traded versus private real estate in a mixed asset portfolio. He writes, “Until recently, the research focused on the ability to improve a mixed-asset portfolio’s efficiency by adding either publicly-traded or private real estate, but not both.” However, the expected return and the amount of risk desired should determine the balance of private vs. publicly-traded REITs in one’s portfolio. Black concludes that the previous data indicates that the “conservative investor benefits from adding both types of real estate to his portfolio, but is better off with a higher proportion of direct real estate. An investor who is willing to take on more risk also benefits from having both types of real estate in the portfolio, but benefits from a higher proportion of publicly-traded REITs.”

Black does state that “private real estate has a stabilizing effect on a portfolio of stocks because it does not fluctuate with the stock market as much as publicly-traded REITs.” Of course, publicly-traded REITs create higher returns for the investor, but they are also a bit riskier and more volatile than direct real estate investment. The paper adds, “Publicly-traded REITs are beneficial to the investor in the upper part of the efficient frontier (higher risk, higher return portfolios) and such portfolios are better off with publicly-traded REITs than without them.”

Interestingly, equity REITs provided portfolio benefits, while mortgage REITs, which invest in mortgages and mortgage-backed securities, offered no such benefits. Culling together data from a variety of industry sources and standing research, Black notes that real estate investment, balanced between private and publicly-traded real estate, should represent approximately 20 percent of a portfolio also consisting of stocks and bonds.