At Ares Wealth Management Solutions, we continue to receive inquiries from financial advisors regarding the forward prospects for private real estate given the recent decline in public real estate. We believe the most useful way to help advisors grapple with these questions is to point to historical data. Thankfully, we have data on both private and public real estate returns going back to March of 1978, and while no one can predict the markets, we believe the powerful benefits that private real estate can bring to a portfolio should persist through this cycle.
First, the basics—
Since 1978, public real estate has delivered approximately thirty percent higher annualized returns than private real estate. However, this can be largely attributed to the use of three times more leverage in public real estate than in private real estate, and as result, public real estate has experienced three times the volatility. Private real estate, by comparison, has provided much better risk-adjusted returns.1
| Public real estate | Private real estate | |
|---|---|---|
| Return | 11.5% | 8.8% |
| Volatility | 17.9% | 5.3% |
| Sharpe ratio | 0.53 | 1.30 |
| Correlation | 0.11 |
Correlation
The low correlation of private real estate to public real estate, we believe, is particularly notable.
Seeing the low 0.11 correlation figure, one of the natural questions that our financial advisor clients follow with is, “But is private real estate just public real estate on a lag?”
To investigate whether the 0.11 correlation with public real estate is just a trick of lagged time, we run the correlation of private and public real estate after applying varying lag lengths.
We find that the correlation ticks up mildly over time while remaining low. So, historically, any lagged effect of public real estate onto private real estate has been tempered.
| 40+ years of private real estate correlation to public real estate with a: | |
|---|---|
| 3-month lag | 0.23 |
| 6-month lag | 0.28 |
| 9-month lag | 0.28 |
| 12-month lag | 0.28 |
| 15-month lag | 0.19 |
Drawdowns
During historical periods of drawdowns in public real estate since 1978, investors in private real estate had a noticeably different experience:
Two-thirds of the time, private real estate had no drawdown at all when public real estate was in drawdown.
On the three occasions when private real estate did experience a drawdown, they came at a nine-to twelve-month lag on average.
Over the past 40-plus years, private real estate drawdowns were meaningfully shallower and shorter-lived than public real estate drawdowns.
Max drawdown
It turns out that private real estate has rarely followed public real estate into its frequent drawdowns—drawing down only three times since 1978 versus twenty-five times for public real estate over the same period. On those occasions when private real estate did draw down, it only moderately followed public real estate, and did so by a lag of nine months, on average.
In fact, there have only ever been two meaningful private real estate drawdowns of more than two percent: one during the early 1990s recession following the savings and loan crisis and the other during the global financial crisis of 2007–2009. These extreme real estate sell-offs were driven by over-building and over-leverage. These forces caused lending to dry up, at which point the private real estate market eventually capitulated, though less than the public real estate market did.
To obtain more specific conclusions about the maximum drawdowns in the real estate market, we investigated the seven largest public real estate drawdowns over the past four-and-a-half decades to determine how exactly, if at all, private real estate drawdowns were related.
| Public real estate | Private real estate | ||||||||
|---|---|---|---|---|---|---|---|---|---|
| Largest drawdown period | Length in qtrs | Max drawdown | Largest drawdown period | Length in qtrs | Max drawdown | Beginning drawdown lag (qtrs) | Max drawdown lag (qtrs) | Recovery lag (qtrs) | |
| 1. | 6/30/2007 - 6/30/2012 | 20 | -65.4% | 9/30/2008 - 9/30/2013 | 20 | -37.8% | 5 | 3 | 5 |
| 2. | 3/31/2022 - Ongoing | - | -27.9% | None so far | - | - | - | - | - |
| 3. | 3/31/2020 - 3/31/2021 | 4 | -23.4% | 6/30/2020 - 12/31/2020 | 2 | -1.6% | 1 | 1 | -1 |
| 4. | 3/31/1998 - 12/31/2001 | 15 | -21.5% | None | 0 | 0.0% | - | - | - |
| 5. | 12/31/1989 - 3/31/1991 | 5 | -20.5% | 12/31/1990 - 3/31/1996 | 21 | -13.3% | 4 | 11 | 3 |
| 6. | 9/30/1987 - 3/31/1989 | 6 | -12.7% | None | 0 | 0.0% | - | - | - |
| 7. | 9/30/1981 - 9/30/1982 | 4 | -10.7% | None | 0 | 0.0% | - | - | - |
| Average | 9 | -26.03% | - | 7.2 | -8.79% | 3.33 | 5 | 2.3 | |
Source: Bloomberg. All data from March 31, 1978, through September 30, 2022. Public real estate measured by the FTSE NAREIT All Equity real estate Index, which is a free-float adjusted, market capitalization-weighted index of publicly traded US real estate equity. Private real estate measured by the NFI-ODCE Value Weighted Index.
History suggests that most public real estate sell-offs have been driven by macroeconomic worries and investor sentiment rather than by real estate fundamentals. This is supported by the fact that public real estate net asset values (NAVs) have tended to hold steady (like private real estate NAVs), even while the equity trades off due to market moves.2
Conclusion
As it turns out, conflicting public and private real estate returns, as seen in the present environment, have always been the normal situation, and it is not a matter of one being “right” and the other “wrong.”
At Ares Wealth Management Solutions, we believe that both public and private real estate can play important, albeit very different, roles in individual investors’ portfolios, and that advisors should consider utilizing these tools to help achieve their clients’ overall financial objectives. That said, historical data indicates that these two investment asset classes should not be conflated, nor should public real estate be viewed as a leading indicator for private real estate.
We find that historically, only during the drawdowns of the Global Financial Crisis and the early 1990s real estate correction (resulting from recession and the Savings and Loan Crisis) did private real estate get deeply pulled into the malaise of public real estate. What each of those events had in common is that they followed a crisis in lending, leverage and over-building. We find none of these forces present in the current cycle.
In 2022, private real estate was not pulled into the drawdown experienced by public real estate, nor was it during the steep drawdown of COVID-19 or the long (four-year) public real estate drawdown of the early 2000s when the dot-com bubble burst.3
Thus, the question an investor should ask is this: Looking forward, do you believe that the world is about to head into one of those over-built and over-levered real estate sell-offs? At this time, we do not believe underweighting would be a prudent action. Because private real estate has historically delivered positive returns in nine of ten quarters, through many market cycles, we believe the investment thesis for a full, long-term (typically dollar-cost-averaged) allocation remains intact.3
