Public and private real estate investments have experienced similar returns in falling and low-rate environments over the past 40 years. Should we expect them to perform similarly going forward, particularly in a rising-rate regime?
Should we expect a reversal of real estate performance in a period of rising rates?
For investors holding commercial real estate over the past 40 years, the experience has been fruitful. Returns for the asset class, irrespective of product structure, have averaged 9% to 11% annualized. Public and private real estate investments have delivered similar overall returns during this period, albeit with very different levels of volatility (private real estate has been 50% less volatile).1,2
This has been driven, in part, by the relationship between real estate returns and interest rates. On the surface, we see a four-decade-long alignment: As interest rates have moved lower (the graph shown here is inverted), real estate returns have climbed higher.
While the picture below certainly looks rosy, a more discerning eye may see that the lines only go in one direction—up. If the relationship is indeed strong between the two, should we not then expect a reversal of real estate performance in a period of rising rates?
We believe not—and we want to arm you with the data and insight as to why. We pose this as a series of four questions.
QUESTION I: To what extent are interest rates and real estate returns related?
First, let’s examine the relationship between the rates and returns in more detail and see if we can explain the historical return of real estate using only U.S. Treasuries.
Over the past 40 years, public real estate, as measured by the FTSE Nareit All REITs Index, delivered an annualized return of 10%. A portfolio of U.S. Treasury bills and 30-year U.S. Treasury bonds delivered a nearly identical cumulative return and closely tracked the path of returns along the way.
This is an important observation because it implies that real estate returns are intricately intertwined with rates, and are being generated more from rates falling over time than from the value of the real estate itself appreciating. If this is true on the upside, will the reverse also be true as rates structurally rise?
Over the past 175 years, the U.S. economy has experienced seven rate cycles, with the average lasting 25 years and delivering a 13% change in rates (adjusted for inflation). If real estate values move in tandem with interest rates, and if the coming rate cycle indeed delivers a change of similar magnitude, this could be concerning.
What we need is a way to disaggregate the sources of return of real estate: How much is coming from the effect of falling rates, and how much is coming from fundamental appreciation in value of the underlying properties? Well, let’s have a look…
FTSE Nareit All REITs Index vs Levered Long Bond
QUESTION II: What if we just look at the equity portion of real estate as a proxy for returns coming from fundamental appreciation?
Re-running the analysis in Question I using other real estate indices incrementally isolates the pieces.
The FTSE Nareit All Equity REITs Index excludes debt and mortgage REITs, isolating the equity component. Unfortunately, returns here track even more closely (see below).
But our work is not done. Perhaps it is not the type of real estate but instead the structure. This takes into account how the real estate is priced, the “market” in which it is traded, the investor types who use it, and the extent and type of embedded leverage.
So far, we’ve only looked at public (securitized) real estate, packaged to trade daily. Given this link to public markets, might there be an embedded link to rates that would not otherwise appear in private, institutional real estate? Let’s take a look…
FTSE Nareit All Equity REITs Index vs Levered Long Bond
QUESTION III: What if we look at private real estate instead of public?
Here we use the NCREIF NFI-ODCE Index to represent private real estate, as it comprises exclusively institutional, private, open-end funds with no more than 35% leverage.*
Private, nonsecuritized real estate appears to march to the beat of its own drum, or at least relative to a portfolio of levered U.S. Treasury bonds. Nevertheless, it still appears at least somewhat aligned with declining rates.
The findings here suggest that there is indeed something about private real estate that is different. Yet our core question remains: If real estate pricing (and related return) is essentially the present value of a relatively constant stream of future rents, can it generate returns in a multidecade-long episodic era defined by ever-rising discount rates?
One way to explore this issue is to examine how real estate performed when interest rates rose most rapidly.
NFI-ODCE Gross of Fees Total Return Index vs Levered Long Bond
QUESTION IV: Were there significant differences in performance between public and private real estate when rates rose most rapidly?
The table below compares the returns of public and private real estate over the entire ~40-year period—during which rates, on the whole, were rising—versus the returns during the 25% of months when interest rates rose most rapidly.5
Moving from all public real estate to equity-only public real estate changes the performance during rising rate periods from slightly negative (-2%) to slightly positive (+2%).
More significantly, moving from public real estate to private appears to have hedged the portfolio against rising interest rates, showing a return of 11%—higher than that achieved over the entire period.
Public and private real estate return comparison during rising rate periods
| Entire period | 25% of months when rates rose most rapidly | |
|---|---|---|
| Public real estate (all) | 10% | -2% |
| Public real estate (equity only) | 11% | 2% |
| Private real estate | 9% | 11% |
BONUS QUESTION: So what does this all mean?
First, there are some market environments for which there is no precedent. This may be one of them. While we’ve been through periods of structurally rising rates before, the investment options for real estate have never been so broad. The combination of the two means we need to re-examine relationships we may have taken for granted in the past.
Second, it is crucial to understand the nuances of how differences in both the type and structure of the investment may ultimately impact performance. If the analysis shows us nothing else, it is that the process of securitizing and publicly trading real estate embeds a link to market rates.
Most institutional investors include an allocation to real estate as a potentially less risky return generator—a diversifier to equity for access to global growth opportunity.6 In hindsight, the choice of structure didn’t matter given the steady returns of both asset classes against the backdrop of 40 years of declining rates. Going forward, we believe a better appreciation for the differences between private and public real estate returns will be key to constructing resilient portfolios for the ever-higher rate environment ahead.
