Sunday, May 8, 2016

Why Historical Beta Does Not Always Work For Real Estate

Real estate investment is typically viewed as an essential part of any balanced portfolio. Its immutable characteristics, such as its relatively long pricing cycles and its above average returns, cause real estate to be seen as a stable asset. On the other hand, due to its sensitivity to interest rates, its lack of liquidity at the property level and its longer periods appreciation, exposure to the real estate can also serve as an inflationary hedge. Although real estate exposure may be purchased for any number of reasons, the risk profile of real estate assets is of interest to most, if not all, real estate investors.

The ways in which the risk profile of real estate has been expressed vary from the informal to the highly computational. On the most informal end of the spectrum, owner-operators of property frequently concern themselves with the tax consequences and appreciation of the property, content to face changes in the market or externalities, as they come. On the opposite end of the spectrum are portfolio managers and fixed-income investors, who seek quantifiable means to express the volatility of real estate securities. One such attempt at quantifying the volatility of real estate and its related securities is through the use of real estate's historical beta.

Historical beta is an often quoted summary of the historical performance of an asset that takes into consideration the asset's correlation to the systemic risk inherent in the market, known as systemic volatility. Essentially, historical beta is used to express the historical return of an asset class from a point in history, typically the end of the Great Depression, until today. As with most derived metrics, the reliability of a calculated historical beta, as measured by the correlation of the inputs used, is driven by the accuracy of data used to derive it.

Historical beta is used as an input in the Capital Asset Pricing Model (CAPM), which is used to explain the relationship between risk and the expected return of the price of equities. As an input in the CAPM, beta is a convenient proxy for market risk. As such, it is tempting to attempt to apply the concept of historical beta beyond the world of equities to other assets. For real estate assets, however, this is done will varying results.

In order explain the limitations of beta in terms of real estate assets, one must first recognize that the myriad of ways that exposure to the real estate market can be gained and the idiosyncrasies of each type of exposure. The most frequently employed methods of gaining real estate exposure are owning a portfolio of cash flowing properties, purchasing equity in a Real Estate Investment Trust (REIT), purchasing mortgage-backed securities (MBS), and purchasing debt in government-sponsored entities, like Fannie Mae, Freddie Mac and Ginnie Mae. Aside from direct property ownership, the most popular methods of gaining real estate exposure comes from the purchase of either real estate securities, either debt or equity.

Since historical beta was designed for equities, it can be applied to the purchase of REIT equity, with little consequence. In fact, most REIT’s have listed historical betas that are regularly employed as part of their valuation. Since an equity is the purchase of interest in a real estate company, such securities are segregated from the direct performance of properties. Instead, REITs give access to the performance of a company that is involved in the practice of lending or property ownership. As such, REIT investments also offer exposure to management decisions of the REIT. As equities, these investments are quasi-perpetual and do not have a term. Moreover, since REITs are formed under federal law, their structure provides a certain level of protection from the risks that arise from the local real estate market exposure, such as local taxation and blue sky laws. Accordingly, REIT equities share many characteristics of other publicly traded equities and thus can have a representative beta that accurately reflect their sensitivity to systemic risk.

Unlike REIT equities, however, mortgage-backed bonds and whole loan portfolios are debt instruments with a definite term.  Also unlike equities, the performance and pricing of MBS and whole loan assets are tied to both short term and long term interest rates. Since MBS assets are bonds, like all other bonds, they have an inverse relationship to interest rates. Moreover, both mortgages and MBS also experience prepayments when short term interest rates are low. A broad historical beta glosses over these inherent characteristics of mortgages and their related securities. Although a modified betas reflecting mortgage performance in different interest rate situations could mitigate this issue, these figures cannot be meaningfully combined into one figure.

Another aspect of real estate debt exposure that historical beta fails to accurately reflect is the local nature of the asset class. Mortgages and even MBS, particularly CMBS, which can be tied to the performance of a few large properties, can be subject to the conditions of the local real estate market. Although the secondary market attempts to mitigate local risk exposure through location diversity in the underlying pool of assets, taking on more real estate risk exposure also means added exposure to the factors that influence all real estate performance, such as interest rates, material costs and  housing policy, to name a few.  Mitigation of exposure to local real estate market risk can also be achieved by very specific hedging strategies that take local performance into account, however the securities necessary to accomplish this typing of hedging have become more and more rare as derivative and synthetic markets move toward standardization and create additional risk from the exposure to the hedge. Regardless of which strategy is employed--hedging or location diversity, the relationship of increased correlation through employment of either method is not meaningfully expressed through a historical beta.

At the property level, local market effects render historical beta almost meaningless. Property value is largely driven by local real estate market factors, the very same factors that are abstracted away by the global nature of beta. Stated another way, the systemic volatility of all real estate assets over the past 100 years has little real effect on the price of an individual property in today's market. The explanation for this assertion is fairly intuitive, in that in most instances, purchasers of property are not choosing between property and all other asset classes available, but are instead choosing among the various properties that are available in the real estate market. Depending on the sales price and status of the property, the property search may be local, regional, national or international. No matter how broad the search, however, the present local market factors surrounding each property affect its pricing in a way that cannot be abstracted away, as is the purpose of historical beta.

Although it is used as measure of market risk for a certain asset classes, historical beta, a figure designed to measure equities, which are identical in nature across companies and systemically behave in predictable ways, is not equipped to measure the historical return and risk premium of real estate, an asset class that thrives on it granularity, locality and time of purchase. Many of the real estate securities are issued as debt and more accurately measured by debt measurements such as duration. There are also property-level metrics that more accurately reflect performance and values such as cap rate and internal rate of return. Beware, therefore, of those who quote the historical returns of real estate. More than likely, the numbers given are not as meaningful as they seem.