Homeownership and Commercial Real Estate

The differences between HOMEOWNERSHIPHAS increased over the past decade. Today nearly 69 per- homeownership and cent of U.S. households own homes, compared with 63 percent in 1996. Home commercial real estate equity is a substantial portion of the over- all wealth of most homeowner house- investment are significant. holds, and for many, their house is their single largest investment. Since most households already own a home, do they need to also invest in commercial real estate? Homeownership and commercial real estate have vastly different investment characteristics and fundamental attributes. Upturns and downturns in the residential home market are not necessarily harbin-

MANIDIPAKAPAS gers of similar movements in the commer- YOUGUOLIANG cial real estate market. Hence, owning a

6 0 ZELL/LURIEREALESTATECENTER home should not preclude investment in estate, let us consider some of the similari- commercial real estate. ties. Both represent substantial portions of Homeownership generally refers to the total investment universe: U.S. resi- owning real estate property (a single- dential homes are valued at $20 trillion, family home or a condominium unit) that and investable U.S. commercial real estate is used as a primary (or sometimes second- at $6 trillion. Homes and commercial real ary) residence. That is, it is first a con- estate are real assets and thus highly collat- sumption good and second, an investment eralizable. Both the home and commercial asset. Commercial real estate, on the other mortgage markets are large and well devel- hand, is purely an investment asset that is oped. Like other tangible investments, intended only to generate a return, in homeownership and commercial real terms of both regular cash flows and value estate can be effective hedges against infla- appreciation. Rental apartment buildings tion. Finally, residential real estate and pri- are regarded as commercial real estate, vately traded commercial real estate have since the owner is not a resident and is low return volatilities compared with stock renting out the units for rental cash flows and bond indexes. in the short term and for growth in value Table I shows the average annual over a longer time horizon. Generally return, standard deviation, and return per speaking, commercial real estate includes unit of risk for some major U.S. and inter- the following property types: office, retail, national benchmarks. The volatility of rental apartments, industrial, hotel, self- homeownership, measured by the stan- storage and senior housing. An individual dard deviation of the Freddie Mac home investor can potentially invest in commer- price index, is 3.3 percent; that of com- cial real estate via two ownership vehicles: mercial real estate, measured by the stan- indirect investment in properties via pub- dard deviation of the National Council of licly traded real estate investment trusts Real Estate Investment Fiduciaries’ (REITs), and direct investment through Property Index (NPI), is 6.4 percent. The property transactions, property funds, or NPI tracks the unleveraged performance private REITs. of U.S. commercial properties held by institutional investors and their advisers. This index, which started in 1978, has the REALASSETS shortest history and thus determines the comparison period of 1978 to 2006. Before we examine the disparities between Publicly traded real estate (proxied by homeownership and commercial real the NAREIT Equity REIT Index), large

REVIEW 6 1 capitalization stocks (measured by the risk-return tradeoffs ranging from low risk S&P 500), small capitalization stocks and single-digit returns to high risk and (measured by the Russell 2000), and inter- high returns nearing 20 percent. national stocks (measured by Morgan Homeownership is both a consump- Stanley’s Europe, Asia and Far East tion good and an investment asset. It serves [EAFE] Index) all have much higher the housing needs of the occupants but is volatilities than private commercial real also an investment asset, with the potential estate and privately owned homes. The for capital gains appreciation, the ability to NAREIT index, which is comprised of be leveraged, and tax benefits to the owner. publicly traded REITs, has a volatility sim- Homeownership is thus driven by both ilar to stocks. Bonds (proxied by the investor sentiment and household con- Lehman Brothers Aggregate Bond Index) sumption needs. In contrast, the only goal have a much lower volatility than stocks. of investing in commercial real estate is to Inflation and the price of gold are includ- generate returns and create value. ed as general economic indicators. As shown in Table I, home prices Despite some similarities, commercial appreciated about 6.0 percent per year real estate investment and homeownership since 1978. Assuming a conservative after- are better characterized by their differ- tax annual cost of carry of 2.5 percent for ences. Commercial real estate provides maintenance, utilities, property tax and high current yields to investors, while insurance, the investment return on home- homeownership has a substantial negative ownership is about 3.5 percent. If an carry due to taxes and maintenance. Thus, owner-occupied home were held solely for the total return of commercial real estate is investment purposes, it would demand a much higher than can be obtained from return similar to the NPI over the same owner-occupied housing over the longer period, as both are private real estate term. From a portfolio perspective, com- investments without any financial lever- mercial real estate and homeownership age. The average return of the NPI from have modest return correlations, the result 1978 to 2006 was 10.1 percent, as shown of different demand and supply forces. in Table I. The difference between the NPI While investing in commercial real estate return of 10.1 percent and 3.5 percent can is purely a financial exercise, buying a therefore be attributed to the imputed home is driven by both consumption and income return on homeownership, which investment considerations. In addition, consists of the consumption, socio- commercial real estate investment can be economic and psychological benefits engineered to provide a full spectrum of derived from occupying one’s own home.

6 2 ZELL/LURIEREALESTATECENTER Table I: Risk and return comparison, 1978-2006 Avg. Return Std. Deviation Return per (% p.a.) (% p.a.) unit of risk Real Estate Market Home Price Index 6.0 3.3 1.8 NCREIF Property Index 10.1 6.4 1.6 NAREIT Equity REIT Index 15.4 14.8 1.0 Stock and Bond Market Indexes S&P 500 13.2 15.3 0.9 Russell 2000 12.8 18.5 0.7 Lehman Bros. Aggregate Bond 8.6 7.5 1.1 Morgan Stanley EAFE Internat. 12.6 21.6 0.6 General Economic Indicators Inflation 4.1 3.0 Gold price 4.7 28.0

Sources: Ibbotson; NCREIF; NAREIT; FHLMC; FNMA; Moody’s Economy.com; Prudential Real Estate Investors. Note:The home price index is the Freddie Mac Conventional Mortgage Home Price Index. It is based on single-unit residential houses only and does not include condominiums.

Table II shows that the investment alternative to fixed income instruments for benefit derived from homeownership is some investors. Homeownership, however, only 35 percent of the total opportunity has an estimated negative carry of 2.5 per- return from investing in property; that is, cent of home price, prior to mortgage homeownership is one-third driven by interest payments. financial considerations and two-thirds Figure 1 shows the current yields on driven by consumption needs. Put differ- different types of real estate assets, and ently, homeownership is one-third an stock and bond benchmarks. The chart investment asset and two-thirds a consumption good, whereas commercial real Table II: Investment and consumption share of homeownership estate is 100 percent an investment asset. Appreciation return 6.0% Income return is an important attrib- Negative carry (2.5%) ute of any investment asset. For commer- Investment return 3.5% cial real estate, income return, or yield, is a Opportunity return 10.1% large part of total return. The stable, pre- Investment share 0.35 dictable income comes from contractual Consumption share 0.65 leases. This cash flow characteristic means Source: Prudential Real Estate Investors. Note: Appreciation return is based on the home price index; opportunity return that commercial real estate is an attractive is the total return from the NPI. Both are shown inTable I.

REVIEW 6 3 Figure 1:Yield comparison of investment indexes 10%

-2%

-4% 1986 1996 2006

S&P 500 US LT Govt. bond NPI NAREIT Homeownership

Sources: Ibbotson; Moody’s Economy.com; NAREIT; NCREIF shows that commercial real estate yields are current return from a home. Table III high on a relative basis. Except for the high- shows that the NPI has averaged a total interest-rate environment of the 1980s, pri- return of 12.7 percent in the past ten years vate real estate yields exceed long-term gov- compared with 7.7 percent for homeown- ernment bond yields. REIT yields also ership. REITs have had an even higher compare more or less favorably with bond return, averaging 14.5 percent over the and stock yields. Homeownership, howev- same time. REITs returned more than pri- er, contrasts sharply with all other asset vate real estate partly because REITs use classes, as it has a negative carry, or current debt, and the NPI measures property-level yield. Clearly, homeownership and com- return free of any leverage. Both the NPI mercial real estate are on opposite ends of and NAREIT indexes outperform home- the current yield spectrum. The difference ownership by a large margin, considering in the current yield of commercial real even longer periods of fifteen or twenty estate and homeownership, of course, years, or since 1978 (the start of the NPI). reflects the consumption value of owner- Figure 2 shows the rolling four-quarter occupied homes. total and appreciation returns for commer- Historically, commercial real estate has cial real estate and for the home price yielded a much higher total return than index. The NPI and home prices have homeownership, largely due to the lack of comparable average appreciation returns,

6 4 ZELL/LURIEREALESTATECENTER Table III:Total return comparisons NAREIT Equity NPI Homeownership 1996 35.3% 10.3% 3.3% 1997 20.3% 13.9% 4.9% 1998 -17.5% 16.2% 5.1% 1999 -4.6% 11.4% 5.4% 2000 26.4% 12.3% 7.6% 2001 13.9% 7.3% 7.5% 2002 3.8% 6.7% 7.2% 2003 37.1% 9.0% 8.0% 2004 31.6% 14.5% 12.0% 2005 12.2% 20.1% 13.2% 2006 35.1% 16.6% 6.3% 10-Year Avg. 14.5% 12.7% 7.7% 15-Year Avg. 15.4% 9.8% 6.1% 20-Year Avg. 13.1% 8.4% 5.7% 1978-2006 Avg. 15.3% 10.1% 6.0% Sources: Moody’s Economy.com; NCREIF; NAREIT; Prudential Real Estate Investors whereas the total return of commercial real correlation between the NPI and home- estate is much higher than homeowner- ownership is 0.38 based on total returns ship due to the positive cash flow compo- and 0.33 based on appreciation returns nent. Moreover, homeownership and alone—a modest correlation from a portfo- commercial real estate returns are not lio perspective. The correlation between strongly correlated. For example, commer- REITsand homeownership is even lower, at cial property returns peaked in 1984 and 0.10 calculated from total returns and 0.11 then drifted downward until 1992, but no from appreciation returns alone. In terms of corresponding pattern occurred in residen- portfolio diversification, the modest correla- tial homes. Another example is the strong tions suggest that homeownership and peak in commercial real estate return in commercial real estate investment are not 1998 without any corresponding return substitutes for each other and, in fact, can behavior in residential homes. be attractive complements. To quantify the relationship, we calcu- The dynamics of the three (NAREIT, late correlations between commercial real NPI and homeownership) are very differ- estate and the home price index from 1978 ent, resulting in a significant variation in to 1Q07 using quarterly data to see whether the amplitude of their cycles. both have a place in the same portfolio. The Homeowners do not have to sell, and the

REVIEW 6 5 value of their property is less important in DIFFERENTDRIVERS the short term. (If they must move, they can always rent if they do not like the sales The lack of strong correlation between price.) Investors view their investments less commercial real estate and homeowner- emotionally, have a shorter time horizon ship returns reflects their different funda- and are more apt to sell through different mental drivers. Today, some investors are cycles. Figure 2 illustrates this point. concerned with the weakening of the resi-

Figure 2: Lack of strong return correlation Rolling four-quarter total returns (%) 25%

20%

15%

10%

-5%

-10% Jun-80 Jun-82 Jun-84 Jun-86 Jun-88 Jun-90 Jun-92 Jun-94 Jun-96 Jun-98 Jun-00 Jun-02 Jun-04 Jun-06

NPI Homeownership

Rolling four-quarter appreciation returns (%) 20%

15%

10%

-5%

-10%

-15% Jun-80 Jun-82 Jun-84 Jun-86 Jun-88 Jun-90 Jun-92 Jun-94 Jun-96 Jun-98 Jun-00 Jun-02 Jun-04 Jun-06 NPI Homeownership Sources: NAREIT; NCREIF; Moody’s Economy.com; Ibbotson. Note: NPI appreciation returns are calculated as (change in market value + partial sales)/beginning market value.

6 6 ZELL/LURIEREALESTATECENTER dential real estate market and its implica- owner-occupied homes. Since office, retail tions for commercial real estate investing. and apartments are the largest sectors in The cooling of the residential market may the NPI, we focus on these sectors to high- not be a harbinger of a weakening com- light the demand and supply cycles of mercial real estate market, since the two commercial real estate and owner-occu- have different demand and supply cycles. pied housing. In fact, currently, commercial real estate is Figure 3 shows the annual growth rate experiencing favorable fundamentals such in the number of households owning as low construction, healthy demand, homes and demand for the three largest improving occupancy and rising rents. sectors of commercial real estate. It is obvi- Affordability, household formation, ous from the chart that growth in home- the shifting distribution of household age owner households is mostly unrelated to cohorts and general employment all drive demand growth for commercial space. demand for homeownership. But com- Financial and demographic factors play mercial real estate demand is strongly vital roles in homeownership demand. linked to business employment and con- Housing demand is mainly driven by sumer spending, among other things. The household formation and affordability, supply of commercial space has always which in turn is driven by the home-price been much more volatile than that of to household-income ratio and mortgage

Figure 3: Growth of homeowner households and demand for commercial real estate

-1%

-2%

-3% Mar-85 Mar-87 Mar-89 Mar-91 Mar-93 Mar-95 Mar-97 Mar-99 Mar-01 Mar-03 Mar-05 Mar-07 growth Apt. demand Office demand Retail demand Homewoner HH

Sources: Moody’s Economy.com; PPR; Prudential Real Estate Investors

REVIEW 6 7 rates. In the past decade, growing housing On the other hand, in the retail sector, affordability, bolstered by low mortgage which is the next largest property type in rates, led to an unprecedented boom in the NPI, space demand is driven by the home purchase and refinancing. consumer sector, which does not always In contrast, office employment growth mirror the corporate sector. Consumer is the main demand driver of office space. spending on retail items is influenced not Employment growth is, in turn, highly only by employment growth, but also by positively correlated with the business population growth, household earnings cycle. When the economy is expanding growth and the elasticity of consumption. and adding jobs, office demand typically Figures 3 and 5 show the close relationship rises. Figures 3 and 4 show that the pre- between net absorption of retail space and cipitous drop in net absorption of office growth in retail sales. space at the start of the millennium was Demand for rental apartments, howev- mainly a result of a downturn in office er, by its nature, is closely affected by the space demand caused by the weakening of single-family home sector but in a largely broad economic forces. As the economy negative way. Rental apartments compete recovered, office job growth resumed, directly with owner-occupied housing, as leading to office space demand growth. In shown in Figure 6 (versus Figure 3). general, the corporate sector of the econo- Demand for rental housing depends on my drives demand for office and industri- household formation, which depends on al properties. population growth and business cycles.

Figure 4: Employment is the main driver of office demand

-2%

-4% Mar-79 Mar-81 Mar-83 Mar-85 Mar-87 Mar-89 Mar-91 Mar-93 Mar-95 Mar-97 Mar-99 Mar-01 Mar-03 Mar-05 Mar-07 Annual Growth in Office Employment Homeowner Household Growth Sources: Moody’s Economy.com

6 8 ZELL/LURIEREALESTATECENTER Figure 5: Retail sales drive retail demand 14%

12%

10%

0% Mar-79 Mar-81 Mar-83 Mar-85 Mar-87 Mar-89 Mar-91 Mar-93 Mar-95 Mar-97 Mar-99 Mar-01 Mar-03 Mar-05 Mar-07 Annual Growth in Retail Sales Homeowner Household Growth Source: Moody’s Economy.com. Note:The annual growth rate was calculated using a three-month moving average to smooth seasonal fluctuations.

Figure 6: Renter household growth is the mirror image of homeowner household growth

-1%

-2%

-3% Mar-79 Mar-81 Mar-83 Mar-85 Mar-87 Mar-89 Mar-91 Mar-93 Mar-95 Mar-97 Mar-99 Mar-01 Mar-03 Mar-05 Mar-07

Source: Moody’s Economy.com

When the economy is strong, many young rise. Rental demand also depends on the people find jobs and leave home, which age distribution of households, as young results in more household formation. Also, people have a higher propensity to rent but in strong economies, immigration tends to are less likely to own. However, change in

REVIEW 6 9 Figure 7: Supply cycles, completions relative to stock 8%

0% Mar-85 Mar-87 Mar-89 Mar-91 Mar-93 Mar-95 Mar-97 Mar-99 Mar-01 Mar-03 Mar-05 Mar-07 Apartment Office Retail Single Family

Sources: PPR; Moody’s Economy.com homeownership has the strongest impact estate and residential homes are not on demand for rental housing, as each new aligned. As shown in Figure 7, the past five homeowner means one less renter. Thus, years have seen a boom in single-family demand for rental housing is mostly nega- home completions relative to stock, where- tively related to demand for homeowner- as offices and apartments have had serious ship. The negatively related demand driv- declines in completions relative to stock. ers for rental and ownership housing are While supply growth for retail space was not likely to lead to a strong positive return healthy over the past five years, no boom correlation between them. in retail construction occurred. The supply cycles of the homeownership market and commercial real estate have a marked dissimilarity. First, com- INVESTMENTSTRATEGIES mercial real estate supply cycles are far more volatile than single-family homes Commercial real estate investment portfo- (most owner-occupied homes in the lios use many investment strategies to tar- United States are single-family). Supply get risk-return trade-offs. For example, cycles in the commercial real estate arena most real estate investment managers offer are also much more pronounced. Second, funds with core, value-added and absolute the peaks and troughs of commercial real return strategies, with target returns rang-

7 0 ZELL/LURIEREALESTATECENTER Figure 8: Multiple investment strategies in commercial real estate

Opportunistic Absolute Return Private Equity

Value Added Value Added Return Public Securities Core Core Property

Structured Debt

Whole Mortgage

Risk Source: Prudential Real Estate Investors ing from 7 percent to 20 percent in today’s percent. Value-added investment may be in environment. Such value-enhancing and the form of financial engineering, such as market-timing strategies are not the real mezzanine debt, development forwards to goal of most homeowners. Some people capture the large value creation associated buy homes, renovate them and sell them with development and redevelopment, and for a profit in certain stages of the business substantial operational improvements from cycle, but that is not a strategy pursued by large increases in income due to improving most homeowners. occupancy and rising rents. Expected Figure 8 shows the full spectrum of returns for value-added investments range investment strategies in commercial real from 9 percent to 15 percent. Typical estate. In the debt area, investors may own absolute return strategies are private equity whole mortgages, different tranches of investing in emerging companies and commercial mortgage-backed securities opportunistic acquisition of highly dis- (CMBS) and collateralized debt obligations tressed assets with high leverage, with (CDO). A core strategy refers to investing expected returns of 15 percent or more. in stabilized, income-producing commer- Investing internationally is another cial properties with no or low financial way to increase risk-adjusted returns and leverage. In today’s environment, expected leads to far more diversification in a port- returns are in the range of 7 percent to 8 folio, exposing investors to growth and

REVIEW 7 1 cyclical opportunities that are not avail- cial real estate and homeownership, plus able in the home market. However, it car- their different attributes, suggests that they ries the additional risk of adverse curren- are not substitutes for each other and, in cy movements and complex regulatory fact, can be attractive complements in a and taxation issues. diversified portfolio. Such market timing and development or predevelopment strategies are not usually pursued with residential real estate. Regardless of market conditions, it is costly, in both monetary and non- monetary terms, to sell one’s house and move to an apartment temporarily to profit from price movements. Homeownership is thus somewhat restrictive as an investment asset.

CONCLUSION

Homeownership and commercial real estate have significant similarities. Both are tangible assets, are large parts of the investment universe and offer a hedge against inflation. However, in terms of current return, total return, demand drivers and supply cycles, they are different. Different fundamental drivers imply that upturns and downturns in the owner-occupied housing market and commercial real estate are not necessarily contemporaneous. Also, commercial real estate is a pure investment asset, whereas owner-occupied homes are both an investment asset and, far more important, a consumption good. The modest correlation between commer-

7 2 ZELL/LURIEREALESTATECENTER