For Institutional, Professional, Qualified and/or Wholesale Investor Use Only in Permitted Jurisdictions as defined by local laws and regulations. Principal Real Estate Antifragility of Real Estate Investments & Black Swans Guy Tcheau, Managing Director, Investment Strategy Principal Real Estate Investors Real Estate is widely recognized as a defensive asset class; however, it has Click on download for another little-known attribute called antifragility which is of key significance in the full paper. light of Black Swan1 events such as COVID-19. Antifragile2 investments are those whose performance improves in relation to the size of the shocks. Antifragility of Real Estate was posited by Guy Tcheau, Managing Director at Principal Real Estate Investors and Professor Norman Miller, Chair of Real Estate Finance, Burnham-Moore Center for Real Estate, University of San Diego School of Business in a paper titled Antifragility of Real Estate in a World of Fat-Tailed Risk3. Black Swans Antifragility The term, Black Swans, emanates from the published There are essentially four outcomes5 as shown in exhibit 1. work of Nassim Taleb on the subject of mathematical Robust outcomes are where outlier events have low finance, uncertainty and randomness. Traditional financial probability and have small consequence, either positive or models assume exogenous shocks are outlier events with negative. Investment performances are fairly predictable low probability of occurrence. However, Black Swans are since outcomes are not materially impacted by shocks. by definition ‘unknowable’ in likelihood. Our observations There are two types of fragile outcomes: symmetric and of systemic shocks suggest that the probability of their asymmetric, which are both descriptors of downside occurrences is generally underestimated. After all, the scenarios. Both give rise to significant negative impacts last Black Swan, the Global Financial Crisis, took place since the tails are fat. Asymmetric tails to the left means only twelve years ago. Furthermore, such shocks are also that the investment is more fragile to negative outcomes ‘unknowable’ in impact, a priori. Taleb contends that it is than to positive upsides. Antifragile6 investments, on the more important to construct portfolios that incorporate other hand, are asymmetric to the right. Here the fat tail to ‘antifragility’ rather than seeking to model ‘unknown the upside means outliers tend to be positive with large unknowns’4. positive payoffs. In short, robust investments are agnostic to volatility whereas fragility implies investments tend to go badly with volatility. However, antifragile investments benefit from dislocations. 1 The Black Swan: Second Edition: The Impact of the Highly Improbable: With a new section: "On Robustness and Fragility" (Incerto) Paperback – May 11, 2010, Nassim Nicholas Taleb 2 Antifragile: Things That Gain from Disorder (Incerto) Paperback – January 28, 2014, Nassim Nicholas Taleb 3 Antifragility of Real Estate Investments in a World of Fat-Tailed Risk. By Guy Tcheau, Managing Director, Principal Real Estate Investors and Norman Miller, PhD | Ernest Hahn Chair and Professor of Real Estate Finance, Burnham-Moore Center for real Estate, University of San Diego School of Business. (Disclaimer: All errors are ours. The views expressed herein are solely those of the authors and do not necessarily represent the views of Principal Real Estate Investors or the University of San Diego School of Business or the Burnham-Moores Center for Real Estate.) 4 The Importance of Taleb’s System: From the Fourth Quadrant to the Skin in the Game. Branko Milanovic - 29 January 2018. Global Policy Journal, Durham University 5 Gold Republic, This Is What I Learned from Nassim Taleb. April 25, 2018 Olav Dirkmaat. (Olav Dirkmaat, Professor in Economics, Business School of Universidad Francisco Marroquín) 6 Farnam Street, Nassim Taleb: A Definition of Antifragile and its Implications (2014) 1 For Institutional, Professional, Qualified and/or Wholesale Investor Use Only in Permitted Jurisdictions as defined by local laws and regulations. Exhibit 1: Possible outcomes Probability density Probability density Probability density Probability density Robust Symmetric Fragility Robust Symmetric Fragility Probability density Outcomes Probability density Outcomes Probability density Outcomes Probability density Outcomes Antifragile Assymetric Fragility Antifragile Assymetric Fragility Outcomes Outcomes Outcomes Outcomes Investment convexity Antifragile investments are investments that benefit from Exhibit 2: Investment convexity volatility. Mathematically this is referred to as investment Price/performance convexity. Convexity under Taleb’s model is different from convexity that is used for bond investments. For bonds, convexity measures the change in the price of the bond in relation to changes in the level of interest rates. Increasing As the diagram illustrates, the higher the volatility in the profits events under Taleb’s model the greater the payoff with convexity.7 Conversely, greater volatility results in greater losses for concavity. Increasing losses Shocks/volatility 7 Edge.org. Understanding is a Poor Substitute for Convexity (Antifragility), Nassim Nicholas Taleb. 12 December 2012 2 For Institutional, Professional, Qualified and/or Wholesale Investor Use Only in Permitted Jurisdictions as defined by local laws and regulations. Mediocristan vs extremistan Taleb explains that there are two environments that describe the real world, ‘mediocristan’ and ‘extremistan’.8 Mediocristan is when outcomes are fairly predictable and stable and where no single outlier outcome significantly impacts the aggregate total. Gaussian or normalized probability distributions are a good fit for mediocristan. The normalized distribution clusters outcomes symmetrically around the mean where the probability of an outcome being two standard deviations away from the mean is under 5% and three standard deviations (3-sigma events) have a probability of occurrence of just 0.3%. In other words, there exists a mild randomness which is reasonably easy to parametrize and model. Black Swans, however, do not conveniently fit Gaussian thin-tailed distributions9. Here, one outlier observation can materially distort the aggregate. Randomness is not mild but severe. Rather than a normalized bell-shaped probability distribution we have instead a fat-tailed curve. Outcome distributions are skewed or have high kurtosis10. This is called ‘extremistan’. As Taleb explains, portfolio construction based on mean variance modeling, become fraught with risks due to assumption that our environments are Gaussian or mediocristan when they are really extremistan. With the benefit of hindsight, financial market participants adjust quantitative models to account for the latest systemic shock followed up by stress tests to derive comfort that portfolios will be immunized from repeat debacles. However, the problem with ‘unknown unknowns’ is that it falls outside the bounds of robust statistics and quantitative models, prima facie. Since modeling Black Swans necessarily require fat-tailed assumptions of risk, which are difficult if not impossible to quantify, investment portfolio performance become susceptible i.e. fragile to shocks. The question then is whether there are investments that are antifragile which can be incorporated into multi-asset portfolios. Asymmetry of real estate - antifragility With public equities or corporate bonds for example, in Exhibit 3: Antifragility of real estate Black Swan events, the value of certain securities might Probability tend towards zero. The reason is that the underlying businesses can become unviable due to shocks. Take for example Lehman Brothers or Bear Stearns during the Global Financial Crisis. These firms were no longer able to remain operational. With COVID-19 it remains to be seen whether certain cruise ship operators will remain in business, for example. However, with real estate there is real tangible property that underpins the investment. Unlimited upside Real property has been a repository of value for many millennia. Real estate provides a non-trivial anchor to the downside which is largely overlooked in traditional financial models. Whereas the upside is technically Outcomes unlimited, the downside has a floor. This makes the return Tangible real estate provides anchor to the downside distribution asymmetric to the right. 8 Edge.org. The Fourth Quadrant: A Map of the Limits of Statistics by Nassim Nicholas Taleb, 14 August 2008. Introduction by: John Brockman 9 CBRE,Finiteness of Variance is Irrelevant in the Practice of Quantitative Finance Second version, June 2008 Nassim Nicholas Taleb 10 How Much Data Do You Need? A Pre-asymptotic Metric for Fat-tailedness, Nassim Nicholas Taleb Tandon School of Engineering, New York University November 2018 Forthcoming, International Journal of Forecasting 3 For Institutional, Professional, Qualified and/or Wholesale Investor Use Only in Permitted Jurisdictions as defined by local laws and regulations. The empirical data on real estate price changes in real terms over a very long time period of nearly 400 years (see the case study on housing prices in Netherlands in exhibit 4) supports asymmetry to the upside and finite downside. Despite major Black Swan events such as the Black Plague, Napoleonic Wars, both World Wars and the Great Depression, real estate showed resiliency to the downside (floors provided by tangible real property value) plus fat-tailed upside. Note