Sovereign Wealth Funds & Real estate Investments

By: Omar Khattaly
Researcher & Consultant on MENA Political Economy and Sovereign Wealth Funds

March 2014

 Despite the focus on stocks and bonds, real estate is still a major part of the institutional investment portfolio. Investing in the real estate market is achieved by either direct (physical) and indirect (securitized). Direct real estate investment involves the acquisition and management of actual physical properties. Indirect investment involves buying shares of real estate investment companies such as REITs.

Direct real estate investment has a desirable risk and return, but is costly and can involve a lengthy and complex process.

Indirect REIT real estate investment can be broken into three subcategories: equity, mortgage and hybrid. (Francis and Ibbotson, 2001).

  • Equity REITs hold portfolios with more than 75% invested in equity positions in real estate, which they manage. Shareholders receive rental income and capital gains when properties sold.
  • Mortgage REITs hold portfolios with more than 75% invested in mortgages. They lend money to developers and collect on the loans. Investors receive interest income and capital appreciation on the loans.
  • Hybrid REITs combine equity REIT and mortgage REIT investment strategies.

Returns and revenue from direct investment and REITs are not interrelated. REIT returns closely related to equity markets than real estate markets.

The first decade of the new millennium has seen real estate make its way into various investment vehicles. Pension funds, investment managers, endowments, and sovereign wealth funds have all started looking into real estate as part of their new investment strategy. Why is real estate as a strong part of an investment portfolio? Hudson-Wilson, Fabozzi and Gordon (2003) have presented a case for the inclusion of real estate in a well-managed institutional investment portfolio. Below is their primary considerations and my comments:

  1. To reduce the overall risk of the portfolio by combing asset classes that respond differently to expected events. Most funds made up of a mix of stocks and bonds. Real estate can be is a great risk reducer to add to an investment portfolio. Real Estate is ideal for investors interested in capital preservation while making a good rate of return over a long or short period. Conversely, investments 100% allocated to inflation-indexed bonds would earn low return.

There have been many recent arguments and studies on whether real estate would be a better choice in a diversified fund than stocks. According to the S&P / Case-Shiller U.S Home Price index, real estate has appreciated 12.4% annually between 2001 and 2006, while stock prices gained only 4.3% a year as measured by the S&P 500. On another study, the results are quite different. A new study by Jack Clark Francis, a finance and economics professor at Baruch College in New York City and Roger G. Ibbotson, Yale, had quite different results. They compared the annual returns of real estate from 1978 to 2004 compared with those of 15 different paper investments, including stocks, bonds, commodities futures, mortgage securities and real estate investment trusts. The result is very impressive and different from the previous study. Housing delivered a solid annualized return of 8.6%, and Commercial property at 9.5%. The S & P delivered a high return of 13.4%.

In reviewing many of these studies, one fact seems to not be taken into account. Many of these studies seem to ignore the steady return real estate investments bring in on monthly and yearly basis from rental income. A typical commercial property may have its market value appreciate by 2-3% annually, which is close to the average inflation rate, and in many attractive markets a return of 8-11%, but an investor must take into account the yield these properties bring in the form of cash flow from monthly rental income and leases over long periods. Tax benefits, write offs, tax-free refinancing and depreciation are additional benefits that many of these studies do not seem to consider.

If stock value and its investment benefits are measured in the form of dividend payout and capital gains, then real estate as a form of investment should not be measured by its overall capital gains but rather on all the other benefits that come with it. It is my opinion that, when considering all benefits, real estate is a far superior investment with a much better rate of return on the risk.

How about REITs? A scientific real estate study by Georgiev concludes Real investment trusts were shown to be poor substitutes to direct investment in real estate. Their returns seem to incorporate a significant equity market component. REITs are not suitable diversifiers for stock and bond portfolios. The fund already has stocks and bonds as part of its allocation strategy; therefore, it would make no investment sense to add another form of securitized investment to the portfolio.

  1. To achieve an absolute return competitive with other asset classes. A second reason to include real estate in an investment portfolio is to bring high absolute or risk adjusted returns to the portfolio. Although the study seems to favor stocks and bonds with higher returns than real estate in absolute terms over the past 23 years from 2003, but in terms of total return per unit of risk, real estate outperforms both stocks and bonds and on risk adjusted basis. In my opinion for a government, owned SWF a moderate level of risk-adjusted return would be much favorable if we were to accept the finding that stocks and bonds bring in higher yields.
  2. to hedge against unexpected inflation. Can real estate as an asset class protect a fund from unexpected inflation? The answer is yes and no. I have looked very closely at this by examining a few papers on this issue, and the findings are quite interesting. Real estate is not homogenous; therefore, the inflation effect is different for different real estate sectors. For example, it is possible to have a negative effect on the apartment and hotel sector while having a positive effect on retail, office and industrial sectors. A strong effect on commodities can affect construction and real estate development. A rise in building material will affect the real estate development industry.

Does inflation affect real estate returns? The answer is yes. Inflation has an impact on NOI (Net operating Income) of offices, warehouses and apartment markets. As inflation goes up, expenses are effected; therefore, NOI will be affected and adjusted lower. In the retail sector, however inflation increases NOI as the percentage of rents increase annually to respond and protect against inflation. Most leases in the U.S market have clause to protect against inflation. In most cases, this increase far exceeds the rise in expenses, which in turn gives the final NOI figure a positive number.

  1. To constitute a part of a portfolio that is a reasonable reflection of the overall investment universe (an indexed or market-neutral portfolio). Real estate is a natural addition to any investment portfolio, and should be a part of any investment vehicle and strategy for reasons that have been justified and explained for the past 20 years in numerous research studies. Real estate is an excellent cash flow producer and risk reducer in a low-to moderate-risk portfolio.
  2. To deliver strong cash flows to the portfolio. If regular distributions of cash are not important, then real estate is a winner. In a comparison study of income return of stocks, bonds, and real estate for the period between 1987-2004Q4 (Hudson-Wilson, Fabozzi, and Gordon), real estate is a superior steady producer of income to stocks and bonds. Real estate’s ability to produce realized income versus unrealized capital appreciation makes it a preferred choice for institutional investors.

Recent years have seen a high flow of cash into the global real estate market, with many of the large institutional investors focusing on key markets in Western Europe and the U.S. This trend has affected commercial property prices positively and thus affected property yield negatively. This has made many investors consider venturing into new international markets in developing areas around such as Eastern Europe, the Middle East and Asia. These markets have higher risks and, resultantly, higher yields. In recent years, investors have had an increased level of risk appetite and thus have comfortably started looking at opportunities across the spectrum both in terms of location and in terms of sectors, mainly outside their geographic areas.

Besides the high flow of capital and its affect on the market, real estate markets are influenced by other economic fundamentals such as cycles. In research by Pyhrr, Roulac and Born (1999), they emphasize the importance of incorporating cycle forecasting into asset allocation models for real estate. The authors discuss two categories of cycles, macroeconomic and microeconomic:

  • Macroeconomic cycles occur at the regional, national and international level. These include the general business cycle, inflation and currency cycles, technological cycles and demographic and employment cycles.
  • Microeconomic cycles work on metropolitan, location and property levels. Urban and neighborhood cycles, physical life cycles, rent rate and occupancy cycles.
  • According to the authors, supply and demand can be either macro-or-micro depending on the focus.

Cycles can affect real estate return and, for a successful asset allocation, cycles should be researched and studied as part of a solid real estate investment strategy.

So, why real estate? The answer is simple: global commercial real estate volume in 2013 was $500 Billion dollars, with much of it coming from institutional investors such as SWFs.

Real estate global market analysis 2011 – 2021

Historically, real estate has always been on the top of the list for private and institutional investors. In this section of the paper I will look at the future of real estate investment in three of the globe’s major markets; North America (the U.S. and Canada), Europe, and Asia- pacific. I will present the future growth map from the eyes of some of the world’s well-known real estate market research.

According to a 2012 report by Prudential Real Estate, global universe of institutional-grade commercial real estate encompassed an estimate $26.6 trillion in US dollars in 2011. This report encompasses 55 countries with 4.9 billion people representing a combined GDP of $65 trillion. The report details its research findings as follow:

  • By region Europe (25 Countries) had the most real estate by volume with $9.4 trillion, followed by US/Canada at $7.5 trillion, Asia-Pacific at $7.2 trillion, Latin America at $1.8 trillion and the Gulf Cooperation Council or GCC at $677 billion.
  • Commercial real estate volume is concentrated in a small number of key countries. The US contains slightly more than one-quarter of all CRE (commercial real estate) globally (25.4%), followed by Japan (10%), China (7%), Germany (6.1%) and the United Kingdom (5.2%).
  • 8% of all commercial real estate by value is dominated by developed nations. Europe encompasses 30.4% of all CRE, followed by the US/Canada (28.4%) and Asia at (17%).
  • Growth in the next decade will be mainly in the developed areas of the world. By 2021, the report forecasts that developed countries will encompass 42.8% of the CRE market, up from 24.2% in 2011. The majority of this growth will mainly come from China and the US markets with a growth of over 51.5%.
  • Globally, real estate growth will show Europe’s CRE market to increase to $13.3 trillion in 2021, up 42% from 2011. With these figures, Europe will fall to second in size behind Asia-pacific.


In making investment decisions and setting strategy, it is important to understand which countries and regions classified as developed versus developing. According to the World Bank the US/Canada is developed, while all countries in Latin America and the GCC are developing. Developed Europe encompasses Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Netherlands, Norway, Portugal, Spain, Sweden, Switzerland and the UK, while the rest of Europe defined as developing. Developed Asia-Pacific encompasses Australia, Hong Kong, Japan, South Korea, New Zealand, Singapore and Taiwan, while the other Asia-Pacific nations are developing. As mentioned above, this classification is important when setting strategy.

Developed areas will have lower risks, easy access to markets, and better laws and regulations to enter the market. Developing markets have higher risks, including much more complicated regulations that are not typically investor friendly, but usually provide higher yields. Advance and detailed market data on developing markets are usually lacking and not credible.

The commercial real estate market of Developing Asia-Pacific projected to grow 17.1% annually to $12.8 trillion in 2021, up 384% from $2.6 trillion in 2011. This will increase its market share globally from 10% in 2011 to 26.3% in 2021.

Developed Asia-Pacific will grow 3.3% annually to $6.3 trillion in 2021, a 39% growth by 2021 from $4.5 trillion in 2011.

Developing Europe will more than double to $3.3 trillion in 2021 from $1.3 trillion in 2011. This is a 146% increase or 9.4% per year. Its market share will rise to 6.7% in 2021 from 5% in 2011.

Meanwhile, the CRE market of the Developed Europe will grow by 2.2% annually to $10.1 trillion in 2021, up 25% from $8.1 trillion in 2011. However, its market share will drop to 20.6% in 2021 from 30.4% in 2011.

Institutional grade commercial real estate defined as shopping malls and office building. The US contains the largest amount of institutional-grade commercial real estate by value, some $6.8 trillion. Japan ranks second at $2.7 trillion, followed by China ($1.9 trillion), Germany ($1.6 trillion) and the UK ($1.4 trillion). At the small end of the scale is Bahrain, with a CRE market of $14 billion, followed by Bulgaria at $16 billion, Ecuador at $16 billion and Vietnam at $ 21 billion and Oman $28 billion. (Source IMF and Prudential Real Estate investors Research).

 Institutional grade real estate is concentrated in a small number of countries. The US is leading the list with 25.43% of the commercial real estate globally, Japan with 10.08%, China with 7.2%, Germany with 6.08%, and UK with 5.16%. Five countries on the top 10 are located in Europe. The top 10 encompasses a cumulative 71.1% of CRE globally. According to a study by Prudential Real Estate, more than 80% of commercial real estate is contained in 15 countries.

The above distribution of CRE is set to change over the next 10 years or so. The Asia-Pacific region will lead the list, as economic growth in that region will be much faster than the US and Europe and by 2021 it will have the largest share of CRE.

Future growth

According to the Prudential Real Estate investors report, the Asia-Pacific region projected to contain $19.1 trillion of CRE by 2021, a 166% increase from 2011. This growth will come from an expected economic growth of over 10% in the region, which in turn will translate into a growth in wealth and a need for institutional types of CRE such as large shopping malls and office buildings. With these numbers, the Asia-Pacific region will encompass 39.2% of the world’s CRE by 2021.

The European region expected to grow to $13.3 trillion in 2021, an increase of 42% from 2011. Europe will have its shares of global CRE drop to 27.4% in 2021 from 35.4%.

The US/Canada market will increase to $11.5 trillion in 2021, an increase of 53% from 2011. This region will have its share of global CRE drop to 23.6% in 2021 from 28.4%. Latin America and the GCC regions will show minimal growth.

Growth in a country’s GDP will have a direct impact on the growth of its institutional real estate, where there will be a growing number of individuals who will be wealthy enough to use institutional-quality real estate. A closer look at the world’s top GDP producers will give us a strong indicator on where real estate growth will be in the next 15 years. Unemployment rate, debt cost, and the central bank’s ability to keep interest rates low are all factors that can affect the growth in CRE globally.

The US tops the world in total GDP, at $15 trillion, followed by China ($7 trillion), Germany ($3.6 trillion) and France ($2.8 trillion).

In conjunction with the pace of GDP growth, the institutional-grade commercial real estate market will grow at a much faster pace in developing nations. China tops the list with an annual growth rate of 18%, followed by India at 16.6%, Russia at 10.6%, Turkey at 9.2% and Brazil at 8.2%. Among developed nations, the US at 4.3%, and the UK at 3.6 %.( per schedule 8 above).

Chine and the U.S. will top the list of contributors to the growth of institutional-grade commercial real estate over the next decade.

China will lead the list of contributors to the CRE market and projected to grow by $7.9 trillion between 2011 and 2021, or 35.5% of total global growth. This will bring the total value of CRE for China up to $9.7 trillion in 2021. The reason for this is rapid economic growth and an increase in personal wealth.

The U.S projected to be in 2nd place with a growth of $3.5 trillion, or 16% of the global total. This will bring total CRE value in the U.S to $10.3 trillion, up 53%, from $6.7 trillion in 2011.

China and the U.S combined will produce more than half of global CRE growth in value by 2021.

The U.S is the only developed nation among the top five contributors to global growth of institutional-grade commercial real estate over the next decade. The top five are China, the U.S., India, Russia and Brazil. Over the next decade, global CRE will grow by $22.2 trillion with almost $14.8 trillion or 67% of this growth coming from the top five.

The US and China topped the growth list over the past decade (2001-2011) as well. The CRE market doubled over the last 10-year period, growing by $13.8 trillion to its present size of $26.6 trillion. The big contributors to the last decade’s growth were the U.S. with $2.1 trillion, and China $1.6 trillion which combined for 27.3% of the global growth in commercial real estate. The rest of the top 5 were Japan at $805 billion, Germany $767 billion, and Brazil at $749 billion for a combined total of $6.1 trillion, or 44% of total growth, compared to the 67% projected growth over the next 10 years.

I think the U.S. and china will continue to grow. Asia-pacific will see steady growth in volume and profits. Europe will continue to grow but not as much as other parts of the world such as Russia and Brazil. Cross border, investors will need to take into account a host of factors when making a decision where to move their money. As noted earlier, developed nations will have much safer investment environment, but with lower yields. Developing will provide higher profits but a great deal of risk.

Investors should decide whether their investment strategies are long term or short term and how big is their appetite for risk? SWFs are government owned and it can be assumed that their tolerance for risk is very low, making developed nations a more comfortable investment. Risk will be higher in some but not all developing nations.

Although a nation’s GDP growth is a good indicator of how well a particular CRE market will do, investors need to take into account other factors such as local demand, transparency, liquidity, governance, and most important political stability and institutional legal framework.