CalPERS Real Estate Portfolio

Wall Street Journal articles yesterday and today (subscription required) talk about how CalPERS has been counseled by its consultants to restructure its real estate portfolio.  In summary, the real estate portfolio is being transitioned from a return enhancement vehicle to a risk reduction vehicle. The new strategic focus comes with new implementation scheme.  Among the recommendations is a recommendation to eliminate the use of publicly traded REITs from the real estate portfolio.  Publicly traded REITs will continue to allowable in the traditional equities portion of the portfolio.  A memo and PowerPoint presentation from Pension Consulting Alliance are available on the CalPERS website.

I bring this up to discuss some misconceptions about real estate risk and returns which are poorly addressed in the CalPERS reports.  Real estate is a portfolio diversifier in that its return streams are affected by economic risk factors differently than other asset classes.  That is, real estate has a relatively low correlation with stocks, bonds, and cash.

This is not to say that real estate is less risky or that it is less volatile than publicly traded securities.  Illiquidity and valuation mechanism combine to create that illusion.  As one erstwhile boss was fond of saying, "If people knew how the value of their houses fluctuated on a daily basis, no one would ever own their own home."  Likewise, the appraisal and desktop valuation methodology used in establishing quarterly values for institutional real estate holdings relies heavily on historical transactions and thus tend to lag market conditions. The consultant acknowledges this risk by assigning a 14% standard deviation expectation in line with what one might expect from a publicly traded equities portfolio, to the real estate pool.

Contrary to what is intimated by a syndicator in a recent Registered Rep article, illiquidity is a benefit only in that it quiets a lot of the noise inherent in publicly traded securities.  Illiquidity is actually a risk factor which demands an incremental return expectation.

Meanwhile, NAREIT says that the CalPERS recommendation is "inappropriate and ill-advised.”  The claim is based on a study that indicates that adding publicly traded REITs to a non-traded real estate portfolio would reduce the overall volatility.  As a matter of fact, this is the principle on which the recommendation is based.  The reduced volatility comes from combining two asset classes that have return streams that are affected differently by economic risk factors.  In the CalPERS portfolio, real estate is being utilized as a diversifier to its traditional liquid equities portfolio.  Publicly traded REITs are included in the liquid equities portion of the portfolio.


In summary, real estate is a diversifier because its returns stream behaves differently under various economic conditions than stocks, bonds, or cash.  Illiquidity is not a diversifier nor is it a benefit.  Illiquidity is a risk factor.  Providing liquidity to a real estate holding transforms its return streams sufficiently that a liquid real estate vehicle (REIT) becomes a diversifier for non-liquid real estate holdings.

Special thanks to the Rational Realist