Real estate can offer many benefits to investors concerned about the effect of inflation on their portfolio. First, real estate tends to rise along with prices in the overall economy and can thus provide an effective hedge against inflation. Second, real estate also has had very low return correlations with more traditional assets, including equities and bonds, which can improve portfolio diversification. Finally, real estate has historically provided steady and growing current income, providing a return cushion against a downturn in prices.
Investors can tap into the benefits of real estate investing through PIMCO’s RealEstateRealReturn strategy. PIMCO’s approach offers exposure to the performance of equity Real Estate Investment Trusts (REITs), which buy, operate and sell residential and commercial real estate.
The Benefits of Real Estate Exposure
Real estate has historically provided an effective hedge against inflation because, as inflation rises, the value of real estate usually increases. REITs, in particular, have shown a close link to inflation because they often invest in commercial properties that generate income through rents, which rise with inflation over time. As the chart below illustrates, the price performance of REITs has outpaced the rate of inflation, represented by the Consumer Price Index (CPI), over the past 24 years.
Sources: National Association of Real Estate Investment Trusts (NAREIT), PIMCO
Real estate has also demonstrated very low return correlations—which measure how closely movements in different types of securities are related—with more traditional asset classes. The low correlations stem largely from the fact that rising inflation tends to result in higher interest rates, which are not generally favorable for stocks because higher rates increase the cost of capital for companies. In fact, the correlation between total returns on REITs and equities has declined over time, as shown in the table below. Inflation and higher interest rates also tend to erode the value of fixed-income returns. Because real estate is not highly correlated with equities and bonds, it can help boost returns in an inflationary environment by diversifying the portfolio and lowering the volatility of returns.
Monthly Correlation of REIT Total Returns and Other Types of Investments
Source: REITs – NAREIT Equity Index
* Russell 2000 Index data since 12/31/78
Finally, real estate can provide investors with income and the potential for growth in income. The chart below shows that REITs have produced income every year for more than 20 years—typically a healthy inflow of between 5% and 10%. During the period from 1981 through 2005, annual income has averaged 8.29%. This consistent income can help boost overall portfolio returns, especially when the performance of more traditional asset classes disappoints.
Source: National Association of Real Estate Investment Trusts (NAREIT)
PIMCO’s Approach to Real Estate Investing
PIMCO’s RealEstateRealReturn approach provides exposure to real estate by investing in REIT total return swap agreements. REITs often invest in commercial properties, such as apartments and offices, and the portfolio can therefore gain from increases in rents as well as property values, thus earning potentially greater returns in an inflationary environment.
PIMCO uses portfolio assets as collateral for the REIT total return swap agreements and typically invests these assets in inflation-linked fixed income securities, such as Treasury Inflation Protection Securities (TIPS). We aim to earn a higher return on these assets than the financing rate embedded in the swap agreements, thus enhancing the total return potential of the overall portfolio. In addition, the inflation-linked bonds can offer returns measured in real, rather than nominal, terms. Thus, the RealEstateRealReturn strategy offers a “double real”TM return investment, and seeks to provide real returns in the form of gains from the REIT exposure and consistent real return income from the inflation-indexed securities.
This approach capitalizes on two of PIMCO’s core strengths: efficient management of derivatives positions and effective management of fixed-income securities. As one of the largest participants in the fixed income market, PIMCO has developed the resources, analytics and substantial experience to effectively manage positions in real return securities. PIMCO was an early leader in recognizing the value of inflation-indexed securities, and remains among the largest participants in the TIPS market.
Conclusion
Recognized as an effective hedge against inflation, real estate investments can also offer low correlations with more traditional assets and therefore help diversify a portfolio. Real estate, especially in the form of Real Estate Investment Trusts (REITs), has historically offered consistent income, which can help boost overall portfolio returns. PIMCO’s RealEstateRealReturn can offer the benefits of real estate by investing in total return swap agreements on REITs, using portfolio assets as collateral. These portfolio assets are typically invested in inflation-indexed bonds with the aim of earning a higher return than the financing rate embedded in the swap agreements. RealEstateRealReturn thus provides a “double real”TM return investment, with potential real returns from the REIT index exposure and consistent real return income from the inflation-linked securities.