1 Investment Perspectives May 2012 Direct real estate: Institutional grade investing for individuals portfolios Direct investment in commercial real estate has been an important strategic allocation for endowments, foundations and pension funds for decades: they seek its potential for high income, stable total returns, and added diversification to investment portfolios in volatile markets. While direct real estate would be especially appealing to retirement savers and retirees -- for these reasons, plus real estate s protection against inflation -- the opportunity for private investment in institutional grade commercial real estate has not typically been available to individuals. In the past few years, however, an innovation in real estate finance has made direct property investment an option for individuals, as a component in target date funds, variable annuities and other asset allocation platforms. The case for direct commercial real estate investments is well established, and innovative real estate solutions are starting to gain traction. As fund managers and plan sponsors with custom fund programs continue to update their strategies for greater diversification and the risks of inflation, it s likely that individuals portfolios will see an increasing allocation to private direct real estate. The advantage of real estate investing The typical individual trying to build capital in a central portfolio, to fund retirement or children s education, has been at an investment disadvantage for many years. The biggest holding in the conventional portfolio is publicly traded equities, but since the end of the tech bubble, highly volatile equity markets have allowed an average annual return of just a few percentage points for a traditional stock-bond portfolio. Over this same period, the portfolios of institutional investors -- pension funds, endowments and foundations -- have fared much better. This stems from the institutional investor having the ability to invest in a wider range of asset classes, most notably alternatives such as hedge funds, private equity, and direct real estate. This is turn, has led to greater portfolio diversification and a more stable return stream than a traditional stock-bond mix. (Compared to the typical defined contribution plan account, pension portfolios have enjoyed greater returns of about 1.4 percentage points over the five years ended March 2011, including the extreme markets of 2008 and 2009.) Callan Target Date Fund Survey: The Evolving Target Date Fund. Callan Associates, June 2011 RREEF Real Estate
2 For many institutions that invest in real estate as part of their overall portfolio, the largest allocation within alternative assets is to direct investment in commercial real estate, typically targeted at approximately 10 percent 2 of the total portfolio. The biggest holdings are in core properties -- well situated and fully leased -- in the office, retail, apartment and industrial sectors. Core real estate pays a steady income stream, similar to that of bonds: commercial tenants are obligated by contract to pay rents monthly, and the typical long term of leases provides a stable and visible source of cash flow. Using the NCREIF Fund Index - Open End Diversified Core Equity as a proxy, between 1991 and 2010, the annual income yield on direct real estate investment averaged 7.5 percent. 3 Direct real estate also offers capital gain potential through price appreciation of properties. Accordingly, during typical market environments, direct real estate has tended to earn a return that is higher than bonds, but below that of stocks, and with much lower volatility. However, it should be noted that, unlike a bond, with direct real estate there is no obligation for the repayment of an investor s principal. Between 1990 and 2010, real estate outperformed equities over 50 percent of the time Exhibit 1 below details the annual returns of US equities, bonds and direct real estate from 1990 through 2010: in many years, real estate s performance indeed was between the other two. 4 But during those 21 years direct real estate outperformed equities 11 times. Moreover, in the five instances that equities were down, real estate earned a positive return four times, and from 1990 through 2010, the correlation Exhibit 1: Annual returns of US equities, bonds and direct real estate, S&P 500 Barclays US Aggregate Bond NFI-ODCE IREI-Kingsley Plan Sponsor Survey, Institutional Real Estate, Inc. (IREI) and Kingsley Associates, Data Source: National Council of Real Estate Investment Fiduciaries (NCREIF) return database. Data sources: US equities: S&P 500; bonds: Barclays US Aggregate Bond Index; direct real estate: National Council of Real Estate Fiduciaries Open-end Diversified Core Index (NFI-ODCE). Please refer to Important Index Definitions found at the end of this presentation. INVESTMENT PERSPECTIVES May
3 between the returns of the S&P 500 and commercial real estate was just Direct real estate is therefore a potent diversifying asset when added to a traditional portfolio of stocks and bonds. Unfortunately, individuals typically have not been able to participate in direct commercial real estate. Investment is conducted through private funds and partnerships limited to institutions and high net worth clients, calling for substantial long-term capital commitments. As a result, direct real estate investments lack the liquidity, as well as daily net asset valuation, that defined contribution, IRA and variable account structures require for daily purchases and redemptions. 5 Real estate has been available to individuals, however, through publicly traded real estate investment trusts (REITs). Earnings of public REITs are produced by the same sources as those of direct real estate -- rents and gains on properties. In contrast to direct core real estate, however, REITs tend to incorporate higher amounts of leverage, and as a result, have higher and more volatile historical returns. Shares of publicly traded REITs trade on stock exchanges, so they provide daily liquidity, and can invest in a range of domestic and international property types. The returns of public REITs are correlated to the overall stock market more so than the commercial real estate cycle, and therefore are generally more volatile than direct real estate. By themselves, therefore, REITs don t provide the same diversifying influence. New flexibility for direct real estate Recent innovations in real estate finance provide the benefits of return and diversification by giving individuals access to direct commercial real estate through target date funds, target risk funds, variable annuities, and other asset allocation platforms. Forward-thinking real estate managers are navigating the obstacles of owning institutional real estate in an individual account by implementing investment strategies that combine public and private real estate. To optimize Why real estate is a true diversifier Investors large and small learned the same painful lesson during the 2008 crisis: simply selecting a large number of assets doesn t protect against falling markets when their results turn out to be highly correlated. What matters instead is adding investments that can be counted on to react differently to economic shocks. Because commercial real estate follows its own unique cycles of investment and leasing, it can add potent diversification to a traditional portfolio of stocks and bonds. From 1990 to 2010, the correlation between the S&P 500 and commercial real estate, as represented by the NFI-ODCE index, was just (See Important Index Definitions provided at the end of the presentation). One reason for the different pattern of returns is the long investment cycle of real estate. For the average manufacturing company, investment and product decisions typically play out in just a few years, while a commercial property takes several years simply to plan and construct, and then has to earn its returns over decades through long-term lease contracts averaging five years or more. 6 Real estate s long cycle also provides protection from the risks of inflation. An office property can be viewed as a bond, and the stream of rental income as the interest payments; over time, rents will increase per lease contracts to offset inflation. Further, many commercial leases provide that tenants pay for operating costs, insulating building owners from rising prices. Last, property prices also increase with inflation over the long run, adding a gain component to total return. Unlike a bond investment, however, there is no obligation for the repayment of an investor s principal. 7 expected returns, managers are allocating portions of their investments to private real estate, through established institutional funds that own diversified portfolios of core properties, and the balance in shares of publicly traded REITs. The REIT allocation provides enhanced liquidity to the portfolio to accommodate daily purchases and redemptions, without adding material volatility. Research Certain individuals within a specific earnings bracket or minimum net worth can also access non-traded REITs -- public REITs which invest in a portfolio of direct real estate and register with the SEC, but are not traded on an exchange. However, the majority of these products requires a seven to ten year lockup of capital, are not valued daily, and come with hefty upfront fee loads. Commercial property has long-term lease contracts averaging 5 years or more, with the exception of rental housing which typically has a lease term of one year or less, and hotels which have daily contracts. Investing in real estate may not be suitable for all investors. INVESTMENT PERSPECTIVES May
4 by NAREIT shows that a portfolio comprised of both direct and public real estate securities provides superior absolute and risk adjusted returns (as measured by the Sharpe ratio) than direct real estate alone 8. Moreover, because the returns of public and private real estate are not highly correlated, combining them not only adds the higher returns of REITs, but diversifies the portfolio s economic drivers as well. Exhibit 2 compares the returns and correlation statistics of direct real estate, REITs, a NAREIT blend and US equities over the past 10 and 20 years. Another obstacle of owning institutional real estate in an individual account has been valuation. Historically, properties in direct portfolios have been infrequently appraised, and while this convention is acceptable to long-term institutional owners, it doesn t meet the needs of savers in retirement plans for daily valuation. The investment strategies that combine public and private real estate include independent valuation services that are able to strike a daily net asset value on the portfolio. Through daily liquidity and valuation, individual investors gain access to an asset class that historically has been dominated by the institutional marketplace. Investment strategies that combine public and private real estate have been introduced by some of the largest and best-known real estate management firms. So far, however, these strategies by retirement plan sponsors and managers of asset allocation funds has been limited: by the end of 2010, for example, only 3 percent of target date funds had made an allocation to direct real estate. Adoption is likely to increase as more sponsors learn about the intrinsic value of direct real estate, and the benefits a combined strategy offers. Although the implementation of such investment strategies that combine public and private real estate are just a few years old, the investment thesis of direct real estate is a classic, and has been a large portion of many institutional portfolios for years. The approach offers high current income, low expected volatility, and high expected riskadjusted returns, and brings to the portfolios of individual investors the diversification of direct investing in high quality commercial real estate. Exhibit 2: Returns of direct real estate, REITs a NAREIT blend and US equities 10, (10 yrs) Direct real estate REITs NAREIT Blend US equities (NFI-ODCE) (NAREIT) (Direct real estate/reits) (S&P 500) Annualized return 5.2% 10.8% 7.9% 1.4% Standard deviation 8.8% 25.9% 11.9% 18.7% Correlation versus S&P (20 yrs) Annualized return 6.1% 12.2% 8.7% 9.1% Standard deviation 6.8% 20.8% 9.1% 16.4% Correlation versus S&P Optimizing Risk and Return in Pension Fund Real Estate: REITs, Private Equity Real Estate and the Blended Portfolio Advantage. National Association of Real Estate Investment Trusts, Callan Target Date Fund Survey: The Evolving Target Date Fund. Callan Associates, June Direct real estate values consistently lag public real estate values by from 12 to 18 months. At the end of 2010, for example, direct real estate was beginning a valuation upswing following historic lows caused by the global financial crisis. Data sources: Direct real estate: NFI-ODCE index; REITs: FTSE NAREIT US All Equity REIT Index; US equities: S&P 500; NAREIT blend: Please refer to Other Important Definitions found at the end of the presentation for details on the creation of model portfolios. INVESTMENT PERSPECTIVES May
5 Six myths of real estate investing Because investment in direct real estate has been largely limited to within the institutional community, it s not well understood by other investors. Here we dispel a few common misconceptions: Public REITs are the same as private real estate: While both markets invest in similar underlying assets, the motivations of the managements of these two groups are very different. The resulting investments differ as well, with public REITs sharing characteristics with other public equities, and private core real estate sharing more attributes with fixed income investments. Lacks transparency: Not long ago, commercial real estate could be criticized for its opacity -- in part to be expected from a business that is dominated in the US by privately-owned companies and private investment funds. Today, however, there are many research services that chronicle large property transactions and study rental and vacancy rates, as well as return indexes that look at the industry from many angles. Moreover, in 2005, NCREIF started to report performance on investible indexes of partnerships dating back to 1978, showing actual returns to investors in operating funds. Market timing: Another misapprehension posits that most of the return from commercial real estate takes the form of property appreciation, suggesting that successful investment is driven primarily by the timing of purchases and sales, and therefore constrained by the property cycle. Not so: the income return of the NFI-OCDE index amounted to an annual average of 7.5 percent from 1991 to During the same period the income return of the Barclays Capital US Aggregate Bond index was 6.4 percent. Mortgages: Commercial real estate investing can at times be viewed as speculative investing with a high degree of leverage. Speculative deals do occur, but for direct core properties, borrowing tends to be modest, at 30 to 40 percent of property value. This level of borrowing is not burdensome for well-situated core properties, with high occupancy rates and top-credit tenants, providing the property with a steady stream of income. Not accessible by 40 Act funds: While it s true that private, direct commercial real estate cannot be held in mutual funds, advances in daily valuations of core commercial real estate allow mutual funds to own private REITs and limited partnerships holding commercial property. Illiquidity: It s true that core properties don t change hands all that often, and that investors in a direct real estate partnership have limited access to their capital. However, core properties generate an attractive income stream, and the combination of direct investment with publicly traded REIT shares provides investors with full day-to-day liquidity. RREEF Real Estate is the real estate investment business of Deutsche Asset Management. During the past 40 years, RREEF Real Estate has built a leading real estate investing business, with nearly 600 professionals located in 22 cities around the world and $57.4 billion in assets under management as of December 31, RREEF Real Estate employs a disciplined investment approach and offers a diverse range of strategies and solutions across the risk/return and geographic spectrums, including core and value-added real estate, real estate and infrastructure securities, real estate debt and opportunistic real estate. RREEF Real Estate aims to deliver superior long-term risk adjusted returns, preservation of capital and diversification to its investors, which include governments, corporations, insurance companies, endowments, and retirement plans worldwide. To learn more about RREEF Real Estate, go to Contact information Scott Brooks, CFA Head of Retail and Defined Contribution INVESTMENT PERSPECTIVES May
6 Important Index definitions NFI-ODCE The NCREIF Fund Index - Open End Diversified Core Equity (NFI-ODCE Index) is an index of investment returns reporting on both a historical and current basis the results of 30 open-end commingled funds pursuing a core investment strategy, including 18 current active funds, some of which have performance histories dating back to the 1970s. The NFI-ODCE Index is capitalization-weighted and is reported gross of fees. Measurement is time-weighted. Funds in the NFI-ODCE Index are limited to 40% leverage (defined as the ratio of total debt, grossed-up for ownership share of off-balance sheet debt, to the fund s total assets, also which are grossed-up for such off-balance sheet debt). NFI-ODCE returns do not reflect reinvestment of dividends. FTSE NAREIT Equity REIT Index The FTSE NAREIT Equity REITs Index measures the performance of all publicly traded equity real estate investment trusts traded on U.S. exchanges. The FSTE NAREIT Equity REIT Index is a subset of the FTSE NAREIT All REITs index. The FTSE NAREIT Equity Index is a free float, market capitalization-weighted real estate index designed to track the performance of US REITs, and does not include mortgage or hybrid REITs. To eligible for inclusion a REIT must have a market cap of at least $100 million at the date of the annual review and meet a minimum liquidity screen as well. The FSTE NAREIT Equity REIT Index is unleveraged, though the underlying stocks have leverage, and is calculated assuming dividend reinvestment. S&P 500 The S&P 500 has been widely regarded as the best single gauge of the large cap U.S. equities market since the index was first published in The index has over US$ 4.83 trillion benchmarked, with index assets comprising approximately US$ 1.1 trillion of this total. The index includes 500 leading companies in leading industries of the U.S. economy, capturing 75% coverage of U.S. equities. Barclays US Aggregate Bond Index The Barclays US Aggregate Bond Index is a broad-based benchmark that measures the investment grade, US dollar-denominated, fixed-rate taxable bond market, including Treasuries, governmentrelated and corporate securities, MBS (agency fixed-rate and hybrid ARM pass-throughs), ABS, and CMBS. The US Aggregate rolls up into other Barclays Capital flagship indices such as the multi-currency Global Aggregate Index and the U.S. Universal Index, which includes high yield and emerging markets debt. The US Aggregate Index was created in 1986, with index history backfilled to January 1, Other important definitions NAREIT Blend The NAREIT blend scenario was created by taking the quarterly total returns from FTSE NAREIT US All Equity Index and the NCREIF Open End Diversified Core Equity Index which include both income and appreciation (gross or net, as noted) and applying the allocation target to such quarterly returns. The standard deviation of the combined quarterly return for such allocation targets was calculated over the identified periods in order to calculate volatility, as of December 31, 2010 where noted. Hypothetical performance results have many inherent limitations, some of which are described below. No representation is being made that any account will or is likely to achieve profits or losses similar to those shown. In fact, there are frequently sharp differences between hypothetical performance results and the actual results subsequently achieved by any particular trading program. One of the limitations of hypothetical performance results is that they are generally prepared with the benefit of hindsight. In addition, hypothetical trading does not involve financial risk, and no hypothetical trading record can completely account for the impact of financial risk in actual trading, for example, the ability to withstand losses or adhere to a particular trading program in spite of trading losses are material pints which can also adversely affect actual trading results. There are numerous other factors related to the markets in general or to the implementation of any specific trading program which cannot be fully accounted for in the preparation of hypothetical performance results and all of which can adversely affect actual trading results. Important disclosures All rights reserved. RREEF Real Estate, part of RREEF Alternatives, the alternative investments business of Deutsche Asset Management, the asset management division of Deutsche Bank AG offers a range of real estate investment strategies, including: core and value-added and opportunistic real estate, real estate debt, and real estate and infrastructure securities. In the United States RREEF Real Estate relates to the asset management activities of RREEF America L.L.C., and Deutsche Investment Management Americas Inc.; in Germany: RREEF Investment GmbH, RREEF Management GmbH and RREEF Spezial Invest GmbH; in Australia: Deutsche Asset Management (Australia) Limited (ABN ) an Australian financial services license holder; in Japan: Deutsche Securities Inc. (For DSI, financial advisory (not investment advisory) and distribution services only); in Hong Kong: Deutsche Bank Aktiengesellschaft, Hong Kong Branch (for RREEF Real Estate s direct real estate business), and Deutsche Asset Management (Hong Kong) Limited (for RREEF Real Estate s real estate securities business); in Singapore: Deutsche Asset Management (Asia) Limited (Company Reg. No N); in the United Kingdom: Deutsche Alternative Asset Management (UK) Limited, Deutsche Alternative Asset Management (Global) Limited and Deutsche Asset Management (UK) Limited; in Italy: RREEF Fondimmobiliari SGR S.p.A.; and in Denmark, Finland, Norway and Sweden: Deutsche Alternative Asset Management (UK) Limited and Deutsche Alternative Asset Management (Global) Limited; in addition to other regional entities in the Deutsche Bank Group. An investment in real estate involves a high degree of risk, including possible loss of principal amount invested, and is suitable only for sophisticated investors who can bear such losses. The value of shares/ units and their derived income may fall or rise. Any forecasts provided herein are based upon RREEF Real Estate s opinion of the market at this date and are subject to change dependent on the market. Past performance or any prediction, projection or forecast on the economy or markets is not indicative of future performance. This material was prepared without regard to the specific objectives, financial situation or needs of any particular person who may receive it. It is intended for informational purposes only. It does not constitute investment advice, a recommendation, an offer, solicitation, the basis for any contract to purchase or sell any security or other instrument, or for Deutsche Bank AG or its affiliates to enter into or arrange any type of transaction as a consequence of any information contained herein. Neither Deutsche Bank AG nor any of its affiliates gives any warranty as to the accuracy, reliability or completeness of information which is contained in this document. Except insofar as liability under any statute cannot be excluded, no member of the Deutsche Bank Group, the Issuer or any officer, employee or associate of them accepts any liability (whether arising in contract, in tort or negligence or otherwise) for any error or omission in this document or for any resulting loss or damage whether direct, indirect, consequential or otherwise suffered by the recipient of this document or any other person. Certain RREEF Real Estate investment strategies may not be available in every region or country for legal or other reasons, and information about these strategies is not directed to those investors residing or located in any such region or country. For Investors in the United Kingdom Issued in the United Kingdom by Deutsche Alternative Asset Management (UK) Limited, Deutsche Alternative Asset Management (Global) Limited, and Deutsche Asset Management (UK) Limited of One Appold Street, London, EC2A 2UU. Authorised and regulated by the Financial Services Authority. This document is a non-retail communication within the meaning of the FSA s Rules and is directed only at persons satisfying the FSA s client categorisation criteria for an eligible counterparty or a professional client. This document is not intended for and should not be relied upon by a retail client.
7 When making an investment decision, potential investors should rely solely on the final documentation relating to the investment or service and not the information contained herein. The investments or services mentioned herein may not be appropriate for all investors and before entering into any transaction you should take steps to ensure that you fully understand the transaction and have made an independent assessment of the appropriateness of the transaction in the light of your own objectives and circumstances, including the possible risks and benefits of entering into such transaction. You should also consider seeking advice from your own advisers in making this assessment. If you decide to enter into a transaction with us you do so in reliance on your own judgment. For Investors in Australia In Australia, Issued by Deutsche Asset Management (Australia) Limited (ABN ), holder of an Australian Financial Services License.This information is only available to persons who are professional, sophisticated, or wholesale investors under the Corporations Act. An investment with Deutsche Asset Management is not a deposit with or any other type of liability of Deutsche Bank AG ARBN , Deutsche Asset Management (Australia) Limited or any other member of the Deutsche Bank AG Group. The capital value of and performance of an investment with Deutsche Asset Management is not guaranteed by Deutsche Bank AG, Deutsche Asset Management (Australia) Limited or any other member of the Deutsche Bank Group. Deutsche Asset Management (Australia) Limited is not an Authorised Deposit taking institution under the Banking Act 1959 nor regulated by the Australian Prudential Authority. Investments are subject to investment risk, including possible delays in repayment and loss of income and principal invested. For Investors in Hong Kong Interests in the funds may not be offered or sold in Hong Kong or other jurisdictions, by means of an advertisement, invitation or any other document, other than to Professional Investors or in circumstances that do not constitute an offering to the public. This document is therefore for the use of Professional Investors only and as such, is not approved under the Securities and Futures Ordinance (SFO) or the Companies Ordinance and shall not be distributed to non-professional Investors in Hong Kong or to anyone in any other jurisdiction in which such distribution is not authorised. For the purposes of this statement, a Professional investor is defined under the SFO. I