In a previous post, we saw that real estate is by market value the largest asset class in the world. According to most interpretations of the efficient market hypothesis, this fact suggests that real estate should be a part of most portfolios that adopt an indexing approach.

In this post, we’ll continue to look at some of the considerations that might go into determining how much and what kinds of real estate to include in a portfolio.

Real Estate Volatility

In most finance theory, risk is represented by the volatility of market price. With real estate, however, as we noted, it is difficult to observe price volatility directly because most real estate does not trade often.

The fact that real estate (and certain other asset classes, such as private equity) does not trade often can give rise to the mistaken impression that the investments are not volatile.

In other words, because there are not daily market prices which can be observed to calculate a volatility, the underlying risk is sometimes understated.

For example, TIAA unapologetically claims: “Private real estate volatility has been significantly lower than listed REITs and other stock categories, producing a record of higher risk-adjusted returns.[1]”

TIAA didn’t make this up. The idea has been around for a while. The following table, reproduced from this source[2] helps us avoid misunderstandings.

Two important factors jump out. They are leverage, and the method of establishing market value.

As should be obvious, the use of leverage increases the measured volatility.

Less obvious is the fact that values determined by appraisal are significantly less volatile than the values determined by observing market transactions.

Appraisal Value vs. Market Value

Which volatility is correct—the appraised volatility or the market volatility? The answer depends on what you care about.

The same phenomenon has been observed in the stock market. Robert Shiller won the Nobel Prize in economics, partly for demonstrating the same phenomenon. Finance theory states that the value of an asset today is the sum of the present values of the expected future cash flows.

That method—present value of the cashflows—is at the heart of most appraisals of income producing real estate.

Shiller used a similar method to estimate the historical “appraised” value of stocks. He found that the actual market prices of stocks moved significantly more than the appraised values based on cash flows.

So, which measurement of volatility is correct? Perhaps it depends on your point of view. However, market price is objective, and it is harder to delude yourself about market price than it is about appraised price. If you don’t like an appraised price, you can seek a different appraisal. But if you don’t like market price, that doesn’t change the market price.

Lease Duration and Cash Flow Volatility

However, if you own real estate for the cash flow, and the cash flows are relatively stable, you might not care as much about the volatility of the market price.

Most income producing real estate is leased out for periods of at least one year. The longer the duration of a lease, everything else equal, the less volatile the revenue cash flows are likely to be.

The expense cash flows for most types of real estate are likely to consist largely of interest and taxes. If the financing is fixed rate, these cash flows are likely to be highly predictable. The remaining expenses are likely spread across a variety of factors, and thus are likely to move, broadly, along with inflation.

Thus, the net free cash flows from real estate are, everything else equal, likely to be less volatile the longer the leases are.

Property Type	Average Lease Duration
Net-Leased Properties (NNN)	10–20 years (Corporate/retail: 15–20 years)
Retail	3–20 years (Anchor tenants: 10–20 years; Inline stores: 5–10 years; Strip centers: 3–5 years)
Healthcare	7–15 years (Surgical centers often exceed 10 years)
Office	5–10 years (Class A: 7–10 years)
Industrial/Logistics	5–10 years (Urban infill: 3–5 years)
Multifamily	12 months standard (6–24 months possible)
Self-Storage	Monthly (30-day termination standard)
Hospitality	Hotels—Room leases day-to-day

Cash Flow Volatility is Less than Price Volatility

We know from the example of bonds that even if cash flows are known with certainty, the market price can still fluctuate.

The same is true of real estate. Even when cash flows are highly predictable, there are other factors that influence the volatility of market price.

Interest rates are probably the major such factor. For example, this graph shows that REIT dividend yields tend to follow interest rates, but that in addition REIT dividend yields have spiked (i.e. prices have fallen sharply) in times of stress.

Source: https://www.mysanantonio.com/business/

As is visible in the graph, at times of financial stress, such as when the stock market is under selling pressure, it may well be the case that liquidity for real estate falls. A reduction in liquidity may be reflected in longer times to sell, wider spreads between bid and offer, or both.

In non-publicly traded real estate, it is hard to see this liquidity reduction in the data. But for actual sellers or would-be sellers, the reduction is nevertheless very real.

Lease Duration and Bond Duration

I deliberately used the term “duration” to describe the length of a real estate lease. The reason is that from a market value point of view, the length of a lease (assuming fixed or contractually fixed – e.g. it could include scheduled increases) can make the real estate quite similar to a bond.

This is probably most clearly illustrated using the case of triple net-leased properties (NNN properties). To a first approximation, when you own a property subject to a long term NNN lease, you own a bond issued by the lessor.

For example, the REIT with ticker NNN (the REIT is called “NNN Reit”), invests mainly in triple net leases. These leases are similar to bonds issued by the lessor.

NNN spreads the credit risk across a large number of borrowers, and because NNN owns a large number of leases with staggered terms, the overall duration of NNN’s lease portfolio is somewhere around half the duration of the original term of the leases. Though NNN doesn’t publish this exact statistic, it appears to be around five years.

The return to owning NNN will thus be mostly a function of the lease payments. The current yield on NNN is about 5.8%, higher than the yield on five-year investment grade bonds, and treasury notes, but significantly lower than the yield on five-year junk bonds.

But NNN is also more volatile than treasury notes. For example, over the past year, the volatility of NNN has averaged about 18% (annualized standard deviation) while UTEN, an EFT that tracks the ten-year note, has averaged about 11.5%.

Predictable Cash Flows and Interest Rate Risk

Because the cash flows from real estate are (relative to most other types of equity ownership) relatively predictable, real estate has certain bond-like characteristics.

The typically long-term stream of expected cash flows means that real estate has a long duration, as that term is used in bonds.

And experience shows (and most people know) that real estate market values are quite sensitive to changes in interest rates.

The volatility of cash flows produced by real estate will be mostly a function of changes in demand, and much more slowly a function of changes in the supply.

Supply, Demand, and Volatility

Because it takes a long time to build, the supply of various types of real estate changes slowly. In many jurisdictions in the US it can take years from the time a builder applies for permits to the time the project is completed. In Los Angeles, for example, it is estimated that it takes four years[3] from application to completed project for an apartment building

Other types of development can take even longer, partly because construction is more complex than with typical apartments.

Thus, at any given time, over a period of a few months to a few years, the supply of a particular type of real estate is, for practical purposes, fixed.

If the supply is fixed, then changes in demand will drive changes in price.

This can be illustrated by the type of supply and demand graph students learn in Economics 101.

Economists call this type of supply curve “inelastic,” meaning that supply is not responsive (in the short run) to changes in price.

Thus, when demand changes, the price movement can be dramatic. In the example graph, the two slanted lines represent different levels of demand. Because supply cannot adapt, price can move a lot when demand changes. That price change can be up or down.

When thinking about the volatility of real estate, even if such volatility cannot be directly observed in market prices (perhaps because the real estate is non-publicly traded), we can get a rough estimate by considering how rapidly demand can change.

Most real estate is leased. The longer the average lease, the more slowly demand changes.

Thus, the table we looked at previously, may provide a rough estimate of how quickly demand for various types of real estate is likely to change.

Property Type	Average Lease Duration
Net-Leased Properties (NNN)	10–20 years (Corporate/retail: 15–20 years)
Retail	3–20 years (Anchor tenants: 10–20 years; Inline stores: 5–10 years; Strip centers: 3–5 years)
Healthcare	7–15 years (Surgical centers often exceed 10 years)
Office	5–10 years (Class A: 7–10 years)
Industrial/Logistics	5–10 years (Urban infill: 3–5 years)
Multifamily	12 months standard (6–24 months possible)
Self-Storage	Monthly (30-day termination standard)
Hospitality	Hotels—Room leases day-to-day

Hotel REITs, for example, over the study period had the highest volatility of any of the six categories studied.[4] This finding is consistent with the idea that hotels typically “lease” their rooms by the day, meaning that changes in demand will show up in revenues immediately.

Next week, we’ll look more at real estate risk.

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[1] https://www.tiaa.org/public/pdf/p/private-real-estate-whitepaper.pdf

[2] https://caia.org/blog/2014/11/18/is-private-real-estate-actually-less-volatile-than-public-real-estate

[3] Tackling the Housing Crisis, UCLA study by Stuart Gabriel and Edward Kung, 2023.

[4] https://www.sciencedirect.com/science/article/abs/pii/S0278431901000263