The performance of each real estate quadrant is produced by a mix of equity-like and debt-like behaviors. Consider the classic case of a private real estate equity asset leased to a credit tenant with a very long-term, triple-net lease. The payments on that lease are analogous to the fixed payments usually associated with a bond, not with equity. The value of this lease to the investor fluctuates with the same factors that influence the value of a bond or a mortgage, such as interest rate movements, inflation, and the credit of the tenant. An opposing case is presented by an equity position in an empty, speculative, multitenant property. The value of that building is a function of the market forces of supply and demand for space, at that particular time and through time. As the building is more fully leased, it changes from a "pure" equity to a debt-equity hybrid, and perhaps—if it were to become fully leased to long-term tenants—becomes very debtlike. In related fashion, as the net lease on the building in the first example ages, the residual value of the property at lease-end becomes increasingly important, and finally the dominant, component of the building's value. Equity forces, such as space market conditions, urban economic health, tenant demand, interest rates, and the unique nature of the property, such as its location, history, visibility, and neighbors, increase their influence on the asset's value (see Booth, Cashdan, and Graff, 1989). So the "pure" equity play can become more fixed income-like and the "pure" debt play will ultimately become a pure equity play There is a continuum of debt-equity behaviors in each asset and through the life cycle of each asset. This is a unique and important characteristic of equity real estate. This characteristic means that before one says they are invested in real estate, they need to be articulate about exactly where on the debt-equity spectrum their position lies. Later in the chapter we will see why this matters to the performance of a portfolio.

Even at the depths of the market in the late 1980s and early 1990s, real estate values were not, and were not even close to, zero. Values for office buildings in Texas may well have fallen by half. In Denver, brand new buildings were not leased at all and stood vacant for years waiting out the cycle. There was no income whatsoever accruing to the bankers who held the debt and were left holding the asset following foreclosure. However, the market cycle ultimately reverses itself (in most but not all cases) and the fact that there was, in the case of Denver, a building standing in a reasonable location, in the midst of an economy that had regained some vitality instantly accorded value to that asset. The reason is that the replacement cost of that new, vacant building is a very large number calculated in terms of both hard and soft construction costs, land value, and time to occupancy. So replacement cost, especially in times of construction cost inflation, preserves the value of many a building even through the toughest of market cycles. This rule does not hold in all cases—for example, a building in an old steel mill town when the steel mill has closed, a hotel in a resort area that has been abandoned by the guests for more easily accessed locations, or an apartment complex in a dying economy driven by a single employer that has lost the global competition for market share—all of these assets will lose value and may never regain what was lost. But, interestingly, these are the exceptions, not the rules. Think of major cities (which is where most of the real estate value is located) like Los Angeles, New York, and Miami. These cities' fortunes certainly ebb and flow, but they never go down and stay down. In almost any market condition, there is a rental rate that will clear the market and render buildings in these markets worth something to someone.

Compare those examples to the example of stock equity in the sectors of technology through the early 2000s and perhaps of biotechnology going forward. These investment options are only as strong as either their people or their ideas. There are large numbers of companies formerly based in Silicon Valley that do not exist at all today. However, the real estate in Silicon Valley had and kept at least minimal value all through the cycle and in fact is now gaining rapidly in value as a new tech cycle is upon us. The cash flow may well falter, a building may suffer from insufficient capital investment to maintain functionality, or a building may even become functionally obsolete, but still between the land and the physical structure, there is virtually always value to be reclaimed.

The Publicly Traded Real Estate Equity Market

The publicly traded real estate equity market is among the better defined of the four quadrants and encompasses around $300 billion of capitalized value, traded in deep public equity markets such as the New York Stock Exchange and the American Stock Exchange, and in global stock exchanges in Hong Kong, Australia, Tokyo, London, and Paris.

Most public real estate companies in the United States and in many other countries are structured as real estate investment trusts (REITs) or as real estate operating companies (REOCs). The REOC is a normally structured corporate entity that simply specializes in buying and operating real estate assets. The REOC is not entitled to the federally tax-exempt status of the REIT, but nor is it subject to the rules on distributions and asset sales to which REITs are held. A REIT, interestingly, and despite its name, is not even a trust. Rather, it is a tax election. Essentially, a REIT acts as a perpetual ownership vehicle of one or more buildings. In exchange for the exemption from all federal taxation at the REIT level (holders of REIT shares must pay federal taxes on dividends, just as do holders of non-REIT securities, and at the same rate), REITs are required to pay out at least 90% of all accrual-based accounting earnings (Block, 2002). Some REITs pay out more than required in order to defend their dividend levels and yields. In the past, there were considerable restrictions on a REIT's ability to sell buildings, but these rules have been relaxed, and REITs are allowed to run their portfolios without undue concern for impairing their tax-exempt status through sales activities.

REITs come in all property types and geographic locations with good coverage across the U.S. real estate investment universe. That being said, the distribution of the REIT universe across property types and locations differs somewhat from the distribution of the true real estate market universe. REITs have historically tended to own relatively more retail and apartment and relatively less office and industrial. The overweight in retail is caused by the fact that most mall operating companies are structured as REITs and many apartment companies of size are REITs as well. Thus, REITs as a group cannot be regarded as anything close to a replica or index of the overall real estate investable universe. REITs are what they are, allocated due to historical accident and not in accordance with any plan. In addition, since REITs only comprise less than 10% of the overall real estate investable universe, it would be an odd accident if at any time the REIT universe did perfectly replicate the larger real estate investment universe. So when investors take a position in a REIT index such as the Morgan Stanley RMS Index or the National Association of Real Estate Investment Trusts (NAREIT) Index, they should be clear that they have not acquired the larger real estate market. They have bought a smaller, idiosyncratic subselection of the larger market. Whether that "skewed" holding is a better or a worse portfolio of real estate exposures is an empirical question and the answer to the question can, and will, change through time.

REITs use moderate leverage at the entity level, introducing additional volatility to the cash flows (which are otherwise quite stable). Volatility is a consideration in REIT investing, although the level of leverage is generally very low as the analyst community has put consistent pressure on REIT managers to keep the leverage low. While leverage contributes to the creation of some minimal volatility in the cash flows, a more important source of volatility is introduced by the simple fact that REITs trade in the public equities markets along with all the other stocks. As a result, values may gyrate for reasons unrelated to cash flow changes. A small sector like the REIT sector, comprising around 3% of the overall capitalization of the U.S. stock equity market (measured against the Wilshire 5000), can be easily whipsawed by relatively large flows into and out of the real estate sector. Some of these flows are driven by investors' expectations for real estate, both positive and negative, but many of the flows are driven by investors' expectations for other sectors' relative performance, and the REITs get swept up in the rush.

Valuation in the public equity market is seemingly straightforward. The market tells you what the share price is. Now, of course, the market can be wrong, and as the real estate sector is pretty small, the market is frequently wrong, but there is opportunity in these misassesments. Investors think about whether a real estate security is over-or undervalued is by comparing the share price with the per-share net asset value (NAV). NAV, however, is a difficult number to determine, as it is simply the estimated or appraised value of each building in the portfolio, less debt. Appraised values are better indications of value today than they were in the past, but they are never absolute. This is discussed further below. Also, some believe that REITs should be credited with franchise or enterprise value, above and beyond the simple sum of the values of the buildings in the REIT portfolio. Franchise value is even more difficult to assess, but it is commonly assessed for "regular" companies trading in the same exchanges. Analysts try to determine NAVs and then offer their views on whether REITs are trading at, above, or below their NAVs. When the analysts believe the REITs are above NAV, the REITs claim that the analysts' estimates are incorrect, and when the analysts think REITs are trading below NAV, the REITs are content to remain silent.

Privately Traded Real Estate Equity

For purposes of this chapter, privately traded real estate equity includes only the traditional categories of office, retail (recall, however, that much of the retail market is held in the public market), apartment, and warehouse. Our best estimates ("best" does not imply "excellent") are that the unleveraged value of the private real estate equity quadrant is near to $1 trillion, comprising approximately 16% of the value of the real estate capital market wheel. If one were to add in hotels, health care facilities such as assisted living, and mini-storage, the size of the sector would certainly expand, although not by a huge amount.

Since there is no investable index of private equity (a goal rendered even more difficult by virtue of the lack of a precise estimate of aggregate, let alone disaggregate, value), there is no potential investment with which to compare the measured allocations. In addition, private real estate equity is highly idiosyncratic and is generally accessed only in sizeable "units," and therefore very difficult to access by smaller institutional investors and individuals.

The traditional categories of private equity can be further divided into subcategories such as suburban office, strip center retail, mall retail, lifestyle center retail, pad retail, community center retail, townhouse apartments, high-rise apartments, major warehouse, secondary warehouse, manufacturing warehouse, and office showroom, as examples. The geographic distinctions are nearly as rich with primary, secondary, and tertiary urban areas; central business district; and suburban, exurban, and resort locations. Each property type and location and each combination thereof have different risks, returns, and drivers, as manifested in correlation matrices used by institutional investors to evaluate the risk characteristics of portfolios. For example, the National Counsel of Real Estate Investment Fiduciaries (NCREIF) Index shows a high correlation between office and industrial performance since 1978 (as measured by total return). Yet within those sectors, there is a much lower correlation between the Central Business District (CBD) office and industrial R&D space, and a similarly low correlation between CBD and suburban office space. Clearly, there are opportunities to increase returns and manage risk by wisely choosing investment markets, submarkets, property type, and subclass.

Layer onto this melange the various stages of, and ways to participate in, private real estate equity. For example—from land banking, land development, pre-sales, infrastructure development, merchant building, construction, leasing, operations, rehabilitation, repositioning, and sales—and there are lots of ways to play and lots of risk profiles to assume within this quadrant. Many more than is the case for public equity, where this variety of activity is far less in evidence, largely due to the pressure to maintain dividend levels.

There are three main categories of strategy within private equity—core, value added/enhanced core, and opportunistic—each quite different from the others and even presenting wide differences of activity within itself. The correlation between core and enhanced core strategies is very high, but the correlation between opportunistic strategies and core and enhanced core are considerably lower. As leverage increases, the differences between the strategies grow. This is interesting given that all of the strategies use the same basic ingredient—private real estate equity. Within each of the three primary categories of strategy are several ways to make (and, of course, sometimes lose) money. Some key strategies are:

Valuation is a definite problem in the private equity quadrant (Fisher, 1998). Since the market is by definition private, transaction and carrying values do not have to be disclosed to anyone except the investors themselves and sometimes, depending on the terms of the adviser/investor agreement, not even to them. That being said, investors work hard to discover transaction values and a firm was founded to research and sell reasonably accurate transaction values. But this enterprise covers only properties that have been transacted; most properties are sold relatively infrequently, so the problem of interim valuation remains. Even when one is an "insider" to a private portfolio, at best the valuation (at least to the buyer and the seller) is "known" when the asset is acquired and sold. Assets that are held in portfolios are typically marked to market annually or even less frequently. Appraisers conduct research to assign an interim value to an asset, and while over time these valuation exercises have certainly improved, there is no guarantee that they are correct. Unfortunately, in the private market, unlike the case in the public market, there are infrequent chances to revisit what may be an incorrect valuation. Thus, until an asset is sold, the investor really does not know what its value is. For the closed-end portfolios of value-add and opportunistic strategies, interim valuation is much less of an issue as your capital is locked up until the fund is liquidated. In addition, assets in such portfolios are even more difficult to value given their complexity and risk profiles.

Privately Traded Real Estate Debt

Privately traded real estate debt includes commercial and multifamily mortgages. This sector comprises the largest portion of the real estate capital wheel at nearly $2 trillion, although it is rapidly giving ground to the public real estate debt quadrant, as will be discussed in the next section. This sector is exactly as it would appear to be—composed of loans backed by real estate collateral. These loans are almost always nonrecourse to the borrower (a unique feature of real estate lending in which the lender can seek redress for a default only on the mortgage to the property and not to any other assets that may be held by the borrower), and so lenders are highly motivated to be sure that they understand the performance attributes of the collateral. Loans can be fixed rate or floating rate, or interest only, and can include various other features like cash-flow participation, shared appreciation, and so on. The only constraints are the borrowers' and lenders' imaginations. Again, these are privately negotiated transactions, so the rules of engagement are subject to the competitive environment and the needs of each party. As the public, securitized market has developed, some increase in standardization of loan terms and documents has begun to develop in order to facilitate the securitization of a lender's portfolio should they choose to use that market.

Traditionally, private debt has been the purview of the insurance companies and the banks, but now the field has opened considerably, and anyone who has enough capital to get started can enter the field. Again, a significant driver of this shift is the advent of the public debt quadrant. Whereas once private-debt issuers had to hold those investments on their own balance sheets, now there is an active secondary market for individual mortgages and pools of mortgages. Even with this greater democratization of the commercial and multifamily mortgage world, the spreads over Treasuries for private mortgages historically have been wider than is the case for comparable risk corporate bonds and private non-real estate issues. This is a signal that the market may not quite understand how to price the risk of a private mortgage. Mortgages are underwritten on all property types in all geographic locations. Most individual mortgages are larger than most individual investors could invest in.

Publicly Traded Real Estate Debt

Publicly traded real estate debt was "invented" during, and as a government solution to, the severe distress of the real estate and economic cycle of the late 1980s. A CMBS is a security, backed by the cash flows from one or a pool of mortgages (see Esaki, de Beur, and Pearl, 2003). The security is "tranched" so that each holder of a piece of the security has a known piece of the hierarchy of rights to the cash flows and risks associated with the underlying collateral. These securities are modeled on the structure of securitized corporate debt. The market's development was spurred by the very large volume of defaulted real estate mortgages held on the books of most lending institutions when the real estate markets fell to earth in the late 1980s. With the help of the Resolution Trust Corporation (RTC), a quasi-governmental agency, lenders could sell their mortgages to the RTC, which then packaged them and resold them to securitizers who were then able to turn the pools into tranched securities and sell the rated securities into the institutional market. This large-scale government intervention saved the lending industry from certain demise, although not before lots of individual banks and savings and loans went out of business.

Those who bought the securities and the underlying collateral were rewarded when the real estate market cycle turned and the buildings were again able to generate positive cash flow over and above the interest rates of heavily renegotiated mortgages. Some have called this episode a major wealth transfer sponsored by the government, but for sure the financial system needed some kind of a fix. The advent of the CMBS market has truly democratized the real estate debt investment sector to the benefit of borrowers everywhere.

A new breed of conduit lenders—lenders who originate loans and, working with rating agencies, form securities and sell them, sometimes retaining a piece of the security on their books and sometimes just capturing an origination and securitization fee along the way—has emerged. As competition from new and traditional issuers of mortgages has increased, interest rates and spreads over cor-porates and Treasuries have come down. This shift in the cost of borrowing, compounded by the historical low levels of all interest rates, has made borrowing even more attractive to real estate investors.

This new market is steadily eating away at the former dominance of the private-debt market and now is within reach of $1 trillion, comprising nearly 20% of the capital wheel. In 1995, the CMBS market size was just $88.4 billion, only 5% of the real estate investment universe.

The market is growing because the idea makes sense. Real estate mortgages are being "deoligopolized," creating greater efficiency, better pricing (from the borrower's point of view) and transparency in the process. However, securitization creates instruments that are far more fractional and so sized to fit the investment parameters of more capital sources, including individual investors. Also, securitization allows for the pooling of risk across more loans and for segmenting the return-risk hierarchy, enabling each investor to participate in just the portion of the capital hierarchy with which they feel most comfortable. Whole mortgages require the investor to buy into the entire hierarchy. So a disaster in the lending business generated a brand new way to participate in real estate investing and created enormous new business opportunities out of what had been a very "clubby" part of the capital markets.

The array of strategies in the public debt market is, as is true for the whole loan market, somewhat narrow. However, there are some extremes nonetheless. Traditional fixed income investors have discovered that they can buy and hold the AAA tranche and receive results that slightly outperform the comparable corporate security with no additional risk (so far). A small number of more entrepreneurial real estate investors have chosen to hold the B and unrated pieces of the securities waiting for the spread compression that must come as the pace of delinquencies and defaults continues at record lows. In fact, considerable spread compression has already occurred, validating their faith in the market's learning curve.

The correlation between the AAA tranche and the B tranche is low, indicating that investors have interesting portfolio strategies to execute within the quadrant. Many have figured this out, and as the rest of the fixed income world catches on, you can expect to see spreads equalize across like corporate credits. Again, barring a disaster in the performance of the underlying collateral, this spread compression should continue until the relative wideness between the corporate and real estate sectors, across like credit quality, is competed away.

It is well established that adding real estate to a portfolio of stock equity, fixed income, and other key assets both domestic and international causes the return of the portfolio to be, as usual, the simple weighted return of the components of the portfolio and the risk to be less than the simple weighted average of the components' risk (See Georgiev, Gupta, and Kunkel, 2003; and Markowitz, 1952). However this benefit is not evenly distributed across the parts of the real estate capital markets. And the benefit is not evenly distributed across each of the component parts of each of the quadrants. Thus, while real estate is an obvious risk mitigator and there is increasing awareness of this on the part of institutional investors, care must be taken when applying the lesson to the actual portfolio.

When real estate is viewed in the aggregate (using an index of all four quadrants, capitalization weighted through time), it is clear that the promise of using real estate as a tool to achieve absolute outperformance is not achieved: Real estate does not outperform stock equity and fixed income over very long time periods. However, and interestingly, aggregate real estate does outperform both stock equity and fixed income on a risk adjusted basis. So an investor needs to be clear about what his objective really is—absolute return without consideration of risk or absolute return subject to consideration of risk?

When real estate is decomposed into its four major parts and then further decomposed into opportunistic private equity and some value added strategies the message can change (see Hahn, Geltner, and Gerardo-Lietz, 2005). Real estate, especially opportunistic strategies, can be used to generate high absolute returns to the investor. However, manager selection becomes crucial to the successful execution of opportunistic strategies. There is wide variation in performance across managers in this arena. Interestingly, there is considerable persistence in performance for both high-performing opportunistic managers and low-performing managers. Unfortunately, as more vintages of funds are offered and executed by the high performers, their results tend to deteriorate. This suggests that while a manager may have a good idea or set of ideas at the start, either the market shifts against the good ideas or others in the industry catch on to and so compete away the good ideas. It also may be that the star employees working for an outperforming manager get hired by others or leave to start firms on their own, taking these good track records with them. At any rate, it is clear that it is hard to use real estate as an outperformer and really hard to achieve this over repeat funds and long stretches of time.

Conventional wisdom maintains that real estate per se is an inflation hedge. Analysts have probed the question through time and, interestingly enough, the answer changes. (See Hartzell, Heckman, and Miles, 1987; Miles and Mahoney, 1997; and Huang and Hudson-Wilson, 2007.)

The bulk of the research has been conducted using various sources of private equity and of public securities returns. A broad and consistent conclusion is that the inflation-hedging capacity of publicly traded real estate securities is extremely limited. Another important conclusion is that the condition of the space market for real estate matters; in other words, if the vacancy rates are high and the capital markets are disinterested in holding real estate, the inflation transmission mechanisms are disabled. This is not surprising and should not deter one's interest in the issue or in the potential utility of real estate as a hedge.

If real estate in total and in terms of the four property types has or lacks inflation-hedging capability, then one's preference for portfolio structure would change, depending on one's view of future inflation. Indeed, if any of the property types acts as a successful hedge, then one would likely maintain a position in that asset despite one's views on future inflation, as it is too late to put a hedge on once an inflationary period is evident.

There are multiple places for inflation to contribute to the total return of a real estate asset—through the growth of rental and other revenue, through the growth of expenses and the issue of who bears those expenses, and through the capitalization rate, where income is transformed into value.

Most investors believe that the key to the success of the hedge is whether net income grows at the rate of inflation. If so, and if all else stays equal, the cap rate will reflect the impact of inflation, and so the value will reflect inflation. As inflation rises, the cap rate will fall and value will rise. However, what if the nominal growth of income comes short of fully reflecting inflation? Is this the only way for inflation to be reflected in performance?

No, if investors believe that real estate is an inflation hedge, then as inflation is either in evidence or is anticipated, more investors will seek access to real estate, and the risk premium will fall, reflecting the flows of capital. Thus, even if incomes do not exactly keep pace, the hedge may be effective. This is especially the case for assets in which construction costs are high and subject to inflation and where construction lead times are long. Excess supply is seen as a smaller risk to such assets, and so the flow of capital will inevitably and sensibly cause cap rates to decline.

Given these pieces of logic, it must be the case that there are important differences in inflation-hedging ability across the four major property types, and indeed there are. Office, which has long construction lead times and very expensive and heavily inflating construction costs, is a superhedge, with the hedge transmitted exclusively via the capital return. Similarly, apartment is the second best hedge among the real estate candidates. This is true of infill and urban multifamily assets, where costs and lead times are long, but it is also true because of the short lease durations allowing owners to adjust to inflation and inflationary expectations more quickly. Warehouse follows, although it is not nearly as capable as is office, and finally the retail sector evidences no hedging capability at all, through income or through value. This is especially interesting as not only has the key source of the hedge switched from income to value, but in past days, when retail leases contained percentage rent provisions, retail was the primary means by which to use real estate to hedge inflation. How times change.

Warehouse and, more acutely, retail are less interesting to investors seeking hedges, as they are characterized by short construction cycles, low relative construction cost (most suburban retail and typical warehouse construction is virtually the same), and longer leases—all negatives in terms of the transmission of inflation to performance.

An overall conclusion appropriate to any investor seeking to hedge inflation is to put a hedge in place before inflation is in evidence. Once the inflation is in evidence, investors are going to respond, adjusting the value of inflation-hedging assets and so reducing the future hedging capability of any specific asset.

Given the ubiquitous nature of the real estate asset, in all of its various forms cumulating to trillions of dollars in the US alone, it is clear that a decision to not include real estate in a diversified mixed asset portfolio is a decision to tilt the portfolio away from a conceptual aggregate market index. Any large "off-market" bet would need to be rigorously defended. It is increasingly common to find real estate in well managed institutional portfolios as the attributes of the asset are better understood and as there are available more sensible and cost effective means of accessing the asset. The institutional world has come a long way since Meyer Melnikoff opened the Prudential Property Investment Separate Account in 1974. Today an investor can access real estate through REITs, separate accounts, direct investment that is self-managed, open-end commingled funds, closed-end commingled funds, private REITs, partnerships, and funds of funds. There are well over 500 vehicles (not counting the individual REITs) available on a variety of terms to institutional investors. Again, the field is not quite so open for individual investors, but that too may change with time.

Unlevered private equity real estate delivers net cash flows to investors that are typically three times greater than dividends from the stock market and typically 200 to 400 basis points greater than 10-year Treasury yields. Any investor with a need for cash flow to meet current liabilities will for sure have an interest in participating in the private equity real estate asset. Of course, the various quadrants are more and less robust from an income-generation perspective, but these differences are highly visible. REIT dividends exceed those for the overall stock equity market and public and private mortgage debt interest rates exceed the payout to comparably rated corporate debt.

Real estate markets are truly ubiquitous, in the United States and around the world. Some institutional markets are more and less evolved, but there is investment real estate everywhere on the planet. The question is: Should an investor residing in any one location have an interest in gaining access to real estate investments, be they public or private or debt or equity, in other locations? Increasingly, the answer to this question is "yes." Despite the complexities associated with currencies, the widely differing degrees of market transparency and cultural differences in how business is transacted, real estate investors are following the lead created by their stock-equity and fixed income brethren and are actively pursuing global strategies.

In some cases, the need to move the investment program beyond one's borders is blatant—for example, the government of Singapore has long had an active global presence in real estate. Think about how much wealth the Government Investment Corporation of Singapore controls and how small the domestic real estate capital market is and so the reasoning is clear. The same can be said for the Dutch, the Swedes, the Aussies, and the Japanese. Each of these is a wealthy country with small (relative to their domestic wealth) local real estate investment universes. In addition, the smaller countries are more homogeneous in terms of investment drivers, and so there are fewer opportunities for portfolio diversification within the domestic market. Going global is an obvious choice.

How about the choice for more diverse economies like that of the United States? Research shows that for a U.S. real estate investor there are quite significant diversification benefits to be gained by adding Europe, Asia, and Canada to a base portfolio of U.S. office buildings located in major metropolitan areas (see Hastings and Nordby, 2007). This research also concluded that the existence of different currencies enhanced the diversification benefits even if greater performance volatility also accompanied the differences in currency. Currency variations can be at least partially hedged at some cost to the portfolio's return.

Investors seeking high absolute return might also heed the sirens' call to "go global." Emerging Asia, emerging Europe, and newly institutionalizing markets can produce outsized returns while in transition (of course, they can also move south pretty fast and by quite large magnitudes). Even in "Old Europe," where real estate had generally been held by owner/users, there are large opportunities created by the shift from owners/users to investors. In several countries (Japan, France, and Germany for example), new REIT markets are being created through national legislation, again reorganizing the manner in which property is held and making it available to investors both locally and internationally.

In the United States, it has long been conventional to finance commercial and multifamily properties and the private mortgage market is deep and well developed. Then the banking crisis of the 1980s led to the creation of the public CMBS market. In Europe, the CMBS market is developing in the absence of a financial crisis, simply because it truly is a good capital markets idea. This is an area of great investment promise as markets gain familiarity with a new investment structure and vehicle. When something is new, unfamiliarity breeds initially wide spreads.

The demands of diversification and the pursuit of higher returns have driven foreign investors to the United States and around the globe, and now U.S. investors are getting into the game. Through it all, one must remain vigilant with respect to the separation of reality, risk, and hype. A good example of a story well told to a susceptible few is that of emerging India, where the promises are huge but the reality is stark. It is often difficult to determine if the grass is really greener on the other side of the fence, or even if that green stuff is grass at all.

While owners of residences routinely use leverage as a means to avail themselves of a home, it is less routinely used among institutional investors in real estate. This is because the use of leverage raises some important questions for institutional investors who are managing large complex portfolios and investing in multiple asset types (see Anson and Hudson-Wilson, 2003).

If lenders lend, then, of course, borrowers borrow. Collateralized leverage is the simple act of borrowing money based on the value and the security of an asset, in this case a property or a portfolio of properties. In the special case of real estate borrowings, the lender's recourse extends only to the property and not to the other assets that might be owned by the borrower. Because of this nonrecourse feature, the use of leverage is analogous to short selling the asset. The borrower takes the proceeds and reserves the option to "put" the asset to the lender at any time with no further penalties. As was mentioned earlier, while it is unusual for a property's value to go to zero and stay there, it is less uncommon for a borrower to be unable to support the mortgage payment through a rough market cycle. Moreover, sometimes a lender lends too much, based on an artificially inflated value or a "sweetheart" deal. Thus, the option value of the put is quite real.

An investor would choose to use leverage for one or more of the following reasons:

The final reason warrants further exposition. As was discussed earlier in this chapter, real estate is a debt-equity hybrid. Thus, applying leverage to a building encumbered by one or more leases is a way of essentially "shorting out" the debtlike aspects of the asset's behavior. This then exaggerates the equity-like aspects of the asset's behavior. This has the additional effect of enhancing the diversification benefit of real estate in the context of a mixed-asset portfolio, essentially "pure" real estate equity behavior is what is left over.

Of course, leverage increases risk as measured by the volatility of the total return of the leveraged asset. There is no escaping this negative. However, one could apply leverage to assets that are, in other ways, less risky than average, thus while the application of leverage does raise volatility, it does not necessarily raise risk to an unacceptable level.

For institutional investors, which invest in multiple asset classes, there are benefits associated with using leverage on the real estate portfolio. First, the diversification benefits of the real estate portfolio itself can be enhanced with the use of leverage. Portfolio managers can gain significant allocation flexibility by using disparate amounts of leverage on different holdings to add to or subdue their risk profiles and to allow for making more investments. Second, the real estate asset produces enhanced diversification by way of stocks, bonds, and bills when it is leveraged.

However, the mixed-asset investor must also wrestle with a key question: Does it ever make logical sense for the same investor to be a borrower and a lender (by making fixed income investments) at the same time? (Certainly not, according to Benjamin Franklin). And, to compound matters, typically the rate at which the borrowing occurs will be greater than the like credit rate at which the lending occurs. So one would borrow more expensively than one would lend. (Remember the earlier discussion about credit spreads.) Don't these two approaches essentially neutralize one another while also incurring transaction costs? Of course, in the stock-equity world, this situation is routine, as it is the case that most securities are issued by companies that use leverage. The stock investor, however, does not have a choice, while the real estate investor (except the REIT investor) sometimes does have a choice.

One approach would be for the fixed income side of an institutional investor to lend to the real estate side. Unfortunately, right up until the moment where there were no problems, there would be no problems, then trouble could begin. Two sides of the same investor entity would be highly conflicted, and the situation would be awkward at best. This conflict would be exacerbated in the typical case where the portfolio manager for each asset class defends his own return and is not accountable for the overall fund level return.

Leverage should be thought of as way for the borrower to raise capital, not to use capital. If a fund is not already fully invested in highly productive investment activities, it is hard to see why leverage would make sense. Leverage can simply add to the dilemma of getting the money put to work.

Leverage, then, can be a useful portfolio management tool as long as the philosophical issues are put aside, the real estate allocation is fully invested, and the real estate and the fixed income portfolio managers are measured on their independent performance.

In the early 2000s, the market for commercial property derivatives has been emergent (see Esaki and Kotowski, 2007). Whether it will take and thrive is still a serious question, however.

In theory, there is ample room for a real estate derivatives product. Insurance companies might wish to hedge their exposure to the property and casualty lines, tenants might wish to hedge their exposure to lease renewal dates, and investors could less expensively take long or short positions in a large, lumpy, complex real estate market just by executing a swap. It all sounds good.

Several exchanges are now prepared to offer such derivatives, using several different underlying indexes of real estate market performance. The indexes being explored are:

All of the indexes suffer from a common flaw. The indexes are in no way representative of the underlying real estate investment universe. The NCREIF Index (NPI) and the MIT Index (TBI) are based only on properties that are operated by the members of NCREIF, principally tax-exempt investment advisers. The NCREIF and IPD indexes are largely comprised of appraisal information on property values. The REXX Index is based on rental rates and values are inferred from those. The GRA Index is based on a small sample of transactions derived from public sources, and the RCA Index is based on a larger pool of transactions and is a better source of what is still a small subset of all properties in the U.S. real estate investment universe, those that were transacted within a particular quarter. In sum, none of these indexes are robust enough to warrant using as the base for a real trade involving real money, and none of them is even close to capturing the behavior of the true real estate investment universe. The basis risk associated with a swap constructed around any of these indexes would be massive. Thus, the risk to the counterparty would be significant, and so the spreads at which such transactions might be done are prohibitive.

Essentially, this is a good idea whose time has not yet come because the degree of transparency in the real estate markets is not yet sufficient to support it. Added to the transparency weakness is the reality that real estate returns are significantly serially correlated and exhibit low volatility. This means that the best predictor of next quarter's returns are last quarter's returns. This persistence makes the idea that there could be two interested parties with opposing views on the future of real estate market performance unlikely. In order to attempt to kick-start this industry investment, banks have been taking the other side of a handful of small index-based transactions and holding them on their own balance sheets. Good derivative markets require full transparency, low-basis risk with the bet one is trying to hedge, index volatility, and lots of reasonable uncertainty around the future directions of the market. The real estate market does not meet these criteria.