Why Invest in Commercial Real Estate?
The U.S. commercial real estate market has become a meaningful and mainstream asset class — the fourth asset class in addition to stocks, bonds and cash. Investing directly in commercial real estate can potentially benefit individual investment portfolios in a number of ways.
- Commercial real estate has historically delivered higher income returns than other major asset classes
- More than 70% of the total returns from commercial real estate were comprised of current income
Average Annual Income Returns1,2
20 Years Ended December 31, 2018
Low Correlation to Other Asset Classes
- Commercial real estate has exhibited historically low or negative correlation to equities, bonds and public REITs
- Public REITs have historically been more highly correlated to equities than commercial real estate
Commercial Real Estate Correlation1,3
20 Years Ended December 31, 2018
Enhanced Risk-Adjusted Return Potential
- Commercial real estate has delivered higher returns than equities and bonds while also being at the lower end of the risk spectrum (which represents volatility) than equities, making its historic risk-adjusted return more favorable than these other asset classes
20 Years Ended December 31, 2018
Prospective Hedge Against Inflation
- Commercial real estate net operating income (NOI) has historically exceeded inflation
- Rent escalation clauses in many leases and organic rental growth provide a strong inflation hedge
Real Estate Income and Inflation4,5
What are the Key Drivers of Demand for Commercial Real Estate?
With the U.S. population currently growing at approximately 1.1% per year on average, there could be up to 38 million more people by 2030 and 68 million more people by 2045.6
38 million more people is approximately 15 additional cities the size of Dallas.6
GDP & Employment Growth
GDP and employment growth create demand for places for people to work, shop and play.8
What are Current Trends in Commercial Real Estate?
Limited New Supply
Limited development financing continues to lead to reduced supply levels.
Aggregate Monthly Construction Starts9
Favorable Operating Fundamentals
Commercial real estate continues to experience positive occupancy and rent growth.10
Increasing Institutional Allocations to Commercial Real Estate
On average, institutions generally have greater than 10% allocated to commercial real estate11 while individuals tend to have limited allocation to the asset class.
Percentage Allocations to Real Estate
1 Source: Bloomberg, NCREIF and NAREIT. Commercial real estate is represented by the NCREIF Open-End Diversified Core (ODCE) Index, an equal weighted, time weighted index representing a blended portfolio of institutional-quality real estate reported net of management and advisory fees (with the exception the commercial real estate income data shown, which is reported gross of management and advisory fees). The term core typically reflects lower risk investment strategies, utilizing low leverage and generally represented by equity ownership positions in stable U.S. operating properties. Funds are weighted equally, regardless of size. While funds used in this benchmark have characteristics that differ from DPF (including differing management fees), our management feels that the NCREIF ODCE Index is an appropriate and accepted index for the purpose of evaluating returns on investments in net asset value (NAV) real estate investment trusts (REITs). Equities are represented by the S&P 500 Index, an unmanaged index of the 500 largest stocks (in terms of market value), weighted by market capitalization and considered representative of the broad stock market. Bonds are represented by the Barclays Capital Aggregate Bond Index, an index of securities that are SEC-registered, taxable and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities and asset-backed securities. Bond income return is represented by the yield to worst of Bloomberg Barclays US Aggregate Bond Index. Public REITs is represented by the FTSE NAREIT All Equity REITs Index, which is a free-float adjusted, market capitalization-weighted index of publicly traded U.S. Equity REITs. Constituents of the Index include all tax-qualified publicly traded REITs with more than 50 percent of total assets in qualifying real estate assets other than mortgages secured by real property. An investment in commercial real estate differs from the FTSE NAREIT All Equity REITs Index in that commercial real estate investments are not publicly traded U.S. Equity REITs; differs from the Barclays Capital Aggregate Bond Index in that commercial real estate investments are not fixed-rate debt instruments; and differs from the S&P 500 in that commercial real estate investments are not large-cap stocks. Cash is represented by the 90-day Treasury bill rate.
These indices are used in comparison to the NCREIF ODCE Index in order to illustrate the differences in historical total returns generated by commercial real estate, stocks and bonds. The prices of securities represented by these indices may change in response to factors including: the historical and prospective earnings of the issuer, the value of its assets, general economic conditions, interest rates and investor perceptions. All indices are unmanaged and do not include the impact of fees and expenses. An investment cannot be made directly in any index. The returns presented are not indicative of returns to be attained by DPF.
Non-traded REITs do not trade on a national securities exchange, and therefore, are generally illiquid. Early redemption of non-traded REIT shares is often very limited, and fees associated with the sale of these products can be higher than other asset classes. In some cases, periodic distributions may be subsidized by borrowed funds and include a return of investor principal. This is in contrast to the distributions investors receive from large corporate stocks that trade on national exchanges, which are typically derived solely from earnings. Investors typically seek income from non-traded REIT distributions over a period of years. Upon liquidation, return of capital may be more or less than the original investment depending on the value of assets.
Distributions for all REITS that are from current or accumulated earnings and profits are taxed as ordinary income, as opposed to the tax rate on qualified distributions, which generally carries a tax rate of 15%. But that rate can be 20% for people in the highest tax bracket or 0% for those in the lowest two tax brackets. If a portion of a non-traded REIT distribution constitutes a return of capital, that portion is not taxed until the investment is sold or liquidated, at which time investors will be taxed at capital gains rates. Fixed income securities are subject to interest rate, inflation, credit and default risk. As interest rates rise, bond prices usually fall, and vice versa. Prices may decline if an issuer fails to make timely payments or its credit strength weakens.
Comparisons shown are for illustrative purposes only and do not represent specific investments or the performance of DPF. Past performance does not guarantee future results. DPF has the ability to utilize higher leverage than is allowed for the funds in the NCREIF ODCE Index, which could increase DPF’s volatility relative to the Index. Total returns presented assume reinvestment of distributions Direct commercial real estate return: 7.31%; risk: 6.45%. Equities return: 5.61%; risk: 15.80%. Bonds return: 4.55%; risk: 3.40%. Public commercial real estate return: 9.94%; risk: 20.24%. Sharpe Ratios — Direct commercial real estate 0.85; Equities: 0.24; Bonds: 0.80; Public REITs: 0.40. The Sharpe ratio is calculated by subtracting the risk-free rate — such as that of the 3-Month Treasury Bill — from the rate of return for a portfolio and dividing the result by the standard deviation of the portfolio returns.
2 The amount of distributions DPF may make is uncertain, is not guaranteed, may be modified at the program’s discretion, and is subject to board approval. DPF may pay distributions from sources other than cash flow from operations including, without limitation, the sale of assets, borrowings or offering proceeds (including the return of principal amounts invested). The use of these sources for distributions would decrease the amount of cash DPF has available for new investments, repayment of debt, share redemptions and other corporate purposes, and could reduce your overall return and dilute the value of your investment in shares of DPF common stock. Our distributions for the quarter ending March 31, 2019 were 41.8% funded from cash flows from operations and 58.2% was funded from borrowings. Our distributions for the years ended December 31, 2018, 2017 and 2016, on an annualized basis, were fully funded from our operations. When looking at individual quarters within those periods, in some cases our distributions were not fully funded from our operations for such quarters. In such cases, the shortfall was funded from borrowings, and ultimately made up with excess cash from operations from other quarters during the same period. Cash flow from operations does not include a reduction to cash flow resulting from on-going capital expenditures as GAAP defines those cash outflows as part of investment activities. Nonetheless, capital expenditures are inherently a significant and material part of the on-going business of DPF. Furthermore, cash flow from operations, after deducting capital expenditures, may not be sufficient to fund 100% of DPF’s distribution. For example, cash flow from operations, after deducting capital expenditures, for each of the years ended December 31, 2017 and 2016, would not have been sufficient to fund DPF’s entire distribution amounts. Furthermore, due to two recent large lease expirations, DPF may incur higher capital expenditures over the next two years, continuing to make funding distributions through cash flows from operations, after deducting capital expenditures, unlikely over that period of time.
3 Correlation measures how one investment performs in relation to another, with a coefficient of +1 being a perfect, positive correlation and a coefficient of -1 being a perfect, negative correlation. When two asset classes have a correlation of +1, they will both move up or down by the same amount in the same direction. Conversely, a correlation of -1 indicates that when one asset class moves up or down, the other moves in the opposite direction by the same amount. In general, asset classes with a correlation less than 0.70 or greater than -0.70 are considered to have relatively low correlation. Research indicates that commercial real estate has a relatively low correlation with other asset classes, and may help reduce the volatility of a stock-and-bond portfolio. The NCREIF ODCE Index is subject to less volatility because its value is based on commercial real estate properties and not subject to market pricing forces. Volatility is measured by historical standard deviation, which is derived from historical returns. Lower volatility could result in lower returns during certain periods of time. Although DPF’s stock price is subject to less volatility, DPF shares may be significantly less liquid than shares of publicly traded securities, and are not immune to fluctuations, including downward fluctuations. Additionally, the value of DPF’s underlying property holdings will fluctuate and be worth more or less than the acquisition cost when sold. Investors are advised to consider the limitations on liquidity of DPF shares when also evaluating the volatility of DPF’s stock price as compared to that of the stock prices of publicly traded securities.
4 Typically, if the overall returns of an asset class exceed inflation, the asset class is considered an inflation hedge. Commercial real estate net operating income (NOI) has historically provided overall returns that have exceeded inflation. There is no guarantee, however, that DPF can generate the overall returns needed to out pace inflation.
5 Source: Green Street Advisors and U.S. Bureau of Labor Statistics. As of February 1, 2019. Net operating income (NOI) growth represents the average NOI growth by year across the apartment, industrial, mall, office and strip retail sectors. NOI may not be correlated to or continue to keep pace with inflation. The Consumer Price Index (CPI) is an indicator of inflation that measures the change in the cost of a fixed basket of products and services, including housing, electricity, food and transportation. Investors cannot invest in any index. Comparisons shown are for illustrative purposes only and do not represent specific investments or the performance of DPF.
6 U.S. Census Bureau — Population Division, December 2018. Census.gov — U.S. and Vintage 2015 Population Estimates: Population Estimates.
7 World Population Clock, March 2018. Estimate based on 2018 census data.
8 Source: U.S. Bureau of Labor Statistics, January 2019; U.S. Bureau of Economic Analysis, January 2019; Moody’s, 2018. Employment rate is calculated as percentage change of workforce receiving a paycheck.
9 Source: CoStar Portfolio Strategy, 4Q18. Data represents all office, retail and industrial properties available in the CoStar database.
10 Source: CoStar Portfolio Strategy, 4Q18.
11 Source: 2018 Institutional Real Estate Allocations Monitor. Institutional investors often invest on substantially different terms and conditions than individual investors, which may include lower fees, expenses or leverage.
12 Source: YaleNews, Investment return of 12.3% brings Yale endowment value to $29.4 billion, June 30, 2018.
13 Source: CalPERS, Allocation & Market Value by Asset Class as of August 31, 2018; The University of Texas Investment Management Company (UTIMCO), 2018 Annual Report, Permanent University Fund and the General Endowment Fund Asset Allocation as of December 31, 2018; PSP Investments Asset Mix as of September 30, 2018.