PGIM Real Estate: Real estate debt can enhance portfolio returns without additional risk

PGIM Real Estate: Real estate debt can enhance portfolio returns without additional risk

September 12, 2023

Real Estate Fixed Income
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Core real estate debt has the potential to enhance performance of an investment-grade fixed income portfolio but not at the expense of additional risk, says Henri Vuong, Head of Real Estate Debt Investment Research at PGIM Real Estate.

Private real estate debt shares similar characteristics to that of bonds: steady income, predictable returns and low volatility. Performance is highly correlated to that of bonds, with a correlation of around 80%.

As a private asset class, it offers a yield premium over bonds known as the private market or illiquidity premium. Since 1978, real estate debt has delivered a higher total return of 7.3% annualized compared to 6.5% for the Agg and 7.0% for Corporates, with on par or lower standard deviation of returns.

Maximum drawdown

Although standard deviation is a commonly used measure of risk that makes sense from a statistical perspective, it is less intuitive from an investment perspective. This is where maximum drawdown (MDD) offers another representation. MDD helps to assess potential large losses in a severe market downturn and, more importantly, the period to recovery.

From 1978 to the second quarter of 2023, drawdowns have occurred more frequently and have been more severe for bonds, especially Corporates. Furthermore, the periods to recovery have also been longer for bonds than for real estate debt.

MDDs can also be applied to portfolios of mixed asset classes. It is especially useful for assessing potential losses, which is crucial when trying to balance potential returns with potential risks. As investors continue to face a volatile and uncertain investing environment, achieving positive returns can be challenging, and strong risk-adjusted returns can be even more challenging. While a higher portfolio return is often desired, to do so while taking on more risk is not, especially in a market downturn where potential losses can be severe.

Boost

So, over the long run, real estate debt has delivered higher cumulative performance than bonds. Therefore, having real estate exposure in an investment-grade bond portfolio would have boosted portfolio returns, while also reducing portfolio risk through lower volatility of returns.

What is more compelling is that when assessing worst-case scenarios through the lens of MDDs, the downside analysis suggests that real estate debt has the potential to reduce portfolio losses through less frequent and less severe MDDs, as well as provide a faster recovery after hitting a trough. These additional benefits emphasize the downside protections and potential for performance loss reduction that could be available by adding real estate debt to an investment portfolio.

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