As 2002 begins, investors everywhere confront arapidly changing landscape. The long globalexpansion of the 1990s, led by a record 10-yeargrowth period in the United States, has beenreplaced by the first synchronzied global economicdownturn in a generation. And, on top of thiscyclical change in the economic winds, theSeptember 11th terrorist attacks on New York andWashington, D.C. have added to the instabilityand economic risks.

In this context, investors are re-evaluating theirinvestment goals and reviewing their strategies. Asthe high-return boom years fade, a thorough re-thinking of each asset class’s position in aninvestment program is appropriate.

In the current environment, real estate hasrenewed attraction for many investment programs.In the past decade, it has developed into an assetclass with viable investment choices in all fourquadrants:

1. Private equity real estate remains a primevehicle for direct control of propertyinvestments.

2. Public equity markets have grownsubstantially, especially since 1992 with thedevelopment of new Real Estate InvestmentTrust (REIT) formats, and have now “comeof age” with the inclusion of REITs inStandard and Poor’s 500 index.

3. Private debt through mortgage vehicles hasbeen stengthened by stronger underwritingstandards.

4. Public debt markets, especially CommercialMortgage Backed Securities (CMBS), havebroadened and deepened.

In sum, real estate in the 1990s developed asophisticated relationship with all aspects of thecapital markets, and in addition saw the ownershipof both equity and debt migrate from local toglobal capital pools. At the beginning of the newcentury, real estate provides a very different assetclass profile than it did a mere ten years ago.

Real estate remains an integral component ofcontemporary mixed asset portfoliosproviding portfolio managers with fiveimportant characteristics:

� high risk-adjusted returns,

� competitive nominal returns,

� low performance correlations with otherasset classes,

� lower volatility than other asset classes,and

� a hedge against unexpected inflation.

Consequently, real estate can be an effective toolin a sophisticated portfolio management strategy.When appropriately managed, real estateinvestments provide both high risk-adjustedreturns and portfolio diversification forinstitutional investors. And real estate can beutilized under a variety of investment styles —ranging from core to opportunistic.

THE CASE FOR REAL ESTATETHE CASE FOR REAL ESTATE

EXECUTIVE SUMMARY

FIRST QUARTER 2002

Pension funds began to include real estate as partof their investment programs in the mid-1970s, achange stimulated by two major events:

� First, passage of the Employee RetirementIncome Security Act (ERISA), also known asthe Pension Reform Act of 1974, whichrequired diversification as part of the “prudentman” rule and mentioned real estate as apotential means of diversifying a portfolio.

� Second, both stocks and bonds posted negativereal returns for a number of years during theinflationary era between 1965 and 1974.

Pension managers searching for investments thatperformed well in an inflationary environment andmet the “prudent man” tests mandated in ERISAbegan to include modest amounts of real estate intheir investment portfolios. Allocations to realestate became more substantial in the 1980s.Today, commercial real estate is a $4.3 trillionindustry, with institutional capital constitutingnearly half of that market. (The ratio of equity todebt is 1:4.)

As institutional interest in property increased, theoverall real estate industry underwent a series ofimportant changes. The most significant wasdevelopment of robust public debt and equitymarkets. During the initial period of institutionalinvestment in real estate, the private debt andequity markets were well developed; but publicequity was restricted to an anemic Real EstateInvestment Trust (REIT) sector, and public realestate debt was limited to the residential mortgagesecondary market. By contrast, an institutionalinvestor accessing real estate markets in 2001 canchoose among a variety of products andinvestment styles in all of the investmentquadrants.

Traditionally, both attractive total returns andportfolio diversification have been importantreasons for investing in real estate. They remainthe most important motivations.

Real estate’s role as a stable producer ofrelatively high and predictable cash yieldsbecomes increasingly attractive with anoverall economic slowdown and return levelsfalling and volatility levels rising in otherasset classes.

Going forward, economic and real estateconditions, along with several underlying andevolving structural trends, offer institutionalinvestors a compelling case for continuing andincreasing allocations to real estate.

Structural ChangesThe late 1990s witnessed a confluence ofstructural trends in the economic, financial, anddemographic environments. Securitizationmandated Wall Street-style informationtransparency and accountability for underwritingand investment management practices for all realestate players, suggesting a faster response tosupply and demand imbalances. Technology hasenhanced access to data, information, and analysis;and has provided underpinnings for evolvingsecuritization and globalization trends in theinvestment arena. Furthermore, the growth oftechnology will force the real estate industry into amore open information environment. As a result,some of the factors that made real estate amanagement-intensive investment will bemitigated.

Market ConditionsMarket conditions change over time, and realestate is not immune. But the case for real estateas part of a diversified portfolio is strengthenedwhen contemporary conditions are contrasted to adecade ago when declining economic indicatorsand excess supply led to very poor real estateperformance. Today, real estate is well positionedto deliver solid performance as well as portfoliodiversification. Most core properties exhibit highcurrent returns, solid multitenant rosters,disciplined borrowing practices, moderate levels ofcompetitive new construction, and attractiverelative pricing. Value enhanced and opportunisticinvestment strategies, while accompanied by

2

INTRODUCTION

increased risk, also benefit from the generallysound fundamentals that define the currentproperty markets in a time of economic flux.

Investment QuadrantsA decade ago, because of lack of available productsin the public markets, virtually all institutionalproperty investment was restricted to either privateequity or private debt. This changed dramaticallyduring the late ’90s, and real estate has developeda track record of excellent performance in allquadrants.

� Private Equity: Equity real estate investmentsoffer very solid returns and exhibit lowcorrelation with other asset classes, whichallows real estate to achieve an enhanced risk-adjusted return in a mixed-asset portfolio.Historically, core real estate has offered totalreturns between 8% and 10%; but in recentyears, returns have exceeded those averages. Inthe stock market, much of the return is basedon appreciation; whereas real estate returnshave a heavy and stable income component.

� Public Equity: REITs, or real estate investmenttrusts, are the public side of equity real estate.REITs provide investors more liquidity thanprivate equity real estate, as well as solid cashreturns and an effective diversification optionin relation to the broader equity market.

� Private Debt: Mortgages or whole loansprovide fixed-income investors an alternativeto Treasuries and corporate bonds. Onaverage, commercial mortgages providespreads over Treasuries ranging between 150and 200 basis points. Commercial mortgageinvesting attracted increased interest asdelinquency and default rates have droppednear historical lows.

� Public Debt: CMBS, or commercial mortgage-backed securities, are commercial real estatemortgage loans that are pooled together andtraded on public markets. Although still afledgling market, CMBS provide solid incomereturns, in addition to more liquidity thanstandard mortgages.

Diversification and its Role for Real EstateBy reducing risk in a well-diversified portfolio, realestate can play an important role in an investmentprogram. Private and public equity real estate havehistorically demonstrated very low correlationswith the broader equity and bond markets. Realestate’s low correlation derives from its nature as aphysical, income-generating asset generallyenjoying multiyear contractual rent streams. Assuch, it is less subject than other asset classes tothe fluctuations of investment markets.

Mortgages and CMBS are more closely tied to theperformance of bonds and other fixed-incomeinstruments. As the overall stock market hasdeclined in recent months, the attribute of lowcorrelations has become increasingly important forportfolio managers.

Recession, Inflation and Real EstateIn the current unstable economic environment,investors and advisors are understandablyconcerned about the viability of an investmentstrategy in either inflationary or recessionaryperiods.

Although institutional real estate is not immune tothe effects of a recession, it is a very stable assetclass that continues to provide cash flows even intimes of economic downturn. Historical data showreal estate performing well during recessions whenoverdevelopment has been absent. In today’schallenging market environment, cyclical declinesin demand are weakening several property sectors,but a reduced supply pipeline in most propertytypes augurs well for a strong rebound when theeconomy rights itself. In short, while not immuneto market fluctuations, real estate is far betterpositioned to weather either an economicslowdown or a recession than was the case adecade ago.

Inflationary threats have been in check over thepast decade, but that does not mean that inflationhas disappeared forever. In inflationary periods,real estate performs very well as a hedge. In

3

addition to being a “real” asset (as opposed to amonetary one) that does not get eaten away byincreases in the CPI, inflation adjustments in leasecontracts offset inflationary impacts.

Modern portfolio theory teaches that aninvestment strategy will, over time, produce thebest risk-adjusted returns if it mirrors the diversityof the underlying economy in which theinvestments are being made. The specific levels ofallocation to different asset classes will vary,depending upon the specific goals of the investor.But the underlying principle of creating a portfoliothat reflects the diversity of the overall economyremains. It is therefore important to understandthe size and nature of real estate investment in theUnited States, so as to determine how, and towhat extent, real estate should be included in aspecific portfolio investment strategy.

As reflected in Figure 1, the entire U.S. investablecapital market was estimated to be approximately$68 trillion as of the end of 1999, althoughsources vary widely. The real estate universe isdifficult to estimate precisely, but it isapproximately $4.3 trillion, or 6.3% of the total

investable universe. The real estate market hasgrown, through a combination of developmentand asset appreciation, by about $1.3 trillion overthe last five years. Of the $4.3 trillion real estateuniverse, about $2.4 trillion is owned by suchnon-institutional sources as government agencies,corporate owners, and individual investors.

Approximately $2 trillion of the total real estateinvestment pie is held by institutions: REITs,savings institutions, commercial banks, insurancecompanies, and pension funds. Institutional equityinvestment is dominated by pension funds andREITs, each with close to 40% of the total $372.7billion investment universe, as shown in Figure 2.Debt is more broadly spread across the variouscategories of institutions, with pension funds stillplaying a minor role (see Figure 3).

Many portfolio strategists contend that amulti-asset investment portfolio shouldrepresent the total investable universe, whichleads to an optimal real estate allocation in arange of 5% to 8%. When an asset allocationstrategy indicates that real estate should beoverweighted, institutional portfolios may have10% to 15%. However, current pension investmentin real estate is very conservative, with the averageallocation to property falling slightly below 4%.

4

FIGURE 1

TOTAL U.S. INVESTMENT UNIVERSEFIGURE 2INSTITUTIONAL REAL ESTATE - EQUITY

REAL ESTATE AND THEINVESTABLE UNIVERSE

U.S. Equity24% REITs

39.3%

LifeCompanies

10.7%

ForeignInvestors

10.5%

Pension Funds38.6%

Commerical Banks0.5%

Savings Associations0.3%

Cash Equivalents4%

Other Equity17%

Other:4%

Japan7%

Dollar Bonds17%

Total Universe = $68.1 Trillion, Year-end 1999 Total Universe = $372.7 Billion, Year-end 2000

OtherBonds13%

Japan Bonds8%

Real Estate($4.3 Trillion)

6%

Emerging EquityMarkets - 2%Emerging BondMarkets - 1%Venture Capital - 0%High YieldBonds - 1%

Sources: UBS Brinson Partners, Rosen Consulting Group Source: Rosen Consulting Group

5

One of the historical difficulties faced by pensionfunds hoping to invest in real estate was thelimited range of investment vehicles. Until the1990s, most real estate investment occurred in theprivate market, as the public debt and equity realestate markets were very small and illiquid (withthe exception of Fannie Mae and Ginnie Mae).Private debt and equity markets were large androbust, but they lacked transparency and providedlittle liquidity — thus requiring significantexpertise on the part of an investor.

In the 1990s, however, active public debt andequity markets supplemented the traditionalprivate modes of property investment. Thedevelopment of Commercial Mortgage BackedSecurities (CMBS) allowed for real estate debtinvestment that could be as varied andsophisticated as investment in corporate bonds. Inaddition, expansion of the modern Real EstateInvestment Trust (REIT) market after 1992enabled institutions to invest in a more liquid andtransparent form of real estate equity.

These developments have placed real estate on anequal footing with other investments in terms ofproduct availability. It is now possible toconstruct a real estate investment program inwhich public and private debt and equity are

all used to further investment goals. In realestate, as in other types of assets, each ofthe quadrants has a specific investmentprofile and a well-defined strategic role.

FIGURE 3INSTITUTIONAL REAL ESTATE - DEBTTotal Universe = $1.68 Trillion, Year-end 2000

CommercialBanks42.1%

Savings Associations9.3%

Life Companies13.0%

REITs0.5%

Other3.3%

Federally RelatedMortgage Pools

4.1%

Pension Funds2.2%

ForeignInvestors

10.6%

Non-Govt.CMBS Issuers

14.8%

Source: Rosen Consulting Group

Private equity commercial real estate represents asubstantial portion of the investable universe, witha market capitalization of approximately $237.2billion. The largest source of private equityinvestment is pension funds, which have investedapproximately $141.9 billion and therefore havecaptured nearly 60% of the institutional qualityreal estate market.

Private equity has been the traditional focus ofmixed-asset portfolios with real estate positions.The private real estate equity market is highlydiverse and consists of numerous product types.An investor can choose among commercial officeproperties, industrial space, retail centers,multifamily communities, or a mixed-assetportfolio with any combination of these products.

Investors also have the option of tapping into themarket at various risk/return levels, ranging fromhigh quality or “core” real estate to higheryielding, but riskier, “value enhanced” and“opportunistic” strategies. The definition of theseinvestment styles varies, but generally correspondsto the following:

Core: Class A office space, super regional malls,new-age industrial research parks, and apartmentcomplexes in high-income neighborhoods allqualify as core real estate. Typically, coreproperties are newer, larger, better located, filledwith higher-credit tenants, and are held free andclear or carry modest debt (under 30%).

Value Enhanced: Properties of any type that canbe developed, redeveloped, or repositioned toprovide above-average returns for the propertyclass. Alternatively, core properties with 50% ormore leverage are classified as value enhanced.

Opportunistic: Distressed properties that canproduce exceptional returns under a successful

turn-around strategy — but at the highest levels ofrisk. Leverage averages 80% under this approach.

There is additional real estate investmentopportunity in specialized products such assenior/assisted living communities, health carefacilities, hotel and gaming properties, self-storagewarehouses, land investments, and numerousoverseas real estate vehicles.

Private commercial real estate equityinvestments can take several forms. Assetscan be held individually, in multi-assetportfolios, or through commingled funds.Whatever the vehicle, private equity realestate is a complement to standard debt andequity investing. Investment in real estateoffers opportunities for portfolio managers togain stable returns at reduced levels of risk.In absolute terms, real estate’s returns arelower than stocks’ but at significantly lowerlevels of risk.

6

PRIVATE EQUITY REAL ESTATEPRIVATE EQUITY REAL ESTATETHE CASE FORTHE CASE FOR

FIGURE 4NCREIF RETURNS BY PROPERTY TYPE

10%

12%

8%

6%

4%

2%

0%

-2%

-4%

-6%

-8%

-10%’79 ’81 ’83 ’85 ’87 ’89 ’91 ’93 ’95 ’97 ’99 ’01

RetailOffice

IndustrialMultifamily

Sources: ACLI, Federal Reserve, Rosen Consulting Group

The benchmark for measuring private real estateequity returns is an index compiled by theNational Council of Real Estate InvestmentFiduciaries (NCREIF). The NCREIF indexmeasures the total, unleveraged return forinstitutional grade real estate contained in theportfolios of contributing members, and iteffectively reflects the universe of institutionalgrade private equity real estate (see Figure 4).

Examination of historic risk/return data for boththe S&P 500 and the NCREIF indices shows that,over the last 20 years, the broad equity market hasoffered annual returns of 14.0%, with a standarddeviation (or volatility) of 14.4%. During the sametime period, as reflected in Figure 5, real estate

equity has offered annual returns of about 8.3%,but with a significantly lower volatility of 3.3%.

During the period 1934-2000, as shown inFigure 6, the S&P 500 exhibited negativeannual returns 18 times (over 26% of theyears), compared to only three years (4% ofthe time) of negative returns for real estate.Consequently, although the stock market canbe attractive to “market timers,” it has been amuch less reliable source of returns thanprivate equity real estate. The latter is aslower but steadier investment vehicle.

Over the past five years, as reflected in Figure 7,real estate has shown average annual returns ofabout 12.7%, with an extremely low standarddeviation of 1.4%. On the other hand, equitiesduring this boom period for stocks averaged about18.3%, with a volatility of 16.2%.

Real estate’s low volatility is no surprise. Thecontractual nature of the underlying incomestream contributes to stable earnings and accountsfor the bulk of a real estate investment’s overallreturn. This cash flow, in turn, produces morestable valuations as compared to equities.

In addition to analyzing return data, portfoliomanagers attempt to assess returns in light of theaccompanying risk. One commonly used measureof “risk-adjusted return” is the Sharpe ratio, whichmeasures how much excess return, over a statedyield on cash investments, can be gained for eachadditional “unit” of risk an investor assumes.

During the business cycle that began in the mid1980s, private equity real estate investmentsoffered risk-adjusted returns superior to thoseachieved in the public equities markets. Over thepast 20 years, the Sharpe ratio for private real

7

FIGURE 7RETURNS AND VOLATILITY1996-2000

FIGURE 5REAL ESTATE VS. STOCKS RETURNS

FIGURE 6“UP” AND “DOWN” YEARS FOR REALESTATE, STOCKS AND BONDS: 1934-2000

Sources: NCREIF, Bloomberg, Rosen Consulting Group

15%10%

5%0%

-5%-10%-15%-20%-25%-30% 1 Year 3 Years 5 Years 10 Years 20 Years

period ending 3Q’01

Real Estate

Stocks

Sources: Bailard, Biehl & Kaiser, Inc., Institutional Real Estate, Inc., “WhyPension Funds Should Invest in Real Estate”, 1997 as updated byRosen Consulting Group, 2000

Sources: NCREIF, Bloomberg, Rosen Consulting Group

80

64

3

49

18

51

16

70

60

50

40

30

20

10

0Real Estate Stocks Bonds

Number of YearsUp

Down

Returns Volatility

NCREIF 12.7% 1.4%

S&P 500 18.3% 16.2%

estate was 1.14 — nearly double the Sharpe ratioof 0.67 for the S&P 500. During the last fiveyears, as stock markets soared, real estate’s risk-adjusted return was even more compelling.NCREIF’s five-year Sharpe ratio was 6.13 — morethan seven times higher than that of the S&P 500(0.86) and approximately 13 times greater thanthat of bonds (0.47) (see Figure 8).

Significantly lower risk, coupled with solid returns,makes real estate an especially attractive investmentvehicle for portfolio managers seeking high risk-adjusted returns. In addition, real estate returnsare based on relatively predictable and reliableincome streams from tangible assets, whereas thestrength of returns in the broader equity market isheavily dependent upon price appreciation. Areview of the past 20 years shows that real estateincome returns have averaged about 8.0%, whereasdividend yields for the broader equity market haveaveraged only 3.3%. The five-year income returncomparison is even more favorable: real estateaveraged 8.7%, while the S&P 500 dividend yieldfell to about 1.6%. (As corporations have used cashto buy back stock instead of paying dividends, theyhave raised their stocks’ volatility.)

To summarize, private equity real estateoffers several favorable characteristics:

� Comparatively high risk-adjusted returns.� Comparatively high nominal returns.� An institutional scale market.� Product diversity.� Stability of returns based on contractual

lease payments.� Comparatively low volatility.

Private equity real estate has drawbacks as well. It isrelatively illiquid, which can be especiallytroublesome in declining markets. There are alsodifficulties in accurately assessing market values;and much of the publicly available data about theproperty markets is of uneven quality. These issuesrecessitate an intensive financial managementprofile, which is accompanied by more hands-onasset management requirements than arecustomary in other asset classes (or in public equityreal estate investments for that matter).

Nonetheless, given the performance advantages ofhigh nominal and risk-adjusted returns, as well asthe potential portfolio diversification benefits thatreal estate provides, private equity real estate canbe a compelling addition to a diversified mixed-asset portfolio.

8

FIGURE 8SHARPE RATIOS -REAL ESTATE VS. STOCKS

Sources: NCREIF, Bloomberg, Rosen Consulting Group

876543210

-1-2

5 Years 10 Years 20 Years

periods ending 3Q’01

Real Estate

Stocks

Ratio

The emergence of numerous, large real estateinvestment trusts (REITs) during the 1990screated a viable public equity property market forinstitutional investors. REITs present analternative to private equity investing and canbring a superior level of diversification to mixed-asset allocations. The public REIT universe hasgrown to 158 companies with a marketcapitalization of $140 billion as of mid-year 2001.If we add in the leverage of these REITs, as well asthe value of operating partnership units (non-trading shares taken by the founders when theREITs were formed), today’s REITs control about$275 billion of real estate.

The “Modern REIT Era” began in November1992, with the initial public offering of TaubmanRealty, which was structured to allow privateequity real estate to be placed into a REIT formatwithout immediate tax consequences to theoriginal owners. As other private owners tookadvantage of the REIT structure to enhance theiraccess to capital (see Figure 9), nearly $100 billionof new equity was issued in the REIT marketbetween 1993 and 1998.

The newer REITs are fundamentally differentfrom pre-1992 REITs: they hold higher-qualityreal estate in their portfolios and are typically runby managements with several decades ofexperience in developing, acquiring, and operatingreal estate. Furthermore, the newer REITs aregenerally fully-integrated real estate operatingcompanies and are much larger than theirpredecessors, with average market capitalizationnear the $1 billion level. In 2001, the Standard &Poors listing committee included two REITsin the S&P 500 Index, and placed severalothers in the mid-cap and small-cap S&Pindices. Analysts noted this as a sign of thegroup’s growing acceptance within theinvestment community.

REITs have become attractive to diversifiedportfolio investors for a number of reasons.Technology, plus the oversight and market analysisthat accompany securitization, have increased thetransparency, security, and liquidity of theinvestment vehicle. Public markets and dailypricing provide investors with a liquid asset — andtherefore a more manageable total portfoliobecause real estate investments can be tailored toportfolio goals. The transparency of the REITmarket provides an additional level of investmentsecurity. Yet the underlying physical properties andthe contractual rental streams are real assets thatprovide investors with a high degree of capitalprotection.

REITs offer an unusual total return profile to publicequity investors: very strong dividend payments,plus any appreciation or depreciation. Amongindustry groups, REITs dividend payouts areamong the highest, primarily because a real estatecompany must pay out 90% of its taxable income individends to investors to qualify as a REIT.

9

FIGURE 9EQUITY REIT OFFERING VOLUME

Source: NAREIT

30

’83 ’85 ’87 ’89 ’91 ’93 ’95 ’97 ’99 2Q’01

’01f

25

20

15

10

5

0

$Billions

PUBLIC EQUITY REAL ESTATE: REITSPUBLIC EQUITY REAL ESTATE: REITSTHE CASE FORTHE CASE FOR

To some extent, REITs act as hybrid securities,providing the strong cash flow advantage of bondsalong with an equity’s opportunity for capitalappreciation. REITs have performed well —producing an 11.2% average annual total returnover the past 20 years. In the more relevant post-1992 period, the S&P 500 outperformed REITs;but REIT returns continue to exceed those ofsmall cap stocks, bonds, and international equities.

REITs have been particularly strong performerssince late 1999. As Figure 10 shows, REIT totalreturns rose to 31.0% in 2000, compared to a9.7% contraction for the S&P 500. Positiveperformance continued into 2001, reflecting thestrength of real estate market fundamentals, aswell as a capital flow into REITs from otherweakening equity assets.

As an income vehicle, REITs are especiallyattractive. Over the past 20 years, REIT dividendreturns have averaged 8.3%, compared with only3.3% for the broader S&P 500 Index. Dividendperformance over the last five years, whichcomprise the modern REIT era and featured risingequity valuations, reveals an even greater disparity:REIT dividends averaged 7.4% and the S&P 500averaged 1.6%. As evident in Figure 11’s yieldgraphic, REITs also have a high average cash flowyield of 9.5%. This implies an average dividendpayout ratio of over 70%, which is low by historicstandards and provides comfort as to the safety ofthis important source of investment return.

REIT cash flow yields represent a more than 500-basis-point spread relative to the 10-year Treasurybond. The spread has increased dramatically overthe past three years and remains high, reflectingboth the underlying strength of the real estate

10

FIGURE 12LOW CROSS CORRELATION OF RETURNS OFFERS DIVERSIFICATION BENEFITS

WilshireREIT Wilshire Russell 10-YearIndex 5000 S&P 500 2000 Bond NASDAQ

Wilshire REIT Index 1 0.21 0.19 0.35 0.12 0.03Wilshire 5000 1 0.99 0.93 (0.15) 0.89S&P 500 1 0.89 (0.12) 0.84Russell 2000 1 (0.08) 0.7910-Year Bond 1 (0.23)NASDAQ 1

1Q’93-2Q’01

Sources: Wilshire REIT, Standard & Poor’s, Bloomberg, Federal Reserve, Rosen Consulting Group

FIGURE 11REIT YIELD COMPARISONREIT CASHFLOW YIELD VS. DIVIDEND YIELD

Source: Merrill Lynch

13%12%11%10%

9%8%7%6%

’93 ’94 ’96 ’97 ’98 ’99 ’00 2Q’01’95

Cashflow Yield9.54%

Dividend Yield6.75%

FIGURE 10INVESTMENT PERFORMANCEREITS VS. S&P 500 INDEX

Sources: Standard & Poor’s, NAREIT, Rosen Consulting Group

40%

30%

20%

10%

0%

-10%

-20%’93 ’94 ’95 ’96 ’97 ’98 ’99 ’00 ’01

Total Return Wilshire REIT Index

S&P 500 Index

markets and the valuation gap created whenREITs were overshadowed by competing growth-oriented investments. The valuation gap persiststoday.

Finally, REITs exhibit low correlations withvirtually every other asset class, as reflected inFigures 12 and 13.

In the relatively short history of the modernREIT, they have traded in a range of ±20% of NetAsset Value (NAV) (see Figure 14). Although it isstill too early to make definitive statements, webelieve that market capitalization and NAV willconverge as the market matures and investorsfocus on REIT performance in a variety ofeconomic environments.

Just as with private equity there are drawbacks topublic equity real estate. The market for manyREITs is thin, which limits liquidity. Reporting,while much more transparent than in privateinvestment, is nonetheless bedeviled by difficultiesin defining profitability for a public real estatecompany. And given the prominence of individual

entrepreneurs in leadership positions, there arequestions of governance and alignment of interest.However, most of these issues are diminishing insignificance as the modern REIT era — whichbegan less than a decade ago — becomesestablished. As income becomes more importantto investors in an altered economic climate, REITsdividend yields and low levels of volatility makethem an increasingly attractive investmentalternative.

11

FIGURE 14REIT VALUATIONPREMIUM/DISCOUNT TO UNDERLYINGASSET VALUE

FIGURE 13BETA VS. S&P 500

Sources: Standard & Poor’s, Bloomberg,Rosen Consulting Group

Investment BanksHomebuilding

Computer SoftwareMoney Center Banks

AirlinesComputer Systems

SemiconductorsLong Distance Tele.

Heavy TrucksEntertainment

Soft BeveragesAutomobiles

Machinery-DiversifiedPublishingChemicals

DrugsGold

RailroadsOther-International

Wilshire REIT IndexUtilities (Dow)

0.0 1.60.4 0.8 1.2 2.0

Source: Green Street Advisors

-40%

30%

20%

10%

0%

-10%

-20%

-30%

’94 ’95 ’96 ’97 ’98 ’99 ’00 ’01’93

Commercial mortgages (or whole loans) provideinstitutional investors with the opportunity toaccess real estate from the debt side. As an assetclass, commercial mortgages are an attractivealternative to most fixed-income vehicles. The sizeof the commercial mortgage market is about $1.3trillion, constituting nearly 30% of the entire realestate investable universe. Consequently, itwarrants consideration by portfolio managers.

The largest issuers of commercial whole loans arebanks, life insurance companies, and savingsinstitutions; together they comprise over 50% ofthe capital going into real estate debt markets.

Today’s commercial mortgage products offerinstitutional investors a range of options to matchtheir strategic goals and objectives. In the past, thewhole loan market was characterized by long-termmortgages (ranging from 20 to 30 years) to fit thetypical insurance company’s investment horizon.Contemporary investors have varying time-framerequirements and preferences; and the commercialmortgage market has adapted by developing newproducts. Although long-term mortgages are stillavailable, such borrowers as REITs and

opportunity funds seek the flexibility of shorter-term loans (ranging from 5 to 10 years) and arewilling to pay a premium in the form of a higherinterest rate.

Mortgage loans are collateralized by theunderlying property and therefore have a highlevel of security. In terms of risk profile,commercial mortgages are similar to corporatebonds in that they carry credit or default risk,interest rate risk, and prepayment/reinvestmentrisk. But the nature of the risks is different in areal estate context.

The interest rate risk associated with mortgages issimilar to that of corporate bonds. However, thecredit/default and prepayment risks of mortgagesare decidedly different. Credit risk, which is themost important and is closely tied to the nature ofthe real property securing the loan, has diminishedover the last decade. During the real estate crashof the early 1990s, lenders were punished for lackof discipline, as nearly 7.5% of all loans becamedelinquent and defaults rose to approximately3.5%. Since then, as reflected in Figure 15,heightened levels of lender discipline (resulting inlower loan-to-value ratios) and a healthy real estatemarket have brought delinquencies andforeclosures down to approximately 0.3%, wellbelow historical averages. Although delinquencyrises in periods of economic weakness, the lowerloan-to-value ratios common in today’s propertymarkets will shield lenders from the massiveproblems they faced in the early-1990s.

Yield maintenance features have become virtuallyuniversal in commercial mortgages, and theymitigate repayment risks. Residential mortgagebacked securities (i.e., Ginnie Mae and FannieMae) do not have this feature.

12

FIGURE 15COMMERCIAL MORTGAGEDELINQUENCY RATES

10

8

6

4

2

04Q’90

4Q’91

4Q’92

4Q’93

4Q’94

4Q’95

4Q’96

4Q’97

4Q’98

4Q’99

1Q’00

2Q’00

4Q’00

1Q’01

2Q’01

PercentRetailOffice

IndustrialMultifamily

Sources: ACLI

PRIVATE REAL ESTATE DEBT: MORTGAGESPRIVATE REAL ESTATE DEBT: MORTGAGESTHE CASE FORTHE CASE FOR

In addition to the traditional debt market risks ofdelinquency, default, and prepayment, mortgagelending carries an illiquidity risk not common toother forms of debt. The illiquidity derives fromtwo sources:

1.Whole loans are not traded on any type ofpublic exchange.

2.These debt instruments are tied to real assetsthat are not easily converted to cash.

Paralleling the corporate debt world, returnson commercial mortgage investments, providesolid spreads to comparable term Treasuries.However, mortgage returns are typically higherthan those of bonds of equal credit standingbecause of the illiquidity premium for privatesector real property assets.

Over the past 20 years, credit-loss adjusted averageannual mortgage returns of 10.7% only slightlyexceeded bond market performance of 10.4%.During this time period, the volatility of bothinvestment classes was also very similar. However,over the last five years, returns on mortgages haveaveraged 7.9%, significantly outpacing annualbond returns of about 6.3%.

On a risk-adjusted basis, the performance of bondsand whole loans over a 20-year period are verysimilar; but again, over the past five years, risk-adjusted returns are more favorable for mortgages

than for bonds. Stronger returns and lowervolatility for mortgage investments yield a five-yearSharpe ratio of 1.04, more than double the Sharperatio of 0.47 for bonds (see Figure 16).

Like all private debt instruments, mortgages areprimarily a vehicle for income, and are generallynot held by investors for appreciation. Whetherfixed- or floating-rate, lenders invest in mortgagesfor high coupon rates. Historically, commercialmortgage investing has offered stronger incomeyields than bonds and attractive spreads abovecomparable term Treasuries. The comparison inFigure 17 of the Lehman Government/Creditindex and the Giliberto-Levy Credit Loss Indexsince 1980 reveals that mortgages slightlyoutperformed bonds.

Mortgages had an average annual incomeyield of 9.8%, compared to an 8.7% yield inthe bond market. During the same timeframe, whole loans provided an averagespread of +143 basis points above Treasuryyields. Over the past five years, yields of alldebt instruments have fallen below historicaverages; however, income yields on wholeloans (7.7%) still outpace average annualbond yields of 7.0%. Mortgage spreads toTreasuries have increased substantially inthe past five years, averaging about +173basis points.

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FIGURE 16SHARPE RATIOS -MORTGAGES VS. BONDS

Sources: NCREIF, Bloomberg, Rosen Consulting Group

3.0

2.5

2.0

1.5

1.0

0.5

05 Years 10 Years 20 Years

periods ending 3Q’01Bonds

Mortgages

FIGURE 17MORTGAGES VS. BONDS

Sources: NCREIF, Bloomberg, Rosen Consulting Group

16%

14%

12%

10%

8%

6%

4%

2%

0%5 Years 10 Years 20 Years

periods ending 3Q’01

Bonds

Mortgages

Commercial mortgage backed securities (CMBS)are the most common publicly-traded debtinstrument for real estate investing. CMBS arepools of commercial mortgages that are securitizedinto public investment instruments. From a totalmarket capitalization of only $5.9 billion in 1990,CMBS had grown into a $213.7 billion market asof mid-2001, representing almost 15% of the realestate debt universe. More important, with annualdomestic issuance now exceeding $70 billion, asseen in Figure 18, CMBS represent over one thirdof all new institutional real estate loans.

Investment in CMBS offers portfolio managersand lenders an alternative source of fixedincome — one that complements bondholdings. CMBS provide a spectrum of riskand return investment alternatives, healthyspreads to Treasuries, and returns somewhathigher than similarly rated corporate bonds.Furthermore, the underlying asset behindCMBS is collateralized debt/mortgages, whichalso reduces investors risk.

Relative to other asset classes, the CMBS market isstill in its infancy — to the point that we cannoteven analyze its performance over one completebusiness cycle. The asset class will mature asincreasing amounts of data become available,

removing uncertainty and leading to morepredictable cash flows. Collaterally, this willenhance the efficiency and liquidity of the market,resulting in a more stable spread to Treasuries andcorporate bonds.

Similar to corporate bonds, CMBS instruments areclassified in tranches. CMBS with a rating of BBBor higher are the “investment-grade” classes thatcarry the highest level of default protection. In theevent of loan defaults, investment-grade investorsare the last to lose cash flow. However, the lowerthe risk premium, the lower the rate of return.“High-yield” CMBS carry ratings of BB or lowerand, consequently, receive higher premiums thaninvestment-grade CMBS because they assumehigher default risk (see Figure 19).

CMBS performance is measured by the LehmanBrothers CMBS Index. Because CMBS are debtinvestments, capital gains are generally small andare largely affected by swings in interest rates.

Because CMBS is relatively new, we do not havemuch historical data to analyze. But what we dohave is suggestive.

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FIGURE 19PRICING SPREADCOMMERCIAL MORTGAGE RATE VS. 10-YEAR T-BOND

Sources: John B. Levy & Co., Federal Reserve

300

250

200

150

100

50

0’83 ’85 ’87 ’89 ’91 ’93 ’95 ’97 ’99 ’01

Basis Points

PUBLIC REAL ESTATE DEBT: CMBSPUBLIC REAL ESTATE DEBT: CMBSTHE CASE FORTHE CASE FOR

FIGURE 18GROSS ISSUANCE OF DOMESTIC CMBS

Source: Commercial Mortgage Alert

80

20

10

0

70

60

50

40

30

’80s ’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 ’00 ’01f

$ Billions

Since 1997, CMBS returns have outperformedboth Treasuries and corporate bonds. The averageannual return for investment-grade CMBS was7.1%, while the Lehman Government/CreditBond index exhibited a 6.2% return. Volatility wasalmost identical for both asset classes (4.1% and4.2%), resulting in a higher Sharpe Ratio (risk-adjusted return) of 1.04 for CMBS investments,compared with 0.8 for bonds for the four-yearperiod (see Figure 20).

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FIGURE 20SHARPE RATIO - CMBS

Sources: John B. Levy & Co., Federal Reserve

0

0.5

1.0

1.5

2.0

2.5

3.0

1 Year 3 Years 4 Years

CMBS

Bonds

periods ending 3Q’01

Relative to other asset classes, real estateoffers strong income returns and moderatecapital appreciation at low risk levels.Examination of return correlations amongasset classes reveals that real estateoperates quite independently of theperformance of other investments. Thus, realestate can serve as a powerful diversificationand risk reduction tool to enhance aportfolio’s risk-adjusted return.

Independence of real estate returns is evident in thecorrelation coefficients matrix in Figure 12. A highcorrelation indicates that the return of one asset isclosely related to the return of another, separateasset. Private real estate equity exhibits an extremelylow correlation with both stocks and bonds. Thecorrelation coefficient of private equity real estateand the broader equity market is -0.08, while thecoefficient of real estate and bonds is 0.01.Essentially, there is almost no correlation or parallelbetween the return performance of non-real estateinvestments and private equity real estate.

From the standpoint of a portfolio manager seekingto enhance risk-adjusted returns, this is extremelyattractive. Investing in assets that do not exhibit thesame pattern of performance effectively reduces risk.The non-correlation of real estate to these otherinvestment vehicles is inherent in the nature of realestate. Private equity real estate is an illiquidphysical asset with a generally medium-term leaseprofile. Therefore, the returns are very stable. Onthe other hand, equities and fixed-incomeinvestments are financial instruments that can betraded in public markets and are, therefore,inherently more volatile.

Private equity real estate can also be an effectivetool in achieving an efficient frontier at a higherlevel of risk-adjusted return. Using an optimizer,

as Figure 21 illustrates, a portfolio with noallocation to real estate over the last five years hasa lower efficient frontier than a portfolio thatincludes real estate. Because real estate offers solidreturns at significantly reduced levels of risk, thedifferential between the two frontiers is greatest inthe preference range for risk-averse investment.

Public equity, or REIT, returns also exhibit verylow correlations to stocks and bonds. Thecorrelation coefficient of REIT returns to thebroader equity market is 0.35, higher than that ofprivate real estate but still relatively low. In thepost-1993 or modern REIT era, this correlationcoefficient is even lower (0.20). Compared withdifferent classes of equities in the modern REITperiod, REITs have even lower correlations(NASDAQ: 0.06, international stocks: 0.13).Because of their high dividend yields, REITs alsoexhibit very low volatility relative to themovement of the broader equity market. REITshave the second lowest Beta of all industry groups,relative to the stock market.

In simpler terms, for every percentage pointmovement in the S&P, an investor can expect a1.43% movement in semiconductor equityinvestments. Conversely, an investor would expect

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FIGURE 21EFFICIENT INVESTMENT FRONTIERS

Sources: Wilshire Associates, Standard & Poors, NCREIF, Lehman Bros.,Federal Reserve, Rosen Consulting Group

THE ROLE OF REAL ESTATE INPORTFOLIO DIVERSIFICATIONTHE ROLE OF REAL ESTATE IN�PORTFOLIO DIVERSIFICATION

20%

18%

16%

14%

12%

10%

8%10 2 3 4 5 6 7 8 9 10 11 12 14 15 1613

Portfolio with Real Estate

Portfolio without Real Estate

only a 0.35% movement in REIT values. This isattractive to investors seeking to diversify a publicquadrant equity allocation mix, especially after aperiod in which the stock market was hammeredwhile REIT returns soared.

On real estate’s debt side, historical data revealstrong correlations with the bond market — forboth private mortgages (0.86) and publicly tradedCMBS (0.94). Mortgage and CMBS returns havepatterned the bond market because both publicand private commercial real estate loans have allthe risk premiums of bonds built into theirpricing, with the exception of real estate-specificpremiums. Nonetheless, real estate debtinvestments provide an effective tool fordiversifying fixed-income allocations because theunderlying asset and source of income aredifferent from other bond instruments.

A Portfolio With and Without Real EstateThe benefits of real estate diversification in amixed-asset portfolio can be illustrated bycomparing two sample portfolios. Both portfoliosrepresent the actual performance for the five-yearperiod ending in the fourth quarter of 2000. Theportfolio with a 20% position in real estate exhibitsslightly higher returns and reduced volatility (seeFigure 21).

In terms of risk-adjusted returns, the portfoliowithout real estate has a Sharpe ratio of 1.28, whilethe portfolio with real estate has a lower Sharperatio of 1.10. Over time, the portfolio with realestate has a greater probability of achieving itstarget returns with lower volatility from year to year.

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Recession and Real EstateReal estate, as we have seen, is a stableasset class with very low correlations toother types of investments and is thereforea useful tool in diversifying away risk. In anenvironment of plummeting stock valuesand declining interest rates, real estate isparticularly attractive, because it is a steady,income-generating asset class withsignificantly lower volatility than manyother investments.

Real estate is not immune to the negative impactsof an economic slowdown, but its inherentcharacteristics can help to provide a durableincome stream during a period of low economicgrowth. Real estate returns are supported by leasecontracts that continue to generate a steady sourceof income from tenants during downturns. Theseleases generally have a duration of 3 to 10 years(except for apartments). In a slow economy,companies look to cut expenses in numerousdifferent ways (layoffs, lower operating expenses,subleasing excess space, etc.) before attempting toterminate existing office or retail leases.

In-place commercial leases generally carrymultitenant institutional properties through adownturn, with the major threat to incomecoming from releasing risk. Apartments, althoughthey generally have one year leases, are the moststable property type because, in any economicclimate, people continue to pay rent on theirresidences.

All asset classes are affected by economicdownturns. However, compared with equity andfixed-income investments, the history of real estateas an asset class illustrates that it very rarely hasyears in which the overall yielding negative. Themost thorough study of the subject shows that

there have only been three years in which realestate has posted negative annual returns since1934. In percentage terms, real estate returns werenegative only 4.5% of the time. During the sameperiod, stocks and bonds exhibited negativeannual returns 17 and 16 times, respectively —approximately 25% of the time. With this verysmall probability that annual returns will benegative, real estate is appealing to risk-averseinvestors.

Inflation and Real EstateInflation is of less concern now than at any point inthe past 25 years. Proactive management by theFederal Reserve Board has put a tight lid ondomestic inflationary pressures. Internationally,inflationary pressures have subsided in mostindustrialized nations, reducing external economicthreats. However, too much liquidity, an overheatedrecovery, or some other currently unrecognizedfactor could restore inflationary fears despite theFederal Reserve’s recent success in this area.

Should inflation return, we would expect realestate to perform well as a hedge against risingprices. During the last period of unusually highinflation (1978-1981), real estate returnsconsistently exceeded inflation. One of the mainreasons for this is that real estate is a physical assetthat does not change much over time, whereasmonetary instruments lose value as inflation rises.

On a microeconomic level, most contemporaryoffice and retail leases contain periodic rental rateadjustments for inflation (in sharp contrast tothose signed in the early 1990s). Apartment leases,with annual renewals, also have upward priceelasticity. These factors help to ensure cash flowdurability from individual properties of all types.Finally, many property owners structure their leaseportfolios so that contracts expire on a rolling

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CONCLUSION:CONCLUSION:REAL ESTATE IN A SLOWINGREAL ESTATE IN A SLOWINGECONOMIC ENVIRONMENTECONOMIC ENVIRONMENT

basis, thus improving their ability of achievingmarket rents over time. These strategies, which arecommon throughout the industry, ensure that rentincreases will show up periodically in a building’scash flow, while cushioning the investment fromthe negative effects of any drop in market rent.

ConclusionThe case for real estate can be made from severalperspectives.

� First and foremost, real estate provides —in each of the investment quadrants —competitive nominal returns and superiorrisk-adjusted returns.

� It also works well as a tool to diversifymixed-asset portfolios, especially thosewith low to medium risk targets.

� It provides significant protection againstinflation in most cases, and its leasestructure provides for relatively stablecash flow yields.

� As real estate’s total return relies veryheavily on these cash flows, its volatilityis relatively low.

� And, as the industry has matured, it hasopened up investment opportunities thatare relatively liquid and increasinglytransparent.

For all of these reasons, real estate merits theportfolio manager’s attention.

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