Quick Bio: David Ling is the McGurn Professor of Real Estate in the Warrington College of Business at the University of Florida. During his 24-year academic career, he has authored or co-authored two textbooks and more than 75 papers on a variety of real estate topics, including returns in both REIT and private real estate markets and the design of commercial real estate return indexes.

By Brad Case

Portfolio: You've researched how commercial property values are determined in markets that are illiquid and found that investor sentiment plays a prominent role, even after accounting for fundamentals. Are we likely to see something similar to the late 1980s and early 1990s, when REIT returns recovered after just 14 months, but losses in direct real estate lingered for more than five years?

Ling: It is very difficult to predict because investor sentiment cannot be explained by the information they have available to them when making valuation or investment decisions. That makes investor sentiment even more difficult to predict than the fundamentals. Nevertheless, I would expect that REITs will lead the recovery in commercial real estate markets.

However, this is complicated by the fact that investors often lump REITs into the small-to-mid cap "value" category—and this can have a major effect on REIT returns. So, as real estate markets and investor sentiment improve, we will have to keep one eye on the property markets and one eye on the stock market.

Portfolio: You studied dedicated REIT mutual funds and found that capital flows into the funds respond to prior-period REIT returns and have a short-term effect on current-period REIT returns. The future, though, looks to be one in which individual investors increasingly access REITs through target-date funds and other asset-allocation products. Is that scenario likely to dampen whatever REIT volatility comes from return-chasing behavior by mutual fund investors?

Ling: That is correct. "We have found that current investor sentiment in a property type or other market sector is determined in large part by returns in that sector over the recent past—even though past returns tend actually to be poor predictors of future performance." To the extent that target-date funds and other asset-allocation products reduce return-chasing behavior, we should observe less sentiment-induced investing and, therefore, less volatility in REIT returns.

Portfolio: You've argued that indexes such as the NCREIF Property Index are based on property value appraisals, rather than transactions, and are inadequate for research purposes. You also developed a new index methodology, which estimated that the true volatility of privately held real estate is roughly twice as high as the level measured by the NCREIF Index. What sorts of mistakes are investors likely to make when they use appraisal-based indexes?

Ling: Although the NCREIF Index is an invaluable tool for the U.S. real estate investment industry, in some respects its construction is not optimized for either the portfolio management function or the benchmarking/performance evaluation function. However, the gap between the reality and the ideal is arguably greatest on the portfolio management side. This is because portfolio allocation decisions, both formal and informal, require estimates of the "own-asset" return volatility of private commercial real estate and its correlation with the returns on other assets potentially includable in the portfolio.

Such volatilities and correlations, at least on a historical basis, are readily available for publicly traded REITs. Unfortunately, for private markets, it is difficult to accurately measure even historical volatilities and correlations. Thus, it is very difficult to make informed portfolio allocation decisions with respect to privately-traded commercial real estate.

Portfolio: You have found that a diversification strategy of randomly allocating investment capital across property types and metropolitan statistical areas (MSAs) is likely to be as effective as an investment strategy that relies on return forecasts aggregated to the MSA level. Do you think it's possible that REIT managers simply have better return-predicting ability than direct real estate investment managers and advisors?

Ling: The implications of the research we have undertaken to date are clear: private market investors should not focus on predictions of rents, property values, and returns at the national or MSA level as there is no evidence of which I am aware that managers and advisors can consistently pick winners and losers among the MSAs and aggregate property types.

As you note, REITs have generally produced superior returns relative to private market investments, but we expect superior returns to come with additional risk or volatility. Because it's difficult to measure volatility in real estate, it is not clear that REITs have consistently produced far superior returns on a risk-adjusted basis.

In short, I can't point to a body of evidence that clearly suggests REIT managers have better return-predicting ability than direct real estate investment managers and advisors.

Portfolio: In a study of the return performance of listed property companies in 28 countries, you found evidence of a strong world-wide real estate return factor. However, your research found country-specific real estate factors, suggesting that there are still international diversification opportunities in real estate. How should a global investor put together a real estate allocation?

Ling: Until index products are more widely available for commercial real estate investors, I recommend, both nationally and internationally, a top-down, diversification oriented approach to individual asset selection.

Diversification is a powerful tool for increasing the risk-adjusted returns of portfolios. And, in the absence of predictable returns and/or stable return correlations, a simple diversification strategy may be preferable to a strategic allocation strategy. In addition to pursuing an effective top-down diversification strategy, I recommend investors focus on specifics, including the analysis of the immediate market area, due diligence and underwriting, and negotiations. In short, I recommend investors focus on both big picture diversification issues and effective deal execution.

Portfolio: Are REITs part of your investment portfolio?

Ling: Indeed. I believe strongly in the power of diversification and have for many years practiced what I preach. In fact, our investment portfolio is overweighted in commercial real estate, including REITs. I wish I could tell you I had the foresight to reduce our REIT allocation in early 2007, but I did not. However, after a tough June, the third quarter in 2008 is off to a good start.