REITs: The missing ingredient for a holistic real estate allocation
By Daniel Greenberger, Greg Kuhl, & Suny Park/Janus Henderson Investors
In recent years, institutional investors have turned to a range of private investments – equity, debt and real estate - in search of higher returns. However, while private equities and debt have outperformed their listed counterparts for the past 20 years, the same cannot be said in real estate. REITs, as represented by the FTSE NAREIT All Equity Index (the NAREIT Index) have outpaced the CREIF ODCE (Open-End Diversified Core Equity) Index by 2.4% per year (on a gross basis) for the 20 years ended 31 December 2019. Our research indicates greater cash flow growth from specialty property sectors, which are, by definition, absent from private funds, primarily explains the historical outperformance of REITs.
Key Takeaways
- Since the turn of the century, REITs have delivered low double-digit annualized returns;
- REITs offer unique access to ’non-core’ property types with superior cash flow growth prospects and daily liquidity;
- Many private funds concentrate their investments in retail and office, yesteryear’s bellwether properties now subject to oversupply, increasing operating challenges and excessive amounts of required capital investments.
REITs Produce the Returns of Their Underlying Properties
“REITs behave too much like equities” is one of the oldest criticisms of REITs and implies that private funds behave differently; however, the difference in relationships of REITs and private funds to listed equities is entirely due to the differences in timing and frequency of valuations. An independent study by CEM Benchmarking Inc. (CBI) examining real estate returns of over 200 U.S. pension funds revealed REITs and private funds exhibit over 90% correlation, once private fund returns are restated to more accurately reflect the timing of changes in property valuations. Any perceptions that private funds provide for a lower risk approach, and are not subject to market gyrations, is entirely due to a long reporting lag. This was evident during the Global Financial Crisis. For the pension plans analyzed by CBI, REITs experienced a sharp sell-off of 38% in 2008. Private funds suffered the same 38% loss; however, it was reported over a two-year period, publishing a modest loss of 8% in 2008 before reporting a much larger 30% loss in 2009, as shown in Exhibit 1A.
Exhibit 1A: CBI As-Reported Private Real Estate Fund Performance
Once private fund returns are standardized, they exhibit a much higher correlation with REITs, as shown in Exhibit 1B.
Exhibit 1B: CBI Standardized Private Real Estate Fund Performance
Growth of Specialty Property Sectors – An Important Return Driver for REITs
The listed REIT sector was early to embrace specialty property sectors - self-storage, cell towers, data centers, single tenant net lease, and manufactured housing – which has been an important driver of the return differential between REITs and private funds. As shown in Exhibit 2A, as of 30 September 2019, non-core property sectors were noticeably absent from the NCREIF Property Index (NPI), whereas, they accounted for 58% of the Nareit Index. And as shown in Exhibit 2B, non-core sectors have grown from 26% in October 1999 to 58% in September 2019 of the Nareit index.
Exhibit 2A: Comparative Sector Allocation - Nareit Index vs. NPI
Exhibit 2B: Nareit Index Sector Allocation - October 1999 vs. September 2019
Due to their differentiated operating platforms and the granularity of their individual property holdings, in our opinion, specialty property types are more commonly found in, and better suited to, the listed market. By their very nature, investments in specialty property types tend not to be compatible with the structure and cadence of private equity capital raising, investment, and distribution of capital.
We expect non-core specialty sectors to continue to outpace core sectors due to higher initial unlevered yields, demand-driven higher secular growth leading to landlord pricing power, and generally lower recurring capital expenditures supportive of higher free cash flow growth. As private real estate managers find it more difficult to expediently deploy capital in specialty property types, institutional investors not allocating to listed REITs risk missing the potential outperformance associated with investing in these more favorably positioned sub-sectors of the real estate market.
Opportunities Amidst an Uncertain Economic Environment
We take a long-term view of the opportunities that exist in the Global REITs market, but can’t ignore the recent market downturn and the threat that the Coronavirus outbreak has to long term economic growth. We share some perspectives below:- REITs offer three key elements - Dividends, Diversification and Defensive Growth. We think these characteristics are currently priced at GFC levels and reflect an attractive basis. Investors do need to be active and selective, so they can benefit from long term structural and technological tailwinds. A focus on the sustainability of underlying income streams and balance sheet strength is needed to avoid REITs that will suffer more during an economic slowdown. When compared to their unlisted brethren, REITs also tend to employ lower leverage levels versus private opportunity and value-add funds.
- REITs entered the COVID-19 crisis with their strongest, most liquid balance sheets in their history. Real estate fundamentals in some sectors will be disproportionately impacted by tenants’ inability to meet near term rental obligations. This should be most acute across retail and hotels properties. REITs in other areas including industrial and many specialty sectors will find themselves more insulated. Volatility creates opportunity: The daily liquidity of REITs, an important asset allocation and risk management tool not generally available to private real estate managers, allows for opportunistic repositioning of portfolios as stock prices and property market fundamentals change.
Conclusion
REITs have delivered low double-digit net-of-fee returns since the turn of the century and can access growth opportunities in specialty property sectors. Moreover, secular headwinds facing core sectors such as retail and office strongly suggest more private property write-downs are waiting in the wings. Despite a steadily growing market, REITs have been a forgotten asset class among institutional investors. If the past 20 years of listed real estate experience is any guide, it behooves institutional investors to reassess REITs as a strategic return-enhancing asset class deserving of their attention. Our advice is not to supplant but rather to supplement a private real estate allocation with a REIT allocation because, in our opinion, the latter will not only offer institutional investors more complete exposure to all real estate sectors but may improve risk-adjusted returns of their overall real estate allocations.
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