REITs Will Benefit From 'Becoming a More Mature Asset Class'

Includes: ICF, IYR, REZ, VNQ
by: Brad Case

Institutional Investor -- one of the most influential voices among pension funds, investment consultants, and others in the institutional investment community -- published a very well written article by Judy Ward called "Public, Private Real Estate Split the Best Shot at Lowering Risk." The article focuses on analysis that I did (and wrote about at using actual historical returns to show that pension funds and other institutional investors could have both increased returns and reduced volatility in their real estate portfolios if they did dramatically more of their real estate investing through publicly traded REITs.

The average pension fund real estate portfolio is allocated only about 9% to publicly traded REITs, but optimally constructed portfolios should have more like one-third allocated to REITs in order to benefit both from diversification (the lead-lag relationship between the public and private sides of the real estate market) and from the fact that REITs post dramatically stronger performance than private real estate investments, even when the private managers use much more leverage to goose up their returns. (You can see the difference and explore different portfolio combinations with the Real Estate Portfolio Optimizer here.)

The analysis isn't directly applicable to individual investors, for whom it's hard to find any good reason to invest in private real estate given its inferior performance and extreme illiquidity. The reason that the Institutional Investor article is important to individual investors is that pension funds in the U.S. total around $5 trillion in assets, which means that any broad shift in their investment patterns is likely to have a significant impact on relative returns among different assets. For example, if the average pension fund invests 7% in the real estate asset class, and shifts the REIT portion of that from 9% to 33% of the real estate portfolio, that would amount to something like $84 million of new money being invested in publicly traded REITs. (Separately, Morningstar has found several times that the real estate asset class should amount to something more like 20% of an overall pension fund portfolio, which would imply a much bigger shift.)

The article quotes Anatole Pevnev of The Townsend Group, perhaps the leading investment consultant for institutional investors focused exclusively on real estate portfolios:

Despite the fact that REITs have been around since the early 60s, it is only in the past 10 years that we have had the depth in the market that pension funds need. It is just becoming a more mature asset class.

That maturation means that pension funds are finding it easier to invest in REITs to take advantage of their better returns and low correlation, both with their private real estate holdings and with their stock portfolios.

If pension funds continue to move toward greater real estate investing through publicly traded REITs--even if that movement is gradual--then that suggests a long-term disequilibrium in which demand for REIT stocks increases ahead of supply, driving up returns.

REITs already have an advantage over private real estate investors in the form of greater access to capital--both equity and debt--on more favorable terms, but if pension funds move toward more REIT investing then that advantage is likely to become more pronounced. Personally, I think it's likely that the last 20 years have been merely the first two decades of what is probably a four- or five-decade disequilibrium, and that may be part of the reason that long-term returns for REITs have actually been significantly better than long-term returns for the rest of the stock market. (Average returns over the last 20 years: 12.0% per year for equity REITs compared to just 8.8% for the S&P 500 and 10.0% for the Russell 2000)

An asset shift like that doesn't mean that every month (or quarter, or year) will be positive -- there will still be real estate market cycles -- but for long-term investors it can amount to a lot of money even if there's only a slight advantage every year.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I am long Vanguard REIT Index Fund and ING Global Real Estate Fund.

Disclaimer: The opinions expressed in this post are my own and do not necessarily reflect those of the National Association of Real Estate Investment Trusts ((NAREIT)). Neither I nor NAREIT are acting as an investment advisor, investment fiduciary, broker, dealer or other market participant, nor is any offer or solicitation to buy or sell any security investment being made. This information is solely educational in nature and not intended to serve as the primary basis for any investment decision.