Download REITs and Real Estate

Fall 2014
TIAA-CREF Asset Management
REITs and Real Estate:
Complementary through good times and bad
TIAA-CREF
Global Real Estate
Strategy & Research
Martha Peyton, Ph.D.
Managing Director
Thomas Park
Senior Director
Fabiana Lotito
Senior Director
In this paper, we re-affirm that REITs and real estate function in a
complementary fashion in investment portfolios. Using data through
mid-2014, our analysis shows that investor portfolios that contain both
REITs and real estate have enjoyed higher return, higher risk-adjusted
return, and lower volatility than portfolios comprised of a traditional
60% stock/40% bond mix.
REITs and Real Estate — the backstory
Commercial real estate has reported stellar returns following the real estate downturn of
2008–09. Following returns of 13% in 2010 and 14% in 2011, NCREIF Property Index (NPI)
returns have since settled into a range of 10–11%. Similarly, FTSE-NAREIT All Equity returns
have been healthy, with the index standing 23% above its January 2007 peak as of July 2014.
Commercial real estate investment is inherently more complicated than investing in stocks
and bonds. The direct purchase and ownership of commercial real estate properties is
perhaps the most common approach utilized by investors, but this requires an experienced
staff to both acquire and manage properties and property portfolios. It also requires the
financial wherewithal to invest the large sums that high-quality commercial real estate
properties command. Additional funds for capital improvements, tenant improvements and
leasing commissions are also required on a regular basis. For many investors, real estate
equity funds provide a more efficient investment vehicle as they create economies of scale
through pooling of investors’ capital to create diversified property portfolios with professional
portfolio and property management. The popularity of this approach is demonstrated by an
investment queue of an estimated $110 billion in committed capital waiting to be deployed
in closed-end funds focused on North America as of mid-year 2014.1
Commercial real estate can also be accessed indirectly via public market Real Estate
Investment Trust stocks (REITs). REITs are public companies that are required by the U.S.
tax code to hold most (75%) of their assets in commercial property, to generate most (75%)
of their revenue from property rents, and to return most (90%) of that income to investors in
dividends. According to the National Association of Real Estate Investment Trusts (NAREIT),
there were 202 REITs registered to trade on major U.S. stock markets at year-end 2013 with
$670 billion in market value.2
REITs and Real Estate: Complementary through good times and bad
Our results show that
REITs and direct real
estate are complements
rather than substitutes.
Investment researchers have produced an extensive body of work over the last two decades
examining the respective characteristics and performances of REITs versus direct property
investment. Their conclusions can be summarized into three major points:
WW REITs
have higher returns on average than direct real estate, albeit with higher volatility;
WW Differences
in return and volatility can be reconciled by adjusting for the differences in
pricing mechanisms and trading processes, liquidity, leverage, and investment fees to
show that REITs are indeed “real estate” investments;
WW Because
of different pricing processes and leverage levels, REITs and direct real estate
returns are not perfectly correlated and thereby offer diversification benefits for portfolios
that contain allocations to both.
In the following pages, we review the performance of REITs and direct real estate over
the long term. Using this information, we show the benefit of having both in investment
portfolios of stocks and bonds. Our results show that REITs and direct real estate should
be viewed as complements rather than substitutes. These results remain consistent with
the findings in our 2005 paper and 2007 and 2012 updates.3
Looking at the data
We start our analysis in 1993 in order to capture “the modern REIT era” which was
fueled by a surge in equity REIT IPOs following the introduction of new ‘UPREIT’ regulations.
REIT equity market capitalization more than doubled from a mere $11 billion in 1992 to
$26 billion in 1993, then doubled again to $50 billion in 1995, bringing it into line with
the aggregate $48 billion of property owned by NCREIF members at that time. Today,
as of mid-2014, the FTSE NAREIT All Equity market capitalization is nearly $610 billion,
while NCREIF-member properties are valued at $383 billion.
Exhibit 1: Year-end market value
Dollars in billions
W NAREIT All Equity W NCREIF
700
600
500
400
300
200
100
0
92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10
11 12 13
2
REITs and Real Estate: Complementary through good times and bad
Since 1993 and through mid-2014, REITs have posted an average annual total return of
11.3% based on the FTSE NAREIT All Equity index. By comparison, direct real estate returns
have averaged 9.0% based on the NPI. However, REITs’ higher returns were accompanied by
volatility which was more than four times higher than for direct real estate as measured by
the standard deviation in quarterly returns.4
Exhibit 2: Total return
Quarterly, 1993Q1 to 2014Q2
W NAREIT All Equity W NCREIF
40%
30
20
10
TR, %
REITs are in fact stocks
and their returns and
volatility differ from
commercial real estate
performance.
0
-10
-20
-30
-40
93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14
REITs are in fact stocks by virtue of being listed and traded on the public markets.
Consequently, their returns and volatility differ from those of directly owned commercial
real estate. As Exhibit 2 shows, the quarterly pattern of REIT returns does not resemble
the quarterly pattern of direct real estate returns. With this said, it is not necessarily obvious
that REITs are real estate nor that they are complementary with direct real estate investment.
Yet, REITs are real estate at their most basic level, simply because real property is the
ultimate source of REIT cash flows. The REIT structure is an ownership and operating
construct wrapped around properties that might otherwise be directly held in the
portfolios of institutional investors. But, at the same time, the REIT structure brings
with it pricing mechanisms, corporate governance considerations, liquidity features, and
leverage characteristics that are different from directly owned real estate. These features,
in turn, contribute to the differences in the return and risk profiles of REITs and real estate.
Researchers have analyzed these differences in minute detail, adjusting both REIT and
property investment returns to achieve comparability, and have concluded that REITs are
essentially real estate.5 But, for investors, the differences should not be ignored because
they have an impact on returns and risk.
3
REITs and Real Estate: Complementary through good times and bad
The different pricing
mechanisms explain a
great deal of the
difference in volatility
between REIT and direct
real estate performance.
Pricing, trading, liquidity, transaction costs, leverage and
investment management fees
The most important difference between REITs and direct real estate is in the mechanisms
through which both are priced and traded. As stocks, REITs are priced and traded daily via
the public stock markets. Investors can conduct detailed analyses of REIT corporate and
financial filings with the SEC which are augmented by analyses of private sector stock
analysts. Like all stock prices, REIT prices incorporate a forward-looking component which
reflects the expectations and sentiment of market participants regarding the quality and
value of each REIT’s property portfolio, balance sheet strength, the quality of management,
the size and quality of the development pipeline, and overall investment strategy.
In contrast, detailed real time pricing information is not so readily available for direct real
estate. After properties are sold, prices are ultimately leaked to or reported to market
participants, but pricing details may not be available until several months after a transaction
has closed. Real Capital Analytics, for example, reports property transactions as details
become available which are then updated and summarized in various quarterly publications.
Like REIT prices, property pricing incorporates a forward looking component reflecting
investors’ views on anticipated rent growth, leasing velocity, tenant retention, and property
expense management. Since transactions are negotiated privately based on confidential
information provided by prospective sellers, there will often be significant differences of
opinion with respect to value among prospective buyers.
To track value changes of portfolios of existing properties, institutional investors rely most
commonly on the appreciation component of NCREIF performance indexes. NCREIF members
submit periodic property values based on internal or independent external appraisals.6
Appraisers apply a consistent valuation methodology and incorporate recent sales of
comparable buildings, recent leasing activity at the subject property and comparable
properties, the current economic and interest rate environment, and the like. The appraiser’s
“opinion of value”, while typically well-reasoned and well-documented, incorporates various
assumptions and subjective assessments such that appraised values can ultimately differ
from the prices willing buyers would pay. Whereas REITs shares are priced and sold daily
with tight bid/ask spreads, direct real estate is sold irregularly with pricing remaining both
opaque and comparatively subjective.
The second important difference between REITs and direct real estate is liquidity. As publicly
traded stocks, REITs are enormously more liquid than direct property. They are priced and
traded contemporaneously via the major stock exchanges thereby providing access to the
deep pool of active buyers and sellers, which in turn enables investors to incur very low
transactions costs. The liquidity of individual REIT stocks will of course vary depending on
company characteristics including size, index membership, and analyst coverage but even
the most illiquid REIT stocks have very modest transactions costs. Direct real estate, on the
other hand, is comparatively illiquid. Acquiring a property involves time for underwriting,
property inspections, and other due diligence activities while selling requires 30–45 days
for marketing and another 45–60 days at a minimum to close a transaction. With respect
to transactions costs, hard costs for both buyers and sellers can add to significant sums
and have a measurable impact on investment returns, especially compared with the minimal
costs of buying and selling REIT shares. Investors in real estate funds have relatively more
liquidity if their holdings are in an open-end fund though that liquidity requires lead time
and is subject to the fund managers’ capacity to accommodate it. In difficult markets, fund
managers might need to slow liquidity if property transactions are sluggish resulting in “exit
queues.” Investors in closed-end funds are locked in for an explicitly defined holding period.
4
REITs and Real Estate: Complementary through good times and bad
Leverage and its effect on return performance is the third big difference between REITs
and direct real estate. As of September 2014, REITs carry leverage ranging from a low of
33% for apartment REITs to a high of 40% for industrial and office REITs.7 By comparison,
direct investors in real property can decide exactly how much leverage to assume and when
to add leverage. While mortgage loans of 65–75% of estimated market value are typically
available for high-quality property, institutional investors are currently opting for leverage
of 50–60% in order to obtain the most favorable interest rates. For real estate open-end
funds with diversified core strategies (i.e, NCREIF’s ODCE Index), overall fund level leverage
is much more constrained, hovering in the low 20% range thus far in 2014. ODCE funds
typically specify maximum leverage limits in their investment strategy documents, both
for individual properties and for the fund as a whole. While REIT returns incorporate the
effects of leverage, direct real estate performance as reported in the commonly cited
NPI does not. NPI returns are calculated on a de-leveraged basis and reported as such.
But, more and more, investors are now closely tracking NCREIF’s ODCE Fund Index, which
unlike the property level NPI index, is comprised of fund level returns.8 Consequently, the
ODCE index includes the effects of leverage on fund return performance. While the ODCE
helps to eliminate the existence of leverage as a difference between REITs and real estate,
levels of leverage remain a differentiator.
Finally, investment management fees and costs differ between REITs, direct real estate,
and real estate funds. REIT funds typically charge management fees of 50–75 basis points.
Managers of core real estate funds typically charge management fees of a minimum of
100 basis points and often more. Direct real estate investment costs are in-line with
the latter due to the overhead costs associated with the investment professionals and
resources necessary to purchase and manage commercial property. Both NAREIT and NPI
returns are reported before investment management fees. ODCE returns are reported both
net and gross of fees. As a result, comparisons of investment performance need also take
into account differences in associated investment management fees.
REITS and Real Estate in investment portfolios
But what role can REITs and real estate play in an investment portfolio? Thus far, we
have explained that both REITs and real estate generate returns from property ownership
and that differences in returns and volatility are due to differences in pricing and trading
mechanisms, liquidity, leverage and fees. Because of these differences, REITs and direct
real estate fill different roles in investment portfolios.
REITs and direct real
estate play different
roles in portfolios.
In the exercise shown in Exhibit 3 below, we compare the hypothetical returns of various
combinations of stocks, bonds, REITs and real estate. We focus on a five year investment
horizon beginning in the second quarter of 1997 and ending with the second quarter of
2014. Five year rolling returns were calculated for the extended period in order to account
for the relative illiquidity of commercial real estate.9 We also assume that each asset type
is held in a fund structure with the relevant investment management fees.
The starting point for our analysis is a traditional 60% stock/40% bond investment portfolio
which generated a 6.71% return on average over the covered period. With a return volatility
of 6.21%, the risk-adjusted return ratio is 1.08. The portfolio’s risk-adjusted return ratio
of 1.08 indicates that the portfolio generated 1.08 basis points of return for each basis
point of volatility. (The risk-adjusted return ratio is the average return divided by the average
volatility.) If 20% of the portfolio’s investment in stocks and bonds is allocated to direct
real estate, the portfolio’s average return increases to 6.80% and average volatility drops
to 5.46%. As a result of the higher average return and lower average risk, the risk-adjusted
return ratio increases to 1.24. An allocation to commercial real estate therefore generates
5
REITs and Real Estate: Complementary through good times and bad
1.24 basis points of return for each basis point of volatility. Alternatively, we could invest
this 20% of the portfolio in REITs, and if we do, the portfolio’s average return increases
to 7.35% while the volatility rises to 5.62%. Though portfolios with a 20% REIT allocation
have higher risk than portfolios with 20% direct real estate, portfolio volatility is still lower
than the 6.21% volatility associated with a standard 60% stock/40% bond allocation. The
risk-adjusted return ratio for a 20% REIT portfolio is also higher at 1.31 vs. the 1.08 stock/
bond portfolio.
Exhibit 3
7.4%
F: Stocks, Bonds & REITs only
Expected return (%)
7.3
E
7.2
7.1
D
7.0
C, D, E: Stocks, Bonds, R.E. & REITs
C
6.9
6.8
A: Stocks & Bonds only
B: Stocks, Bonds & R.E. only
6.7
6.6
5.4%
5.5
5.6
5.7
5.8
5.9
Expected risk (%)
6.0
6.1
6.2
6.3
Stocks &
Bonds
Add
R.E. only
A
B
C
D
E
F
Real Estate Open-End Funds
0
20
15
10
5
0
REITs
0
0
5
10
15
20
Stocks
60
48
48
48
48
48
Bonds
40
32
32
32
32
32
Expected Return
6.71
6.80
6.94
7.07
7.21
7.35
Standard Deviation
6.21
5.46
5.48
5.51
5.56
5.62
Risk-Adjusted Return Ratio*
1.08
1.24
1.27
1.28
1.30
1.31
*
Stocks/Bonds/Real Estate/REITs
Add
REITs only
Expected return divided by standard deviation.
When we allow the 20% allocation to vary between REITs and real estate, portfolios can be
created along a frontier.10 The frontier shows that every allocation to REITs and real estate
creates a portfolio with a higher return, lower volatility, and higher return per unit of risk than
the basic 60% stock/40% bond portfolio. The average return and risk associated with a simple
stock/bond portfolio as shown by the square at the lower right hand portion of Exhibit 3 differs
significantly from those of portfolios with real estate and REITs by a sizeable margin.
6
REITs and Real Estate: Complementary through good times and bad
REITs and real estate
work together in
portfolios to diversify
stock and bond
performance and to
diversify each other.
The bottom line for investors
REITs and real estate work together in portfolios to diversify stock and bond performance
and to diversify each other. Even though REITs and real estate are both essentially real
estate, the differences in pricing mechanism, trading processes and leverage create
different return and volatility characteristics that contribute to their mutual diversifying
power. Timing is also an important component of this diversifying power. Specifically,
REIT performance commonly leads direct real estate performance because public stock
markets are relatively more responsive to shifts in expectations and sentiment.11
Exhibit 4: Total return, REITs and Real Estate
2006
2007
2008
2009
2010
2011
2012
2013
35.1%
-15.7%
-37.7%
28.0%
27.9%
8.3%
19.7%
2.9%
16.3%
16.0%
-10.0%
-29.8%
16.4%
16.0%
10.9%
13.9%
NAREIT
All Equity REITs
NCREIF
ODCE Index
The ‘lead’ of REITs was clear during the last cycle downturn, as shown in the exhibit above.
The REIT market turned negative in 2007 as the financial crisis began. Real estate openend fund performance was quite strong in 2007 before turning negative the following year.
Similarly, REITs produced a strong rebound in 2009 when direct real estate performance
nose-dived before rebounding in 2010. The higher leverage in REITs intensified both the
downturn and recovery in REITs relative to direct real estate. While the lead and lag
relationship of REITs and real estate has held up, it has been muted in more recent years.
In particular, direct real estate investors do not expect that REITs’ tepid 2013 returns
portend considerably weaker ODCE results in 2014, especially given that first half results
are on par with results in the first half of 2013. First half results for ODCE equate to an 11%
return on an annualized basis, only marginally weaker than 2013 as a whole.
The most recent return data for stocks, bonds, REITs and real estate confirm that the
conclusions of our earlier work in 2005, 2007, and 2012 remain intact: REITs and real
estate function in a complementary fashion through good times and bad. Investors benefit
from maintaining investment allocations to both over the long term.
7
REITs and Real Estate: Complementary through good times and bad
Notes
Preqin Real Estate Spotlight, Volume 8, Issue 6, July 2014.
The total here refers to equity and mortgage REITs. This analysis in this paper focuses on equity REITs due to their
comparability with direct real estate investments.
3
Peyton, M.S., T. Park and F. Badillo, “REITs and Directly Owned Real Estate: A Perfect Pair,” TIAA-CREF, Summer 2005.
Peyton, M.S., T. Park and F. Lotito, “REITs and Real Estate: A Perfect Pair,” TIAA-CREF, Summer 2007.
Peyton, M., T. Park and F. Lotito, “REITs and Real Estate: Complementary through the cycle,” TIAA-CREF, Summer 2012.
4
Direct real estate performance is reported by NCREIF on a quarterly basis. While REIT returns are available daily, REIT
performance is calculated on a quarterly basis for comparability.
5
Clayton, J. and G. MacKinnon, “The Time-Varying Nature of the Link Between, REIT, Real Estate and Financial Returns,”
Journal of Real Estate Portfolio Management, 2001, Vol. 7, No. 1, pp. 43–55.
Oikarinen E., M. Hoesli and C. Serrano, “The Long-Run Dynamics between Direct and Securitized Real Estate,” Journal of Real
Estate Research, 2011, Vol. 33, No 1, pp. 73–104.
Pagliari J., K. Scherer and T. Monopoli, “Public Versus Private Real Estate Equities: A More Refined, Long-Term Comparison,”
Real Estate Economics, 2005, Vol. 33, No. 1, pp. 147–187.
Ling, D., “Returns, Volatility, and Information Transmission Dynamics in Public and Private Real Estate Markets,” NAREIT Real
Estate Research Conference, June 2013.
6
Quarterly appraisals are now required by NCREIF but were not consistently submitted in the past. Because appraisal
frequency changed markedly in late 2008 when contributors were motivated by the unfolding recession to appraise more
frequently, the quarterly performance history reported by NCREIF prior to 2008 is imperfect. Analysts commonly either
“de-smooth” the quarterly data or utilize four-quarter moving averages or annual data. Both methods correct some of the
judgmental dampening of volatility that naturally occurs when appraisers update individual property values. These are
necessary before direct property values can be compared to the property values implied in REIT stock prices. The different
pricing mechanisms explain a great deal of the difference in volatility between REIT and direct real estate performance.
7
Source: Green Street Advisors, Real Estate Securities Monthly, September 2, 2014.
8
Open-end Diversified Core Equity (ODCE) Fund managers also submit property level data which is included with non-ODCE
submitters’ property level data in the calculation of the NCREIF Property Index (NPI).
9
Our first data point, 2Q 1997, is an annual average covering the periods 3Q 1992 through 2Q 1997 and our last data point
covers 3Q 2009 through 2Q 2014. As a result, our data series of expected returns are derived from annual returns ending
in the second quarter of each year from 1997 to 2014. Each year is equal to the annualized five-year average of quarterly
total returns for each asset class so that our start date of 1997 actually incorporates returns back to the start of the ‘modern
REIT era’ as described on page 3. The standard deviation is calculated from that same annual data series. Expected returns
are net of management fees which are assumed to be 75 basis points for stocks and REITs, and 35 basis points for bonds.
Direct real estate is represented by the NCREIF-ODCE net of fees, which are about 100+ bps lower than the ODCE gross
of fees returns, REITs by the FTSE NAREIT All Equity index, stocks by the S&P 500, and bonds by the Barclay’s Capital U.S.
Aggregate Bond index. The longer-term horizon as described above flattens the volatility of all four asset types and most
notably reduces the relative volatility of REITs versus direct real estate.
10
Notably, an allocation to REITs of up to 5% is consistent with the findings of “REITs, Private Equity Real Estate and the
Blended Portfolio,” National Association of Real Estate Investment Trusts, February 2011, which examined a portfolio
containing only real estate and REITs with REIT allocations of 9% to 30%. Our results align when the real estate-REIT
combination is assumed to comprise 20% of the total portfolio.
11
The correlation of calendar year REIT and ODCE returns over the 1993–2013 period was very low at 0.07. The correlation
increases considerably to 0.73 when REIT returns are lagged by a year, or in other words, when REIT returns lead ODCE.
1
2
TIAA-CREF Asset Management provides investment advice and portfolio management services to the TIAA-CREF
group of companies through the following entities: Teachers Advisors, Inc., TIAA-CREF Investment Management,
LLC, TIAA-CREF Alternatives Advisors, LLC and Teachers Insurance and Annuity Association® (TIAA®). TIAA-CREF
Alternatives Advisors, LLC is a registered investment advisor and wholly owned subsidiary of Teachers Insurance
and Annuity Association (TIAA).
This material has been prepared by and represents the views of Martha Peyton, and does not reflect the views
of any TIAA-CREF affiliate. These views may change in response to changing economic and market conditions.
Any projections included in this material are for real estate sectors only, and do not reflect the experience of any
product or service offered by TIAA-CREF.
Please note real estate investments are subject to various risks, including fluctuations in property values, higher
expenses or lower income than expected, and potential environmental problems and liability.
The material is for informational purposes only and should not be regarded as a recommendation or an offer to
buy or sell any product or service to which this information may relate. Certain products and services may not be
available to all entities or persons. Past performance does not guarantee future results.
© 2014 Teachers Insurance and Annuity Association of America-College Retirement Equities Fund (TIAA-CREF),
730 Third Avenue, New York, NY 10017
C19907
184925_480401
(12/14)