A growing number of institutional investors are combining REIT portfolios with their non-listed real estate investments. Christine Senior explores the opportunities that arise from such an approach

While many institutional real estate investors eschew listed property securities, rejecting them as an equity investments rather than a pure real estate play, others have embraced them. For the latter, real estate investment trusts (REITs) and other forms of listed property have earned their place as a complement to private, non-listed markets, offering liquidity in an otherwise illiquid asset class, and providing access to markets that otherwise would be out of reach.

As the size of the listed market increases, there are increasing opportunities for investors. Figures from the European Public Real Estate Association (EPRA) put the value of the global market at $2.44trn (€1.69trn) at the end of July 2011, more than double the $1.06trn recorded in December 2005. The total number of listed real estate companies now stands at 3,630.

Listed real estate securities are gradually gaining ground among investors. It's not only small institutions that use listed securities to gain diversified access to a portfolio of global real estate in an easily accessible way, but also larger investors that are putting REITs to work in a variety of ways in their portfolios.

According to Marc Halle, senior portfolio manager and global head at Pramerica, average allocations have climbed significantly over the past four or five years. "The numbers are starting to increase as the history and tenure of these companies increase," he says. "People are looking at it as a new market, with the attitude: ‘let's see how it goes.' You see many institutional investors increasing their allocations."

REITs are proving increasingly popular, especially among US institutional investors, as a diversification tool. They provide a means for investors to step out of the comfort zone of their domestic markets and acquire a global allocation in a relatively simple and efficient way.

"We have seen an evolution," says Joseph Harvey, president and CIO at Cohen & Steers. "Initially, US institutions may have had a US REIT portfolio that some did allocate to a separate international portfolio. But we find they have now combined the two to end up with a global portfolio. The vast majority of new allocations and mandates we are seeing are for global."

As many institutions use both listed and unlisted vehicles for investment, the debate continues around the optimal allocation. US endowments and foundations have been more proactive in allocating to REITs, with an average allocation of close to one-third of their overall real estate portfolios, compared with an average of around 5% for public and corporate pension funds in the US, according to Cohen & Steers.

"If you look at the return data, you would say they should have allocated a substantial part of their portfolio, probably more than 50%, to the public market," says Harvey. "Endowments and foundations are closer to the right answer."

Meanwhile, research from RREEF produced a somewhat different optimal split, which recommended allocating one-third to real estate securities, more in line with the actual investment of US endowments and foundations referred to above.

John Hammond, RREEF's head of European real estate securities, says: "By combining a portfolio of direct assets and securities, because of slightly different risk and return characteristics of each, you end up with better risk-adjusted returns for each unit of risk you take."

Combining listed with non-listed
Institutions that have a foot in both the listed and unlisted camp have been able to benefit from the arbitrage opportunities. Differences in pricing between the two provide opportunities, although the illiquidity of the private market can prove to be an obstacle. Daily market prices from stock exchanges take account of investors' views of future market direction, while valuations in the unlisted market are based on external appraisals and always have a time lag.

Hans Op‘t Veld, head of listed real estate at Dutch pension fund PGGM, says this is one of the advantages of using both listed and non-listed in an institutional real estate portfolio. The pricing differential was particularly evident during the global financial crisis.

"You saw real estate securities starting to go down quite rapidly quite early on because there is liquidity and the pricing mechanism is fairly efficient, but it takes time to feed into private real estate pricing," says Op‘t Veld. "And while the listed market was in the early stages of recovery, we saw private real estate markets still adjusting to price levels. If you combine those two it dampens the movement. That's quite a nice characteristic if you are trying to provide stability of returns in the total portfolio of an institutional investor. That is key."

Another arbitrage opportunity lies in allocating more or less to whichever side looks the most attractive. PGGM's real estate team keep track on a quarterly basis of where relative prices are going.

"We see whether valuations in one market are different from valuations in the other market and we are trying to get comfortable with levels that would provide us with opportunities to reallocate capital from one into the other," says Op‘t Veld. "There is some liquidity in the property share market but, if you want to overweight private real estate, that's hard to do because of the illiquidity. There are ways around that from distribution and natural growth in portfolios and through the derivatives market though that is still in its infancy."

The REITs market has profited from the spectacular rebound in the equity markets from the depths of March 2009. More recently it returned to more stable levels. According to figures from EPRA, over the 12 months ending in July 2011, the FTSE EPRA/NAREIT developed global index showed returns of 11.1% globally (in euro terms), made up of 19.9% for Europe, 4.6% for Asia and 13.5% for North America. REIT prices were looking expensive at this point, although this was soon corrected by falls across global equity markets in August.

As examples of how listed and unlisted real estate can fit together in an institutional portfolio, the two large Dutch pension fund asset managers, APG and PGGM, have built up some years of experience, but each operates in a different way.

APG runs two different real estate pools, one investing tactically, solely in real estate securities with the objective of beating relative return benchmarks. The second pool takes a strategic long-term view, and is invested both through larger stakes in listed companies and stakes in non-listed companies, funds and joint ventures. The division between the listed and non-listed is currently around 50/50, but this breakdown is not set in stone.

APG's real estate investment strategy uses a fully integrated approach to listed and non-listed, which brings increased opportunities, according to Patrick Kanters, global head of real estate. He singles out shopping centres as an example. "On average the better quality large-scale regional shopping centres are held by listed companies. By having this integrated approach we are able to select the companies that have the higher quality shopping centres. Otherwise you would limit yourself to non-listed funds and their ownership."

APG's investment process uses separate teams. In each region one team focuses on listed real estate and another looks at non-listed, but their combined approach gives a broad view of the market. "There are no Chinese walls between the teams," says Kanters. "Listed markets are often a good indication of what will happen in non-listed. The slightly different approach of the two teams is highly valuable for us to build up and also sell positions."

Investing in listed real estate companies has enabled APG to build relationships that have in some cases led to fruitful co-investment deals. The Westfield shopping centre in East London is an example. Westfield has a 50% stake in the mall, and APG, as a large investor in the listed company, has co-invested, taking a 25% stake, alongside the Canadian pension fund CPPIB.

PGGM takes a different stance in managing its €13bn real estate portfolio, which is split roughly equally into listed and unlisted. The two portfolios are now managed independently, although before 2008 they had been run as one department. The reason for the split was the different investment processes for each.

But the two teams adopt a collaborative approach. "It's important to emphasise we spend a lot of time together," says Op‘t Veld. "Ultimately it's real estate. We invest in the same market; we share market information with each other. If you add both teams' experience together, you get a lot of data. We benefit from what [Guido Verhoef, head of private real estate] and his team see on the listed side and vice versa. Our strategy is quite similar."

In the listed sphere, Op‘t Veld's starting point is the FTSE EPRA NAREIT benchmark. Verhoef also considers the global universe, roughly splitting his global allocation 40% to Europe, 30% to the US and 30% to Asia.

Verhoef says the advantage of non-listed is the ability to customise a product through a joint venture if no ideal product exists. "If you want to make investment in Asia or generally the emerging markets, the size of PGGM and the team we have offers a lot of opportunity to customise our product," he says. "Focusing on recent developments in China, if we, say, are interested in investing in core retail in China, then if we can't find a product we look for a partner and create the product ourselves through a joint venture or as a leading investor in one of the funds we set up with local fund partners."

The two-pronged approach obviously allows the two sides to complement each other's capabilities. Where there are gaps on the listed side, unlisted can plug that, and vice versa. The listed side is the easiest way to get exposure to regional malls in the US, while the unlisted side offers access to China and India where the listed markets for real estate are still at an early evolutionary stage.

And what of performance? Obviously in the short term the volatility of the listed market plays a part but, over the longer term, that works itself out and performance of the two sides comes into line. "When you look at returns it's nice to have a portfolio that works on both sides, because we can compare," says Op‘t Veld. "Performance comes in different ways, but ultimately it's the same return, because ultimately you are invested in the same assets."