REITs are increasingly being cast as a complement to non-listed property rather than an outright replacement. Rachel Fixsen looks at how to create an optimal blend

Around the world, real estate investment trust (REIT) markets are maturing.
The advantages of these listed property vehicles are clear: they are liquid, can give broad diversification, and are accessible to the smallest of investors. And for larger investors, REITs are often a supplement to direct property holdings.

But for investors seeking to blend REITs and direct property, what is the best mix between the two?

Dutch pension asset manager APG sees listed and non-listed investments as interchangeable and complementary to each other within a real estate portfolio. "It gives an investor the opportunity to get exposure to real estate, irrespective of the way it is structured," says Patrick Kanters, global head of real estate at the organisation, which manages €275bn on behalf of collective pension schemes.

APG has a pool in which it combines both listed and non-listed investments. Rather than having a pre-conceived idea of what the split should be, the manager takes a systematic approach to decide how it gets the exposure it is after. "We determine how our ideal real estate portfolio should look and assess what kind of real estate exposure we need to add to achieve this ideal portfolio," Kanters explains.

"Subsequently, we will assess how we can get this exposure and what kind of alternatives we have. Finally, we will compare and contrast the different investments. These investments will be compared on quality of assets, management track record, governance and pricing, irrespective whether they are listed or non-listed.

"We have a roughly 50-50 split in our portfolio, with a 20% bandwidth to cater for differences in pricing cycles. In the short to mid term, this split provides some diversification benefits. In the long term, however, risk-return characteristics are comparable and diversification benefits will therefore decline."

There are certain moments in the cycle when it can be more efficient to increase the exposure towards listed investments, he says. On the other hand, if the team judges the listed sector to be overpriced, given its better liquidity, it can decrease the exposure towards the listed investments.

New York-based real estate investment firm Cohen & Steers argues that investors should channel more of their property assets into listed investments. "We believe that pension funds that want a broad allocation to real estate should use a balanced approach to investing in listed and direct property," says Joseph Harvey, CIO of Cohen & Steers.

Having assessed different property investments, Cohen & Steers has found that listed and opportunistic private real estate can offer attractive long-term results, although in the past, returns of core and value-added real estate fund returns have been less compelling.

Over the past 15 years, listed REITs have outperformed core and value-added funds at least 73% of the time over all time periods, according to the research (see table). But compared with opportunistic funds over the past 15 years, REITs outperformed just 27% of the time.

On top of this, Cohen & Steers says cycles for REITs and opportunistic funds have been out of phase, giving opportunities for "complementary diversification benefits" between the two strategies. "In our view, traditional real estate allocation models have a tendency to systematically over-allocate to direct real estate, based on commonly held misconceptions that private real estate is not volatile and that listed REITs are much more volatile than private real estate," Harvey says.

The perception that REITs show higher risk stems from the short-term volatility related to liquid securities markets, even though real estate is considered a long-term investment,
he says.

But using standard deviation of monthly or quarterly returns to capture the risk of an asset class is fundamentally flawed, Harvey argues, and this methodology will lead to an over-allocation to private real estate. He says this is because REIT returns are based on short-term market-clearing prices and direct real estate returns are measured by a long-term appraisal-based methodology that can take months or even years - if ever - for values to be accurately reflected in the data.

Cohen & Steers contends that REITs could be a significant portion of a pension fund's core property exposure. The instruments are cheaper and perform better than core non-listed funds over the long term, it argues. This could, the firm suggests, be complemented by higher-returning value-add and opportunistic non-listed funds, depending on the needs of the pension.

APG's Kanter agrees that certain REITs are more cost-efficient due to size. But the extent to which an institution should invest in them depends on the kind of exposure it wants to add, he says.

"Certain property sectors or types of properties are difficult to obtain through the listed sector and therefore you will have to focus on the non-listed investments to get this exposure and vice versa."

But overall, value-add or opportunistic types of investments are more difficult to come by in the listed sector, Kanters remarks. "So if investors want to add some opportunistic exposure, they have to turn to non-listed investments."

Kanters sees other advantages in mixing the two types of property vehicles. "An additional benefit of combining listed and non-listed is that in our experience it has enabled our group to capitalise on the interchange of the broad capital market and real estate market intelligence," he says. "Also, non-listed investment opportunities have been created through our long-term listed company relationships."

Cohen & Steers also points out that since the listed market tends to lead the direct market, it can give useful information for decisions on tactically increasing or decreasing direct property weights, or timing strategic allocations.

Simon Hedger, senior portfolio manager at Principal Global Investors, says that, in practice, some property investors choose only direct holdings, while others mix this with listed vehicles such as REITs. But there are some clear advantages for investors at any level in channelling at least some of their property exposure through listed vehicles.
"Trying to buy into the direct real estate market has a high unit cost, and it is also illiquid," Hedger says.

For investors or pension funds with only €50m to €100m to invest in property, their assets will only buy a handful - or maybe only one - of decent property. Added to this are the substantial costs involved in buying buildings directly, including stamp duty and agents' fees.

"Once you're locked in, even in a good market it will take you three months to sell. But with listed property, the costs of getting exposure are minimal in comparison," Hedger says. "This is likely to be around 1% as opposed to 10%, and investing a similar amount through a property securities fund will give global listed exposure to diversify risk."

While some big institutional investors in the UK are property owners on a grand scale, it does require them to invest in in-house teams to run those properties. "Some of the big pension funds do invest directly and run such departments, but research shows that the longer you're invested, the more the returns blend between direct and listed real estate, and then match the underlying market," Hedger says. If this is the case, he argues, then the more efficient option of holding property exposure in the form of listed vehicles such as REITs makes more sense, depending on the risk-return profile of the investor.

"The trend over time has been towards using property securities, in place of direct," he says. "Some have exited altogether and have gone down the listed route. Some institutions use the listed portfolio as the liquid part of their real estate, using this part to make adjustments to their exposure."

REITs have been perceived as higher risk than direct property investment because of greater volatility of returns, plus the listed companies' use of debt to leverage returns. But Hedger says their level of gearing has come down substantially since 2007, and now stands at around 40% on average. Volatility, too, is reducing and the yield from the sector is becoming more attractive, relative to equities.

"There is definitely a lower appetite for risk by investors, as a result of the recent turmoil in financial markets," he says. "Appetite is increasing for real estate exposure again, because of its favourable risk-return profile compared to other investment sectors.

"Since the start of the turmoil, a number of listed real estate groups have strengthened their balance sheets and reduced the amount of gearing they use," Hedger says. "Research has questioned how much value gearing adds to returns over the long-term. Good management and good quality assets typically generates better performance and thus it has been shown that higher gearing is not so necessary."

Pension funds have been increasing their appetite for real estate steadily over the last couple of years, he notes. "We've noticed this trend over the last year or two, after the initial correction in valuations following the credit crisis hit in 2009. Major financial cities like London, New York, Singapore and Hong Kong are quite in favour at the moment, as they are seen as safe havens," he observes.

At Henderson Global Investors, head of property Patrick Sumner says the optimal split between listed and non-listed depends on various factors: whether the investor wants the sort of geographical and sector diversification offered by the listed sector; whether it can tolerate the volatility; whether it minds the leverage; what its income requirements are, and so on.

"The UK is somewhat unusual in that its institutions, if they hold listed real estate at all, do so as part of their equities portfolio," he observes. "Only in the US, the Netherlands and Australia do institutions regards REITs as proxy for direct investment, and their allocations to listed are, I would estimate, not more than 10% of their overall real estate exposure."

The UK REIT regime came into being five years ago, and following the conversion of existing listed property companies into the new vehicles and the launch of some start up REITs, there were 24 UK REITs as at December 2011, according to data from Deloitte.

But the US REITs market has been going for much longer. The first REITs were created in the early 1960s, although there have been numerous changes to the rules governing them since then. "In the US, REITs have been around long enough and have sufficient size and liquidity to have gained a degree of acceptance," Sumner notes.

"In the Netherlands and Australia the large scale of the pension funds, relative to that of their domestic real estate markets, have led institutions to look overseas, and they have found over time that the listed sector offers opportunities that are more attractive than unlisted options."

Although listed property investments have the advantage of being liquid and allow investors to spread their risk broadly, direct property can allow investors to create value for themselves through good business management, Henderson Global Investors argues in a research paper.

By treating a property investment as a business, an investor is not at the mercy of the markets as with liquid ‘paper' investments. Instead, the property owners have the direct control they need to turn a real estate holding around, even in worst market conditions.

"Landlords, for example, can seek innovative ways to retain and find tenants in economic downturns or perhaps time refurbishments to take advantage of periods when good quality property is in short supply. With retail in particular, owners of shopping centres have endless possibilities to re-gear the mix of retailers in line with the economic climate, popular fashion trends or changes in the local demographics," the manager says.

But whatever the benefits of creating a certain mix of listed and unlisted property, in some countries regulations do not allow an easy blending of the two types within one investment class.

Stefan Wundrak, Henderson Global Investors' director of research, property, points out that German institutional investments, for example, are usually required by law to put listed real estate in the equity allocation.

Their target for direct real estate allocations is therefore almost separate to their possible listed holdings, he says, but adds that this might change with the wave of new European regulations under way.