REIT time, REIT place
Could emerging allocation trends and changes to public-market indices help create greater allocations to listed real estate companies? Christopher O’Dea reports
Less than a year ago, listed real estate was given its own classification among public-market indices, meaning the performance profile of REITs could be seen more clearly, separate from financial stocks. The question remains whether listed property companies will see greater investment as a result.
At the same time, recent listed real estate searches by US pension funds suggest an increased focus on using public-market managers in a more strategic manner. Liquid, listed property shares have often been used to gain exposure to property markets while private-market managers are evaluated for potential capital commitments.
But it may be time for investors to revisit that allocation process, and when allocation decision are based on the investment attributes specific to public and private implementation methods, managers say, the public option may offer the best of both worlds, affording access to the long-term cash flows of property in a transparent and liquid format.
“The listed market now has a track record that extends back 10 to 15 years, which investors can touch and assess, including the benefits of listed property relative to private vehicles,” says Collin Bell, managing director and client portfolio manager in the fundamental equity team at Goldman Sachs Asset Management (GSAM). “We have a data history that provides enough integrity to conduct an analysis and come to a fairly conclusive argument for including listed property in a diversified portfolio,” Bell adds. “In our opinion, the maturity of the listed market has hit an inflection point where the trend towards institutional use of listed property is likely going to continue to increase.”
While private equity vehicles can give investors more control over specific investments, and tend to be better-suited to opportunistic strategies, Bell says the primary reason interest in private property has continued to outpace listed companies is the perception that REITs are more like equities than real property.
That view is validated by short-term data which shows REITs historically exhibit equity-like volatility and a high correlation to equity markets not found in the private property market. This has led many investors to conclude that securitising a pool of real estate assets fundamentally changes its investment attributes. But GSAM’s fundamental equity team argues that “we believe that this conclusion is misplaced.”
The major finding, says Bell, is that when listed and private property are compared on an apples-to-apples basis – adjusting for leverage, frequency of pricing, and sector composition, and using a long-term timeframe consistent with property investment horizons – listed property outcomes are similar to direct private investments, and distinct from those of broader equity assets.
Volatility is a clear illustration. If the NCREIF Property Index (NPI), a benchmark for private US property, is adjusted to include the effects of leverage, for example, the volatility jumps from 11% to 17%. “Pretty darn similar,” says Bell, to the 18.5% volatility of listed property. Short-term market swings can cause REIT prices to deviate from fundamental value, but over a 10-year period, GSAM concludes, property investors assume similar capital risk whether they own listed or private vehicles. “We think investors are slowly beginning to understand that a lot of the concern about volatility is more illusory than reality,” Bell says.
The classification of property as a distinct sector reflects that view, and by attracting more generalist investors to property, REIT investing has evolved. REITs are increasingly being analysed as companies rather than just collections of assets. Management teams, balance sheets and relative valuations take on greater importance in that analysis.
Fundamental analysis and security selection are hallmarks of the investment process at Cohen & Steers, which pioneered investing in diversified portfolios of listed property companies. They include assessment of cyclical and secular demand factors that affect operating income and capital values.
In the US, REITs historically have tended to trade over the long term at a modest premium to the net-asset value (NAV) of their property holdings, says Evan Serton, a senior vice-president at Cohen & Steers. “Investors typically have been willing to pay a bit of a premium to get both strong growth prospects and sound company management and corporate governance,” he says. “One of the attractive features of owning commercial real estate through a REIT is that investors do not have to be experts in property management. You are relying on the REIT manager to do that, and a small premium to NAV is consistent with that.”
In the US, REITs “have done an excellent job of restoring their balance sheets to health since the financial crisis, and the equity recapitalisations Cohen & Steers has invested in over the past eight years have been part of that effort,” Serton says. Some companies that now have loan-to-value ratios of about 35% have reduced leverage from as high as 65% 10 years ago. “These companies are now better positioned to finance their businesses, even as we expect rates to rise modestly over the next few years,” he says.
Funds investing in listed property companies also offer convenient access to a range of sectors, which can provide institutional clients with additional potential opportunities to economic growth. Cohen & Steers is overweight data centres, for example, a property sector appearing to benefit from growing secular demand for cloud-computing services, as well as cyclical increases in capital spending.
“Data centres are highly specialised properties that corporations are using to migrate their IT operations to the cloud,” says Serton. “We have seen outsized demand for those capabilities, and very strong cash-flow growth from the companies that own these assets.” And despite data centre share prices performing strongly since 2016, “we continue to be overweight this sector”, he says.
The best news for pension investors might be that listed property is trading at attractive valuation levels. At the end of April, REITs were trading at a 4-5% discount to NAV, below the sector’s average premium of 2% to 3%, according to Lazard Asset Management.
The discount could be an opportunity to get in front of the $248bn, according to Preqin, earmarked for investment in property.
That could drive nearly $500bn of total transaction value power when 50% leverage is included, according to GSAM. “To the extent REITs trade at a discount, we may see more REIT privatisations,” GSAM says, “especially given the amount of capital raised in the private market.”