What is the relationship between REITs and the underlying markets? Does trading on public markets mean REITs have different investment characteristics to direct or fund-based investments in real estate? Greg MacKinnon sheds some light

Investors continue to debate the merits of REITs and private real estate and their places in a portfolio. To compare the characteristics of REITs and private real estate in the US, PREA Research used a transaction-based index of private real estate and the FTSE/NAREIT Index, each reweighted to have the same property-type breakdown and with private real estate adjusted for the average fees faced by a US investor in an open-end fund. The results of a direct comparison are not, perhaps, surprising. Even using a transaction-based index, which will have higher volatility than the more common appraisal based indices, the volatility of unlevered private real estate on a quarterly basis is substantially lower than that of REITs. REITs, however, provide significantly higher returns on average, outperforming private property by 159bps a year since 1994.

So REITs have exhibited both higher return and higher volatility through time. How do these two balance out on a risk-adjusted basis? Consider an investment in private real estate financed partially with debt; gearing the investment has the effect of raising both the average return and the volatility. As shown, based on their historical performance a diversified private real estate investment with an LTV of 68.5% would have had the same volatility as a diversified REIT portfolio. A comparison of returns on these equivalent volatility portfolios depends on the rate paid on debt; if private real estate could be financed at less than 6.84% per annum (1.67% per quarter) then private real estate would have outperformed REITs on a risk-adjusted basis.

But, no matter how the results stack up, is this type of direct, head-to-head comparison really the question of interest? It is really the role of an asset class within an overall portfolio that matters to investors, not how that asset class would perform on its own. Further, a direct comparison might not really be fair in the sense that we are comparing two different things. As figure 2 shows, the correlation between REITs and private real estate is quite low on a quarterly basis; REITs have a stronger relationship to equity, corporate bond, and hedge fund returns than they do to real estate returns. Even over a much longer, 25-year horizon recent research suggests the REIT-real estate correlation tops out at just over 0.5.*

Quite simply, REITs are not real estate; they are a hybrid security with aspects of both real estate and equities. So, while REITs and private real estate are related, they each have distinct characteristics and might have different roles to play within an overall mixed-asset portfolio. One might think of them as two different breeds of dog; while bulldogs and poodles share common characteristics, they are definitely distinct.

Figure 3 shows the optimal allocations to REITs and private real estate that result from a traditional portfolio theory approach. The figure is based on an overall portfolio allocated among equities, corporate bonds, Treasuries, hedge funds, REITs and real estate (all US based). The general message is that REITs have their greatest role in more aggressive portfolios. Optimised allocations to private real estate dominate in portfolios with conservative to mid-range target returns, but significant allocations to both forms of real estate are shown for more aggressive portfolio targets. The roles of REITs and private real estate therefore depend on the investor.

Although an important tool, traditional portfolio theory is based on a simplified world, ignoring some aspects of what goes into a well-constructed portfolio. But again, the importance of these other considerations depends on the objectives and constraints of the particular investor. Smaller investors without the financial heft to effectively invest in the non-listed real estate market will obviously find an advantage in REITs, which allow investment on any scale. Similarly, REITs can provide easier access to certain investments due to their liquidity. Valued management teams, or specific quality assets, are always accessible to investors if they are within a REIT structure; a skilled management team in the private equity space might be closed to investment, and specific types of properties simply not available. REITs are often particularly valued as an easy way to access international real estate exposure. With many international commingled funds being opportunistic in nature, investors desiring foreign core exposure might do so via foreign REITs. In taking this route, however, it is important to remember that REITs are not equivalent to real estate; investing in a REIT is not investing in its underlying assets, it is investing in something related to its underlying assets.

Liquidity is perhaps the greatest difference between the private and public markets. The financial crisis brought to the fore the fact that even institutional investors, usually thought of as the prototypical long-horizon investors, can have short-term liquidity needs. Even if traditional portfolio optimization shows no allocation to REITs for more conservative investors, the need to access liquidity might mean that even they might want to assign a portion of their overall real estate allocation to REITs. This decision, however, hinges on two investor-specific factors: how highly do they value liquidity, and can they stand short-term volatility?

The importance of liquidity varies across investors. REITs might become relatively more attractive to those with higher liquidity needs. But this is a two-edged sword. A need for liquidity means that there is some chance that an investment will need to be monetised quickly. While REITs allow a quick sale, it is done at the prevailing price (or less if selling a large position) which is subject to the higher volatility of REITs. In early 2009, REIT values in the US were off over 70% from their peak; REITs certainly would have provided more liquidity than private real estate during the crisis, but it would have come at a cost.

However, many investors prefer private market real estate not only because of its risk-return characteristics but also because of the greater degree of control it allows over the investment and investment process. Bespoke investments are simply not possible within REITs.

Though related, private real estate and REITs have unique characteristics and each can serve a distinct role within an overall portfolio. While conservative investors will likely lean more heavily on private real estate, the various advantages and disadvantages of the two forms of real estate mean that there is likely a role for both within most portfolios. But there is no one size fits all answer.

* "Real Estate for the Long Term: The Effect of Return Predictability on Long Horizon Allocations", 2009, by Greg MacKinnon and Ashraf Al Zaman, Real Estate Economics, Vol. 37, No.1.

Greg MacKinnon is director of research at PREA