Listed real estate is outside the comfort zone of many investors. However many now appreciate the role REITs can play as part of institutional real estate allocations, although further research is still required. Jim Clayton reports

Over the past 15 years publicly traded real estate investment trusts (REITs) have developed into a viable alternative for equity investment in real estate by a broader range of investors, including pension funds. There appears to be a strong case for the inclusion of both REITs and private real estate in mixed-asset portfolios. However, notwithstanding improved visibility and acceptance in the plan sponsor community, on the whole the real estate allocations of pension funds and other institutional investors remain heavily weighted towards private real estate (direct, separate accounts, open-ended and closed-ended funds).

The continued preference for private property investment vehicles in pension fund real estate holdings is something of a puzzle to many in the REIT business and a growing source of frustration for them. To the REIT community, it seems that major institutional investors are ignoring the liquidity benefit of public REIT shares as well as the transparency, strong corporate governance and value creation abilities of REIT management teams. Furthermore, there is mounting evidence to suggest that these positive attributes might be reflected in superior investment performance; plan sponsors that ignore REITs appear to be leaving money on the table.

Two recent studies show that public equity REITs have, at the market index level, outperformed private real estate (both core property and funds) over full property cycles since the beginning of the modern REIT era, while also offering a liquidity benefit that is absent from private real estate vehicles.(1)

Figure 1 provides similar evidence within a broader comparison of equity REIT, real estate, stock and bond returns, dating back to 1978, the start of the National Council of Real Estate Investment Fiduciaries (NCREIF) Property Index, and also for the more recent, and relevant, period extending from 1993 that marks the beginning of the modern REIT era.

Equity REITs outperformed private property (unlevered or ungeared) both from 1978 and since 1993, as tracked by either the appraisal-based benchmark NCREIF Property Index (NPI) or the MIT Transaction-Based Index (TBI) derived from sales of properties from the NPI, as well as core open-ended funds, measured by the NCREIF Open-End Core Diversified Equity Fund (ODCE) Index.

Two additional observations of note in figure 1 are; first, while REIT returns exceeded NPI and ODCE returns by close to 100bps per quarter or more since 1993, the excess over TBI returns is considerably smaller, and also the differential in standard deviations much less pronounced; and second, equity REITs outperformed the broader stock market and the small-cap value subset, although equity REIT returns were also the most volatile of the three over this period.

While these ‘outperformance' results have generated lively debate and discussion among investors, by themselves they are probably not enough to help public REITs attract a greater share of the plan sponsor real estate allocation. While return is obviously important, investors need to know more about risk and portfolio considerations of REITs, and whether these might be part of the explanation for the apparent outperformance and under-allocation puzzles. This suggests that the long-term return comparisons should be augmented with research that:

• Uncovers and validates the causes of outperformance. Is it the superiority of public real estate or does at least some part of it derive from public market risk considerations that have not been accounted for and/or perceived private market benefits that are not reflected in asset category index returns? Many private investors are sceptical that REITs outperform and provide liquidity. If liquidity is valuable then should not investors be willing to pay for it, in which case private real estate would outperform public, all else equal?

• Incorporates a portfolio perspective. Plan sponsors care not only about long-term returns but also about risk, both of REITs as well as at the overall investment portfolio level. How do public REIT returns relate to returns from the stocks, bonds and real estate held by investors? How does this differ in the short and long term? How do REITs and private real estate fit with investor goals, portfolio structure, liabilities, risk tolerance and liquidity needs?

Public versus private return indices: proceed with caution
Appraisal-based indices are appropriate (and designed) for benchmarking the performance of portfolios for which properties are valued in a similar fashion. Given the somewhat backward-looking nature of appraisals, indices like those produced by NCREIF (and IPD) are less suitable for asset class and market dynamic research than are indices derived from actual transactions. As such, the summary statistics in figure 1 for the TBI are more relevant for comparison with NAREIT returns. As noted previously, the difference between NAREIT and TBI returns is relatively small, although the volatility of TBI returns is much higher than with NPI and ODCE returns, both factors suggesting that over the long term REITs and real estate might not be all that different.(2)

Another factor in comparing public and private returns is that REIT share values reflect more than the value of the underlying real estate - REITs are operating companies (going concerns). For most firms that choose to be public REITs we would expect that the present value of growth opportunities and management franchise would be positive, yet also be more volatile than the value of underlying existing property assets. Therefore we might expect that over long periods REITs should outperform the performance of their properties but also be riskier from a volatility standpoint.

A third complicating factor is that REIT and NCREIF indices differ in the mix of properties (types and locations) as well as debt financing. Variation of performance by property sectors will therefore be reflected in differential index returns that might not be related to differences in public versus private return dynamics. Accounting for these differences, however, will not likely change the conclusion. Previous -studies that carefully adjusted for property mix and leverage differences across REIT and private market indices report that the REIT outperformance differential narrows but remains positive.(3)

Liquidity and volatility
The outperformance of REITs over private real estate has been interpreted by some as conclusive evidence that there is no ‘illiquidity premium' in private property investment, implying that private market investors are not compensated for the high costs and risks of illiquidity of property, and hence public REITs are a superior option because of the liquidity they offer. Once again, caution is urged before rushing to a conclusion.
Pension fund and other institutional investors know that direct (and indirect) real estate is far less liquid than public securities and this is taken into account ex ante when formulating policy weight targets. Investors allocate on average about 10% of their assets to real estate and certainly should not put private real estate in the ‘liquidity bucket'. This calls into question whether plan sponsors care about real estate liquidity and an illiquidity premium.

In fact, it seems to be the case that many private market investors dislike the liquidity and resulting volatility associated with public REIT shares. While liquid public markets are generally regarded as more transparent and efficient than private ones because information is widely dispersed and quickly capitalised into asset prices, many private real estate investors shy away from the liquidity offered by public REITs because the ease of moving in and out allows people who know nothing about REITs or real estate to trade and add volatility.(4)

It is therefore possible that some of the perceived outperformance of REITs is actually a ‘noise trader' risk premium to compensate long-term investors that have to mark to market quarterly for the volatility created by short-horizon investors and also momentum/sector chasers that at times park money in REITs.

In thinking about the implications for the public REIT versus private real estate investment choice, these considerations suggest that the value placed on the higher liquidity of REITs could be less than the costs associated with added volatility from short-horizon traders and the loss of control and related corporate governance issues relative to private market investments (direct and in commingled funds).

REITs versus stocks and real estate
Most investors combine their REIT investments with significant holdings in other sectors of the stock market. It is therefore crucial that investors understand how REITs tend to perform relative to other stock ‘baskets' and also how this differs from private real estate.

Figure 2 illustrates how quarterly equity REIT index returns have moved on average with large caps, small caps, bond and private real estate index returns. From 1989, REIT returns showed declining correlations with large caps, although these began to creep up soon after REITs began being added to the S&P 500 in 2001 and especially during the financial crisis. REITs have consistently had fairly high correlations with small-cap value stocks, and at times show relatively high correlations with private real estate.

Given the high correlation between REITs and small caps, plan sponsors need to understand the implication for diversification benefits and risk quantification of REITs. Does the high correlation imply low diversification benefits? Not necessarily. Correlation is a necessary but not sufficient statistic for evaluating different benefits. Existing academic research finds that despite equity REIT and stock (particularly small caps) returns sharing common drivers, there is a unique component to REIT returns unrelated to financial asset returns - REITs offer significant diversification benefits.
The R-squared in regressions that aim to explain REIT returns as a function of stock and bond factors are typically much lower (50-65%) than the 80% correlation observed between REIT and small caps, suggesting that REITs can still offer significant diversification benefits.(5)

Taking a longer-term, and likely more relevant perspective from real estate investors' perspective, and evaluating how the correlations behave over extended time horizons, figure 3 indicates that REITs become more tightly connected to real estate returns as the correlation with large caps declines at a rapid rate. Interestingly the strong connection with small caps remains. For investors with long-term horizons (ie, those incorporating REITs into the private real estate allocation) public equity REITs represent a unique asset class with characteristics of both small caps and private real estate yet differ from each. REITs also provide liquidity and flexibility to the real estate allocation.

Despite the development of the public market, US institutional real estate has remained largely private. This is beginning to change, however. Plan sponsors are increasingly turning to the developing global REIT marketplace to execute their expanding international investment strategies. Investors have a renewed sense of the benefits in terms of access to capital and flexibility of the public REIT business model following the remarkable REIT recovery after the financial crisis.

It will take time for many plan sponsors to get comfortable with the idea of mixing public and private in their real estate allocation. Many have struggled with the issue of where to house the responsibility for REITs within the portfolio management team, with the stock team or the private real estate group, and with understanding exactly what REITs represent in terms of investment attributes within the portfolio.

Larger institutions have historically invested in private real estate both for control reasons and to diversify away from public market return dynamics (sometimes investing alongside REIT management teams in private market ‘wrappers' including joint ventures and funds).

Further research addressing the issues raised in this article should help to put public REITs in the comfort zone of more investors.

(1) "The Truth About Real Estate Allocations," Cohen and Steers, July 2010 and "REITs: Real Estate with a Return Premium," NAREIT Special Report, May 2010.
(2) Assuming debt financing with an average loan to value of 50% on properties in the TBI index yields a volatility two times higher than the TBI standard deviation, or almost 10%, a figure very close to the standard deviation of REIT returns.
(3) See "Public versus Private Real Estate Equities: A More Refined, Long Term Comparison," by Pagliari, Scherer and Monopoli, Real Estate Economics, 2005, 33(1):147-187; "Privately versus Publicly Held Asset Investment Performance", by Riddiough, Moriarty and Yeatman, Real Estate Economics, 2005, 33(1):121-146; "A Successive Effort on Performance Comparison Between Public and Private Real Estate Equity Investment," by Tsai, MIT Center for Real Estate Masters Thesis, 2007; "REITs and Real Estate: Is There Room for Both in a Portfolio?" Pension Real Estate Association (PREA) Research Report, October 2010
(4) Related to this, though not focused specifically on REITs, recent academic research finds that across public companies high liquidity is associated with weaker corporate governance ["Corporate Governance and Financial Markets," by Subrahmanyam, Corporate Ownership & Control, Volume 5, Issue 3, Spring 2008: 259-274.] because highly liquid shares are relatively inexpensive to trade they attract short-horizon traders, who almost by definition do not have a long-term interest in a firm's corporate governance.
(5) See "REIT Returns and Pricing: The Small Cap Value Stock Factor," by Anderson, Clayton, MacKinnon and Sharma, Journal of Property Research (2005), 22(4): 267-286; "The Substitutability of REITs and Value Stocks, Lee and Stevenson, Applied Financial Economics,(2007) 17: 541-557, "Securitised Real Estate and its Link with Financial Assets and Real Estate: An International Analysis", Hoesli and Moreno, Journal of Real Estate Literature (2007) 15: 59-84.

Jim Clayton is vice-president of research at Cornerstone Real Estate Advisers LLC