Will the move from DB to DC pensions result in more allocations to REITs? The answer depends on a number of variables, as Stephen Ryan explains
Commercial real estate is a fundamental asset class that can justifiably claim a role in most, if not all, pension portfolios, alongside equities, bonds and cash. The features that attract pension investors (diversification, potential inflation protection, high income and attractive risk-adjusted returns) have not changed over time, but the ways to access those features have.
The growth of REITs across the world as a means of accessing real estate returns and the move from defined benefit (DB) to defined contribution (DC) pensions are bringing REITs to greater prominence. While REITs may have begun life as small and medium-sized owner-operators, they are playing in the big league now. Global REITs are worth over $1trn (€796bn) and in the US public REITs control approximately 40% of all institutionally held real estate. Outside the US, giant REITs include Australia's Westfield Group, Sun Hung Kai Properties of Hong Kong and Unibail-Rodamco in Europe.
Positive characteristic of REITs also include:
• Efficient means of gaining real estate exposure, including global exposure;
• Skilled operators;
• Ability to buy and sell quickly.
There are some negative characteristics too:
• High short-term volatility;
• They are less familiar outside US, Australia, Japan, France and other select markets;
• While REITs themselves are large, REIT funds in Europe tend to be small.
To understand the role that REITs play in pension portfolios, we need first to clarify how DB and DC pensions differ. DB portfolios are split between liability-matching assets and growth assets, and the role of REITs within the growth component is determined by the a board of trustees, investment committee or similar group running the plan (plan members do not directly control investment strategy). The role of REITs is decided in a two-step discussion:
Step 1: Whether REITs should be included as a separate asset class;
Step 2: If yes, what weight should REITs be assigned?
DC plans generally offer ‘self-select' investment options and a default investment option. Default options are intended for those plan members who do not feel willing or able to make their own investment choices; self-select options are for the others. Within the self-select options in DC, one generally finds multi-asset funds, arranged along a risk and return spectrum, and single-asset class funds.
For the default option and the multi-asset self-select options, the inclusion and weighting of REITs is decided by a board of trustees or similar expert body, much in the same way as DB plans operate. For self-select single asset class funds, this body decides whether to present or not to present REITs to plan members. The committee does not decide the weighting, which is left to individual members.
Where annuitisation is compulsory for DC plan members (for example, in the Netherlands) or compulsory and subject a means-test (Ireland and the UK), the role of REITs will tend to finish before retirement. In countries where members can stay invested in the market into retirement (such as in the US), any REITs allocation can endure into the depletion (post-retirement) phase.
Asset allocation decisions are often made using either a mean variance framework or a factor analysis framework. Whichever framework is used, asset allocators usually prefer to work with a finite list of asset classes, and therefore not every asset class is considered a candidate. Allocators and their advisers prefer a ‘parsimonious' model - that is, using the least number of asset classes consistent with efficiency.
Objectively, REITs seem like a good candidate for inclusion in any asset allocation framework but in practice they are often excluded. Their dual equity and property nature can be the problem, as can (in Europe) their relative novelty and unfamiliarity.
The decision to exclude or include REITs may depend on what other assets they are being compared to. For example, investors who tend to compare REITs with core income-producing real estate may find the short-term volatility of REITs a shock, whereas investors who tend to compare REITs with broader equity markets, including small cap and emerging markets, should take this in their stride.
In other words, the view taken may depend as much on the decision-maker's own reference point as on the objective nature of the asset class.
Let us say that the test in step 1 is passed. Step 2 is to work out the weighting for REITs, and may be done using mean variance or factor analysis approaches.
Under mean variance the ‘asset pie' is sliced based on three inputs: expected returns, expected volatility and expected correlations. If the asset allocator focuses on annual data, REITs will be input as highly volatile and highly correlated to equity markets. Over longer holding periods the correlation with equities declines, so reliance on shorter-term data, especially correlation inputs, by asset allocators is bad news for REITs.
Factor analysis is an asset allocation approach that tries to look through asset classes to understand the drivers of return. Real estate, for example, might be seen as driven by factors like inflation, non-government GDP growth and illiquidity. Asset classes that share factors can be grouped together: for example, some consider that there is overlap between forestry, infrastructure, commodities and real estate. Sometimes this group is labelled ‘real assets'. For example, CalPERS has the following allocation.
Real can mean tangible to some investors (so REITs would be excluded) but even when this is not the case, REITs, despite impressive inflation-beating credentials, might be excluded. REITs might also fail to gain a separate entry in category containing equities, as this could lead to double counting
REITs provide long-term pension investors with another form of access to real estate returns, and play a particularly useful role in DC pensions.
Arguably, REITs are punching below their weight in pension portfolios.
Stephen Ryan works in the Mercer real estate team