REITs have very specific characteristics that place them in a class apart from other forms of real estate investing, as Steve Smith explains
Should REITs be considered as a substitute for direct property in a multi-asset portfolio? Or, should they be viewed as an alternative asset class and, if so, will their addition to a multi-asset portfolio provide similar risk/return trade-off benefits that the inclusion of direct property brings? The rationale behind the introduction of REITs in the UK is to provide access to a more liquid, tax transparent form of property investment the performance of which would be tied more closely to the stable performance of the underlying property. This is particularly important for smaller pension funds whose ability to gain exposure to commercial real estate, as an effective diversifier in a mixed equity/bonds portfolio, is limited. This is because of the typically larger lot sizes of the sector and the need to invest a substantial amount in order to gain the desired benefits of diversification.
Although the underlying asset is property, REITs are traded as shares (in the same way as the quoted property sector) and it is important to understand whether the pattern of returns will replicate that of direct property investment or the quoted equity market. Or, will REITs represent a unique mixture of direct real estate and equity investment performance?
There are a number of reasons why the pattern of REITs' returns may exhibit a closer correlation to that of equities rather than direct property.
Most important is the fact that REITs are constantly traded in a public forum and so are bound to be affected by stock market noise.
The relatively limited number of valuations associated with direct property means these physical assets change value a small number of times as opposed to REITs, which are traded on a daily basis. In addition, the value of REITs will be influenced by the volume of trades for the vehicles on a daily basis, whereas the relatively few trades in direct property limits the potential for value changes in response to short-term market sentiment.
These factors might lead to the belief that REITs will behave more like traditional UK property company shares, which exhibit a significant degree of correlation with the equity market.
However, a number of inherent structural features that were incorporated into the creation of UK REITs in order to provide investors with returns more closely aligned to those of the underlying real estate assets. The requirement to distribute 90% of income, tax transparency and restrictions on gearing were the key qualifying criteria intended to differentiate REITs from the traditional quoted property sector.
We have no empirical evidence on which to examine the pattern of REIT returns given that they were only launched in the UK in January 2007. However, we can learn from the experience of the US where REITs were introduced in 1960, thus providing the longest and most comprehensive time series for analysis in the deepest REIT market globally. There have been a number of studies investigating the relationship between the performance of REITs and the equity markets in the US. Although the precise nature of the results varies according to the time period under consideration, a review of these studies reveals two recurring themes:In the short term, REITs correlate with equities, most noticeably with the share performance of small and medium-sized companies (the corollary of this is that REITs' short-term performance differs from directly held real estate); Over a longer-term horizon, REITs are co-¬integrated with directly held real estate, ie over the longer term the performance of REITs reflects the underlying property assets of the vehicle.
The results from these studies have led some in the property industry to claim that REITs offer limited diversification potential. However, the conclusions to be drawn from these studies are perhaps not as clear cut as one might expect.
The short-term correlation between the equity market and REITs is not constant, fluctuating by some considerable margins depending upon the analysis period. In addition, the relationships are neither robust nor stable, with some evidence pointing to closer correlations during market downturns. Although it is clear that REITs do not mirror the real estate market in the short term, there is no consistent linear relationship between REITs and equities over the same timeframe. This relationship is also important in relation to volatility, with the lower beta of REITs only translating into lower volatility if there is a high correlation with the broader market.
Over the longer term, however, the picture is different. There is a long-term correlation between the returns from direct property and REITs, with no evidence of co-integration with the equity market index.
Therefore, REITs cannot be considered either an equity or a direct property investment but rather should be viewed as an asset class in its own right, with its own distinct characteristics. The crucial question, therefore, is whether the addition of REITs to a mixed portfolio will bring any diversification benefits?
Looking at the empirical evidence from the US, it would appear that the addition of REITs to a mixed equity and bonds portfolio almost always enhances the risk/return trade-off, extending the efficient frontier of a mixed asset portfolio. This is especially the case for those portfolios with longer-term horizons, unsurprising given the longer-term correlation between REITs and direct property returns.
Furthermore, studies from the US confirm that the benefits of adding REITs to a mixed portfolio are not wholly attributable to the direct property element of the REIT. Indeed, portfolios that already contain direct property can be improved by the addition of REITs.
Judging from the US experience, the introduction of REITs in the UK will offer investors a more liquid, tax transparent method of accessing the benefits of the property market.
However, REITs should not be considered a substitute for direct property in a multi-asset portfolio. Rather, they should be viewed as a distinct asset class in their own right that can offer greater real-estate-like diversification potential for longer-term investment strategies as well as allowing for short-term tactical adjustment to quasi real estate investment at the margin.