In spite of their many advantages, REITs have never been big among US pension funds as Stephanie Schwartz-Driver reports

Real estate investment trusts (REITs) have no rivals when it comes to investing in securitised real estate, so for pension funds interested in an easy entry to US real estate investment, there is no question of what route to follow. The question is, however, why more pension funds, both domestic and international, are not using REITs more extensively to fill their real estate allocations.

Potential investors are watching REIT returns carefully. Although the REIT stocks have been outperforming for the last few years, this year has been tough. The six real estate investment trust indices declined anywhere between 3-6.5% from the beginning of the year to July, against a gain of 8.5% for the S&P Composite 1500. But REIT advocates will stress that this kind of short-term volatility should not be a disincentive to REIT investment.

The requirement of REITs to distribute most of their income means that REITs are high dividend paying structures, as opposed to other investment vehicles that might retain their income for other corporate purposes. Mike Grupe, executive vice president, research and investor outreach, at the National Association of Real Estate Trusts (NAREIT) pointed out that while the average dividend yield on the S&P is around 1.8%, on REITs, the yield currently stands around 4-4.5%. This yield gives REITs the cash flow profile of fixed income, without the inflation risk or the need to forgo capital appreciation.

Despite this attractive investment profile, pension fund investment in REITs is historically low. REITs have only been getting around 2% of institutional investors' real estate allocations in the past year or so, according to Mike Kirby, chairman and director of research at Green Street Advisors, a research and consulting firm that concentrates on publicly traded real estate securities, primarily REITs and other publicly traded real estate companies. The rest went to core funds, direct investment and opportunistic or value strategies.

The 2006 Pension Real Estate Association (PREA) Plan Sponsor Survey similarly found a low take-up of REITs. In the survey, which covered 75 respondents with total asset holdings of about $2.6trn (€1.90trn), 36 of the 75 investors reported REIT holdings. These holdings totalled only around $17bn, compared to private real estate equity holdings of about $167bn. In other words, public REITSs comprise only about 12% of the total real estate holdings of the plans surveyed, and fewer than half the responding plans held REITs at all.

These low figures do not represent any significant decline in REIT investment by pension funds, Kirby stresses. "It is not that they have pulled in their investment in REITs - US pension funds have never been big in REITs," he explained. However, this low participation by pension funds is so noticeable and so significant because "marginal dollars have shifted so that pension capital is a huge source of investment in real estate", he explained.

"We are just perplexed at why pension funds are doing what they are doing, when the REIT vehicle is at least as good as any other vehicle for buying and owing real estate," said Kirby.

Kirby cites several positives about investing in REITs. One is the level of fees, which makes them very efficient vehicles - "and look at what that does to your returns".
Private real estate investment comes with substantially higher fees, agrees Barden Gale, managing director and CIO of global real estate at ABP Investments, the investment arm of Stichting Pensioenfonds ABP in the US. "REITs are a low-cost delivery vehicle - the cost relative to indirect private vehicles is at least 100 basis points less, and the cost difference is usually greater," he says.

Gale notes that most recent institutional investment in private real estate is in commingled funds, which are typically more expensive than separate accounts, and are an option open only to a few of the largest investors.

ABP is a big advocate of using REITs to fill its real estate allocation. Currently, the fund has around $8.5bn in US REITs. It has an additional real estate exposure of around $2bn, which is accounted for by commitments to private commingled funds, exclusively value-added and opportunistic strategies.

"We not only believe but we feel we can prove that investing in REITs is the same thing as investing in core real estate," Gale says. To an extent, REITs even represent core plus, because of the additional benefit of development and some management fees. And he maintains that they are representative of the real estate market in general, because "REITs own the same institutional real estate as everyone else", when you look at the big picture.

There are some traits that may discourage institutional investors from investing. Gale notes that REITs tend to be more volatile than private real estate, but this is more a function of daily measurement; there is not as great a difference when measured over longer periods. "Sure, there are time lags in adjustment between the private and the public markets, but these adjustments do take place over any reasonable period of time, as the markets are pretty efficient. So for long-term investors, this should not be as great of a concern."

Mike Kirby of Green Street Advisors points out that many institutional investors claim that REITs have more volatility than private equity real estate investment. However, he maintains that "it is because they are liquid and you see the volatility. That volatility drives pension funds crazy."

If you go into real estate direct, you will match the index, and pension funds like the fact that they will match the benchmark annually," Kirby continues. "But in doing that, they may well be sacrificing long-term returns, and I think that is a shame." He points out that in fact, over the long term, REIT performance very closely tracks real estate performance.

And Gale asks: "If you are allocating real money to core real estate, and if you're buying a commodity - because in my view that is what core real estate is when you think of the universe of assets - then why not go with the low-cost execution? With REITs, you get the added benefits of top-tier management, immediate broad diversification, and not a lot of leverage."

Gale is willing to look at core real estate as a ‘commodity'. Cynically, Mike Kirby wonders whether investment managers like to complicate real estate investment in order to justify their jobs. "Real estate investment staff have little incentive to make their jobs as easy as buying REITs."

The reluctance of pension funds to invest in REITs is not a question of mistrust in the quality of management. In fact, Mike Grupe of NAREIT notes that there is an increasing trend for many larger pension funds to develop investment strategies involving a variety of joint ventures with publicly traded REITs. "This is an indication that they highly value the management expertise of REITs."

Today it is estimated that REIT joint ventures account for between one-third and one-half of total assets under management in real estate fund or private equity vehicles. Around half of the REITs in the multi-family sector are involved in joint ventures.

A major benefit of REITs is the cheaper cost of capital - and the ability to raise funds not only in public markets but also in the private markets. The requirement that REITs distribute at least 90% of income leaves them very little capital to finance development, growth and acquisition, and other capital needs. In addition, by going to the private markets, they can raise funds without diluting shareholder value. At the same time, they have found that it is also a highly profitable business line.

For the institutional investor, a joint venture gives them access to management expertise and access to product, especially in the industrial and retail sectors, and the ability to put tailor-made investment products together. REITs also cite the benefits of lower fees (no double promotes) and the alignment of interest that comes from co-investment. Mike Kirby of Green Street Advisors notes that the alignment of interest may be better with direct investment in REITs since the REIT's financial stake is higher in its on-balance sheet activities.

Significantly, the joint venture is structured as an off-balance sheet entity, or it can be done through a taxable REIT subsidiary. When the first REIT joint ventures began in the mid-1990s, during a market bust, with only a few participants, analysts had a hard time reckoning with them, but today they are an accepted part of the landscape.

In fact, some analysts view joint ventures as a positive, noting that such relationships ensure varied access to capital and also boost return on equity because of the fee income they bring in from acquisition, incentive and management fees.

The early joint ventures were spin-out joint ventures but today they take numerous forms and fulfil different purposes for various REITs. Many REITs start with a single partner in a close-end fund structure, then move on to forming club-type relationships with two or three institutional investors. Recently some REIT managers, including AMB, Regency and Prologis, have been forming open-ended multi-investor funds. Typically a REIT will hold 10-25% of the property in the joint venture and charges its institutional investor partners market-rate fees.

Mike Kirby again questions why institutional investors want to take the high cost option. "Our numbers show that REITs are trading at a 20% discount to NAV - but if you go private you pay dollar on the dollar," he says, "and then you pay a huge management fee - it is a really good business for them."

REITs are well aware of the potential conflicts of interest that might arise when they are doing significant amounts of off-balance sheet business, serving as joint venture partners or even fund managers. Some firms draw clear lines between the types of business the firm will do with investor money and with shareholder money. All stress that they follow ‘one-portfolio policies', remaining ownership-blind when it comes to leasing and management.

NAREIT sees the growth of joint venture deals as a sign that "capital markets keep changing, and investor profiles change", says Mike Grupe. "REITs, like any other publicly traded entity, have to adapt."

For the same reason, REIT and real estate derivatives trading is on the horizon in the US.

The first real estate futures contract was launched on the Chicago Board of Trade in February, based on the Dow Jones US Real Estate Index, which includes 85 REITs among a total of 91 constituents. Real estate futures contracts will allow investors in REITs to manage risk, and will also give pension funds and other institutional investors a synthetic route to gaining real estate exposure.

Also under development is a futures market by the New York Mercantile Exchange, which will be tied to the FTSE EPRA/NAREIT Global Real Estate Index, which is also underlied by REITs. The Chicago Mercantile Exchange is also preparing to launch a futures product based on the Global Real Analytics Commercial Real Estate Indexes, which is not based on REITs.