Institutions are refining their REIT allocation strategies amid a compelling divergence in values between private and publicly listed real estate that many believe places REITs in a strong position to outperform in a more challenging market ahead.
“The current moment in time is really an extraordinary opportunity in REITs,” says Jon Treitel, portfolio strategist at CBRE Investment Management. Although the firm has been fielding steady interest from institutions regarding REIT allocations in recent years, the first few weeks of 2023 has been one of the busiest year-to-date periods Treitel has seen in close to a decade. “We have a lot of clients that are looking at the current market as a tactical opportunity to make a strategic allocation to the asset class,” he says.
That surge in interest is largely a function of the arbitrage that emerged between listed and unlisted real estate last year. At the end of the third quarter, the 12-month trailing returns between public and private real estate represented a 38% valuation gap—one of the largest spreads on record.
“That valuation gap is already starting to close, and we expect that to be one of the key themes in 2023,” says John Worth, executive vice president, research and investor outreach at Nareit. According to the FTSE Nareit All Equity REIT Index, total returns for 2023 through Feb. 22 were up 4.53%.
Historical Track Record
Adding to that investment thesis, REITs have a historical track record of delivering a strong performance following similar periods of sharp discounts. According to a Nareit analysis of the last six recessions, REITs, on average, outperformed both private real estate and the broader stock market during and after each downturn. Notably, in the four quarters after a recession, the Nareit All Equity REIT Index generated average annualized total returns of 22.7% compared to returns of 5.2% for the NFI-ODCE Index and 8.2% for the Russell 1000 Index.
The recent spike in interest coincides with a longer term trend of institutions that have been adding strategic allocations to REITs within their real estate portfolios. REITs are now widely used in the real estate strategies of nearly two-thirds of the largest and most sophisticated institutional real estate investors in the United States and around the world.
Approximately 64% of the top 25 largest defined benefit (DB) and sovereign plans in North America and an equal percentage of global institutions use REITs to optimize their real estate investment portfolios. Combined, these top U.S. and global plans have, on average, $430 billion in total assets under management, with an average real estate portfolio size of more than $30 billion.
Institutions are using REITs both as pure strategic investments in real estate and as part of completion strategies to fill gaps within real estate portfolios that are not being met by private real estate investments. Specifically, institutions are using REITs to get access to modern economy property sectors, global real estate, and companies that meet ESG investment requirements.
“Over the very short term, the measured share of REITs as part of institutions’ real estate allocations could dip a little bit because of the decline in valuations. However, over the longer term, I think we’re going to see continued growth in the share of institutional investors who use REITs as part of their strategic real estate allocation,” Worth says.
REIT Strategies Vary
Institutions are attracted to a variety of characteristics that REITs offer, including risk-adjusted performance, diversification, liquidity, and income that offers some inflation protection.
Research by Nareit and CEM Benchmarking Inc. shows that REIT returns have consistently outperformed private real estate by around 2% per year. However, REIT strategies are by no means one-size-fits-all, with the percentage of real estate portfolios allocated to REITs running the spectrum from single digits to those that have a majority invested in REITs.
APG Asset Management is one firm that takes an agnostic approach to public versus private structures, with a view that REITs are an integral part of the investible universe. “The way we look at it is that we assess all of the available investment options holistically, and then access those that we deem to be best positioned as it relates to various characteristics, including risk-return, as well as ESG and other considerations,” says Rutger van der Lubbe, head of global investment strategy, real estate at APG Asset Management.
For example, if APG were looking to invest in student housing in the U.S., the firm would look at the various choices, such as funds, joint venture partnerships, and also REITs. “Those listed entities in which we invest typically own very high-quality real estate portfolios, are very professionally managed, and also meet the requirements that we impose in terms of ESG,” Van der Lubbe says. “So to us, this is a very efficient means to allocate capital in what we generally believe to be best-in-class real estate entities.”
Filling “Gaps” in Portfolios
Increasingly, institutions are turning to REITs for portfolio completion strategies, and the ability to get exposure to “next generation” sectors, such as data centers, cell towers, single family rentals, and life sciences.
There is a huge sector weighting dispersion to alternative property types when comparing listed versus unlisted real estate investments, which has implications for future returns, Treitel notes. “We look at those next generation real estate sectors as having stronger returns relative to the traditional sectors,” he adds.
REITs are a powerful tool to easily change the composition of an investment portfolio. “One of the conversations that we’re having with institutional investors is that the economy has changed dramatically over the last 20 years, but for many institutional investors, the components of their real estate strategy have not changed that dramatically,” Worth says.
For example, the vast majority of market cap among funds listed in the NCREIF ODCE Index— 93%—is comprised of industrial, apartments, office, and retail. In contrast, more than half of the FTSE Nareit All Equity Index—53.2%—is outside of what has traditionally been considered the four core sectors.
“The concept of core real estate is being redefined by a lot of the emerging property types that investors are able to find access to in the REIT market,” says Uma Moriarity, senior investment strategist at CenterSquare Investment Management. The REIT market has better adapted to changes in consumer behavior and advances in technology that has changed how people and businesses use real estate.
“As we think about core real estate and what is really fundamental to how a business works today, is an office building more core to that business, or is it the data center that allows the connectivity of the business to function in the 21st century?” she says. “A lot of the property types that you can find in the REIT market today are what many consider to be the ‘new core’ assets.”
Another factor that attracts investors to REITs for exposure to alternative property sectors is the quality of the operators. “There are so many more nuances in how these niche property types have to be operated,” Moriarity says. The scrutiny on public companies tends to weed out weaker players and create a “survival of the fittest” where the best companies survive and thrive, she adds.
“By default, what that means is that the platforms that remain in the public markets offer incredibly strong management teams, and in times like this, you want to be betting on the best jockey,” Moriarity says. Institutions want strong management teams, great capital allocation expertise, and strong operating platforms, all characteristics of REITs operating in the niche property sectors, she adds.
ESG, Diversification and Liquidity
REITs also offer strategic solutions for portfolio diversification, liquidity, and ESG requirements. The top 100 REITs all report on ESG; 83 of the top 100 own green or LEED certified buildings or structures; and two-thirds publicly disclose their carbon and sustainability goals.
“If you look at companies in real estate, those with solid ESG fundamentals have the opportunity to outperform,” Treitel says. A strong commitment to ESG can result in lower capital development costs relative to peers, as well as an ability to charge premium rents in green buildings. “What that all adds up to is better profitability metrics, which generally supports better valuation multiples and better returns for portfolios over time,” he says.
In addition, investors can easily diversify the geographic footprint of their real estate portfolio using REITs and listed real estate without the need to build out dedicated international teams or an on-the-ground presence. REITs also offer an opportunity for global diversification. As of December 2021, there are 865 listed REITs with a combined equity market capitalization of approximately $2.5 trillion in more than 40 countries and regions.
Another point relevant today with a potential downturn ahead is that REITs screen more attractively today compared to equities more broadly, Moriarity points out. Earnings expectations and earnings growth is a big driver of performance in the listed market. That is something that played out in 2022 and is continuing in 2023. “So as focus has shifted to those sectors that perform well in a rising rate environment, you have seen REITs do really well because they do offer the stability of cash flows, which you don’t really find in the broader equities market to the same extent,” Moriarity says.
Generally, allocations to REITs have been on the rise in recent years. As institutions deal with the denominator effect and the need to rebalance portfolios, it could very well create some bumps in that growth trajectory. Rebalancing also is likely going to result in institutions that are highly selective in how and where they deploy new capital into real estate in 2023. Institutions are going to be looking not only at tactical and strategic opportunities, but also those companies and sectors that are positioned to withstand some of the economic headwinds ahead and deliver the best risk-adjusted returns.