REITs in the Real Estate Portfolio
Listed equity REITs have historically provided stronger returns than most other ways of investing in the real estate asset class. REITs typically use substantially less leverage than “value-add” or “opportunistic” real estate investments, and impose fees and expenses that are a fraction of the costs of investing in real estate through private equity funds. Finally, REIT returns respond much more quickly to changing market conditions than do investments in private equity real estate, meaning that combining REITs with private real estate investments provides a diversification benefit that is beyond the reach of portfolios with inadequate REIT holdings. For all of these reasons, REITs play a very important role in constructing optimal real estate portfolios.
A study by the independent investment research firm Morningstar confirms that REIT returns have historically been much stronger than returns to private equity real estate funds—even those funds whose use of excessive leverage “bumped up” their returns while exposing their investors to excessive risk. During the last full real estate cycle—from a market peak in the late 1980s or early 1990s (depending on how the cycle is measured) to another peak in 2007 or 2008—listed equity REITs provided returns averaging 13.4 percent per year, net of fees and expenses. During the same cycle, opportunistic funds posted net returns averaging just 12.1 percent per year; value-add funds averaged just 8.6 percent; core funds averaged just 7.7 percent; and unlevered core property investments averaged 7.6 percent.
Because the returns measured for private real estate investments lag behind actual changes in asset values, combining listed REITs with private investments results in a diversification benefit that cannot be achieved with combinations solely of private real estate holdings. Beta measures how returns to one investment fluctuate relative to another; the beta of REIT returns relative to unlevered property returns is just 0.73, meaning that adding REITs actually reduces the volatility of a portfolio of unlevered real estate holdings (while increasing portfolio returns sharply). In contrast, adding other private real estate investments—core funds, value-add funds, and opportunistic funds—increases the volatility of a portfolio of unlevered property holdings: the three forms of private real estate investment have betas of 1.25, 1.63, and 2.03, respectively, relative to an unlevered property portfolio.
This public-private diversification benefit means that listed REITs actually protect against downside risk while increasing expected portfolio returns. For example, unlevered property holdings frequently cost their investors negative returns even over holding periods as long as five years: in fact, historically nearly one of every ten five-year holding periods (9.6 percent) has resulted in losses for investors in unlevered property portfolios; on the upside, never have returns averaged more than 20 percent per year for five years. Downside risk for REITs is much more limited: only 1.7 percent of five-year holding periods have seen losses, while gains have averaged at least 20 percent per year in nearly one-fifth (19.6 percent) of five-year holding periods.
A blended portfolio of 70 percent core properties and 30 percent listed REITs, however, has never suffered losses during a five-year holding period. On the upside, however, this simple blended portfolio has provided returns averaging more than 10 percent per year during more than half of all historical five-year periods.
REITs also provide downside protection to investors with holdings in core private equity real estate funds, which by themselves are much more likely to expose investors to losses even over five-year holding periods. Again, a blended portfolio with 30 percent invested in listed equity REITs and the remainder in core funds has never suffered a five-year period of negative returns.
The poor historical performance of core funds, however, can be mitigated by including opportunistic funds to boost returns while maintaining a significant allocation to listed REITs to reduce portfolio-level volatility and provide downside protection. For example, a blend of 43 percent in core funds, 28 percent in opportunistic funds, and 29 percent in listed equity REITs has historically never resulted in a five-year period of negative returns, even though both core funds and opportunistic funds have suffered negative returns in more than one of every five periods of that length.
The different investment characteristics of listed equity REITs and private equity real estate funds means that investors can optimize their real estate portfolios by combining the different real estate investment options to achieve their expected return targets while minimizing portfolio-level volatility. The chart below shows optimally constructed portfolios of listed equity REITs, core funds, value added funds, and opportunistic funds with different average net returns. The left edge of the chart, which summarizes the portfolio that would have achieved the lowest possible volatility, is composed of 95.5 percent core funds along with 4.5 percent listed REITs, emphasizing again the essential role of listed REITs in providing downside protection to a portfolio of private real estate investments. Not until REITs account for about one-fifth of the total portfolio is it optimal to begin making investments in opportunistic funds. (Value-add funds play no role in any real estate portfolio that is optimized on the basis of actual historical returns.) Investors seeking higher returns do so optimally by reducing core fund holdings and adding both REITs and opportunistic funds, thereby achieving the benefits of public-private diversification.
For more information on using REITs to gain diversification benefits and construct an optimal real estate portfolio please contact Meredith Despins, NAREIT’s Vice President, Investment Affairs & Investor Education, at firstname.lastname@example.org.