The Role of Real Estate in Pension Funds

Pension, endowment, and foundation funds control over $9 trillion in total assets, with nearly $800 billion invested in real estate. Most pension funds that invest in real estate, on an asset weighted basis, invest in real estate using a blend of REITs and private real estate investment. Investing in both REITs and private real estate can be a powerful risk management tool.

Diversification is among the most powerful risk management tools available to investors and it is primarily achieved by investing the plan’s assets in different types of investments or “asset classes.” Commercial real estate is a substantial component of the $97 trillion investment opportunity set in the United States; in fact, it is the third largest asset class. As the third largest asset class, real estate houses the U.S. economy and is a fundamental component of a diversified investment portfolio.

See footnote 1. 

A key question for pension funds is how much of the investment portfolio should be allocated to real estate.

So How Much Real Estate Should Be in the Pension Portfolio?

Models that include a broad mix of asset classes demonstrate that an allocation to real estate in the 15-20% range is appropriate.

There are many factors that go into determining the appropriate allocation to any asset class, including real estate within an investment portfolio, and these factors are unique and specific to each pension fund. One very simple approach is the “market portfolio,” which invests in each asset weighted in proportion to its total presence in the market. This would suggest that pension funds should be allocating about 16% of their investments to real estate.

More detailed asset allocation methods that include a broad mix of asset classes and consider returns, correlations, and volatilities consistently, demonstrate that a meaningful allocation to real estate, somewhere in the 15 to 20% range, is appropriate.

See footnote 2.

Even though pension fund allocations to real estate have increased over the past several years, on average the target weight to real estate at 7 to 10% is less than market weight, and lower that of what other models would suggest as being optimal.

How Pension Funds Invest in Real Estate

Real estate is a mature asset class, and like equity and fixed income investments, exposure to real estate can be achieved through public market investments as well as through private market investment. In real estate, when we say “public market” investment, generally we mean investment in real estate through REITs (real estate investment trusts). “Private market” investments are investments in real estate through private transactions and vehicles. This would include, for example, direct property investment; private comingled funds (some familiar terms for these private market investments include, core funds, value-added funds, and opportunistic funds); and separately managed accounts.

For investors who are considering adding a real estate allocation or are beginning to build their real estate portfolio, REITs generally provide the most cost-effective and efficient way to gain exposure to the asset class.

For investors who have only private real estate investments in their portfolio, there are specific benefits of adding a meaningful allocation to REITs. REITs and private real estate are complementary investments within a portfolio. As the graph below shows, downside or drawdown risk, as measured by negative investment returns, is mitigated by combining REITs and private real estate investments. Upside opportunity, or the ability to achieve higher returns from your real estate portfolio, comes from the addition of REITs to the portfolio due to their comparatively stronger historical performance.

To see how this might work in your portfolio, visit pensionsandrealestate.com.

See footnote 3. 

The 21st Century Real Estate Portfolio

REIT strategies can help address priorities that have become critically important over the last decade.

Today, most pension funds, on an asset weighted basis, invest in both REITs and private real estate. Including REIT strategies in combination with private market real estate investments helps pension funds to address several issues that have become critically important over the last decade, and which are difficult to achieve by investing solely through private real estate investment.

What Are the Challenges with Investing in Real Estate?

Access. The ability to efficiently invest fully in the real estate asset class, including “new economy” real estate. Real estate houses the U.S. economy, and, like the economy, the real estate asset class is dynamic and ever evolving, offering investors a broad menu to choose from both in terms of property types and locations. A 21st century real estate portfolio includes a wide array of traditional real estate properties (office, retail, industrial, and apartment), new economy real estate properties (data centers and infrastructure like telecommunications towers, fiber cables, and energy pipelines) and natural resources (timberland and agricultural land). Investing in REITs gives pension funds exposure to all the real estate asset class offers.

See footnote 4. 

Historically, retail centers, apartments, office buildings, and industrial warehouses were the dominant property sectors. Today, the industry has expanded to include property types that reflect the changing U.S. economy, including data centers, cell towers, and logistics facilities, it now provides access to both traditional and new economy properties.

Governance. Commercial real estate is a physical “bricks and mortar” asset and traditionally has been relatively illiquid. Because REITs are real estate companies traded on stock exchanges, they provide real estate investors with real estate returns in a vehicle that also provides effective governance and market liquidity. Market liquidity allows investors to be nimble in controlling risks that are otherwise difficult to control when managing a portfolio of physical assets like real estate. Market liquidity makes it easier to strategically and tactically manage your real estate allocation, as you would other assets within your portfolio.

Performance and Cost Management. For long-term investors like pension funds, investing in real estate through REITs has provided not only asset class diversification, but also enhanced investment performance. REITs' track record of delivering reliable and growing dividends, combined with long-term capital appreciation, has historically provided investors with total returns that outpace private real estate returns by 2.5 to 3% per year.

Cost management is a critical component of a pension system’s long-term investment performance. REITs provide investors with access to real estate, and because they are public market investments and listed on the stock exchange, are highly transparent. Real estate investment through REITs is often the most cost-effective and highest total return way for pension funds to invest in the asset class.

See footnote 5.

Risk Management. Diversification of a pensions plan’s assets is among the most powerful risk management tools available to investors; and having real estate in the pension’s portfolio is one arrow in the risk management quiver. Diversification within the pension’s real estate portfolio is another important risk management tool. In general, it is desirable to have a real estate portfolio that includes a mix of different property types and geographies to avoid undue concentration in any specific type or location.

See footnote 6. 

Nareit recently launched pensionsandrealestate.com, a new website that has been designed especially with pension trustees in mind, and is intended to provide information to help trustees and pension fund investors think critically about their plan’s real estate investments.

In conclusion:

  • Real estate is a fundamental asset class that can be accessed through public and private market investments
  • REITs provide the ability to efficiently invest fully in the real estate asset class, including “new economy” real estate
  • REITs help to maximize performance and cost management
  • Adding REITs to a portfolio of private real estate investments can be an important risk management tool by historically mitigating drawdown risk and providing the opportunity to achieve higher returns

Please reach out Meredith Despins, Nareit’s SVP of Investment Affairs & Investor Education, with any questions.

 


Sources

1. Stock and bond data from Board of Governors of the Federal Reserve, Financial Accounts of the United States, 2018Q4; commercial real estate market size data based on Nareit analysis of CoStar property data and CoStar estimates of Commercial Real Estate Market Size, 2018Q4
2. The Role of REITs and Listed Real Estate Equities in Target Date Fund Allocations, Wilshire Funds Management, 2019 https://www.reit.com/data-research/research/nareit-research/reits-critic... Global Listed Real Estate Investment: Asset Allocation in a Non-Normal World, Morningstar December 2010; Commercial Real Estate Investment Through Global Public Markets, Morningstar, November 2011; The Role of REITs and Listed Real Estate Equities in Target Date Fund Asset Allocations, Wilshire Funds Management, January 2013; Real Estate Investment In Liability-Driven Portfolios, Morningstar Inc., July 2011; Real Estate Investment Through REITs, Morningstar Inc., September 2008.
3. Nareit analysis of quarterly net total returns for NCREIF Fund Index – Open-End Diversified Core Equity (ODCE) and FTSE Nareit All Equity REITs Index, 1978Q1-2018Q4, after subtracting assumed fees of 12.5 bps/qtr for REITs.
4. Source: FactSet, Nareit New Sectors incudes cell tower, data center, self storage, timberlands, single family home, and farmland REITs. All Other includes all other sectors in the FTSE Nareit All Equity REITs index. Data as of June 30, 2019.
5. Source: CEM Benchmarking, 2018 available, at https://www.reit.com/sites/default/files/media/PDFs/Research/NAREITCEMES...
6. Source: Nareit analysis of property data from S&P Global Market Intelligence.

The Nareit Developments section on reit.com provides updates of Nareit's activities and key events impacting the REIT and commercial real estate industry. Nareit is the worldwide representative voice for REITs and publicly traded real estate companies with an interest in U.S. real estate and capital markets. Please see our Terms of Use.