Pension funds are deploying more capital to REITs to diversify and balance their portfolios.

05/27/2022 | by
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Real estate has long been a staple within pension fund investment portfolios, yet more of that capital allocation is currently flowing to listed REITs as their performance, liquidity, and the access they provide to growth markets is seen as a strong complement to private real estate.

“The activity that we have seen in the last two or three years has really stepped up in terms of engagement and interest,” says Raj Rehan, head of real estate securities, Americas, at BlackRock Real Assets. In particular, REITs have been a topic of conversation with clients as part of their growth portfolio, given the potential to hedge against inflation and the ability to take advantage of economic upside, he says.

A Nareit analysis based on Preqin data confirms what many fund managers are seeing first-hand. The share of U.S. defined benefit (DB) plans investing in REITs as part of their real estate allocation is on the rise, growing from 55% in 2016 to an estimated 67% as of Sept. 30, 2021.

The trend line is similar when including endowments and foundations. The share of those institutions investing in REITs jumped from 51% to 63% over that same five-year period. Additionally, a recent annual survey conducted by Pensions & Investments found that REIT assets in the largest 200 U.S. retirement plans grew to $34.2 billion as of Sept. 30, 2021—a 22% increase compared to the prior year. In comparison, real estate equity portfolios grew 13.4% to $418.3 billion in the same period. That data highlights another key point—significant runway ahead for greater capital flows to REITs. Based on those numbers, REITs represent a small fraction of total real estate allocations at about 9%.

“Obviously, REITs had a dramatic rebound last year,” says John Worth, executive vice president for research and investor outreach at Nareit. The Nareit All Equity REITs Index was up 41.3% in 2021, which contributed to asset allocations rising. However, the data over a five-year period also shows that REITs are up 47.4% versus real estate’s 40.5%. “What that tells me is that, while REITs are outperforming private real estate in terms of their returns, pensions are not selling out of REIT positions to bring down their allocation as REITs outperform,” he says. Pension plans are opting to maintain and grow REIT allocations as an important part of their portfolio, he adds.

Although pension funds have increased allocations to REITs over the past few years, there are some different strategic drivers behind those capital flows. As context, it’s important to note that a new investment cycle started in the second quarter of 2020 at the bottom of the COVID-19 market, notes Joe Smith, chief investment officer, listed strategies at CBRE Investment Management.

Beginning in the second half of 2020 through early 2021, institutions that were already invested in real estate strategies were the first to add money to REITs for a number of reasons. In some cases, pensions were “buying the dip”, Smith says. Pensions that wanted to stay true to their allocations to REITs had to add new money due to the underperformance in that sector to get back to target allocations. That sounds easy but buying at a time when values were down took some fortitude and showed strong confidence in the sector, he adds.

Key Attributes Attract Attention

A number of factors are fueling pension plans’ interest in listed REITs for both existing and new investors. Performance is certainly at the top of the list for most investors.

REITs have outperformed private real estate by an average of 2% per year over the last 20-plus years, Worth notes. A second factor is access to 21st century real estate. “As the real estate landscape has changed, reflecting the shift to an increasingly digital economy, REITs have been on the front edge of that innovation,” he says.

“When we engage with clients directly, a lot of the conversation is around access to assets that are more difficult to get a hold of otherwise—non-traditional real estate sectors like self-storage, data centers, cell towers, and healthcare,” Rehan adds. Buying REITs is an easier way to deploy capital into assets that also have a very easy-to-manage wrapper and best-in-class management teams, he says.

Institutional clients who are new to the REIT space are taking notice of their strong performance relative to private real estate and other public securities, Smith says. Having said that, REITs from 2015 to 2020 underperformed broader equities and were out of favor. “I believe investors coming to the market in late 2020 and early 2021 were acknowledging that the REIT market has changed. They could get exposure to new growth sectors, and they were coming in at a time where they saw a buying opportunity,” he says.

Both existing REIT investors and those new to the space are gravitating towards growth sectors. The Nareit All Equity Index is a good indicator of the extent to which the market has evolved. “You can get a very quick allocation solution to some of the best-in-class operators in those emerging growth sectors in the public market, and we think that is going to continue,” Smith says.

Another reason for the growing appetite for REITs is the view that real estate has been a good hedge against inflation. “Since 1972, anytime inflation is above 2.5%, REITs have always outperformed the broad market. Maybe this time will be different, but history usually rhymes if not repeats,” Smith notes. On the operating side, it’s about pricing power, revenue growth, and dividend growth. The thesis being, if a company can grow its earnings and dividend in excess of the inflation rate, it should be a good inflation hedge.

REITS Complement Private CRE Investment

Increased capital flows to REITs also reflect more capital flowing to real estate and real assets allocations generally. According to the Pension Real Estate Association (PREA) 2022 Investment Intentions Survey, the average current allocation to real estate among global institutions is 8.9% with an average target allocation of 10.1%.

Pension plans are working to push more capital out to meet those targets, and there are different strategies at play within those real estate allocations. Some firms are deploying more capital to REITs, but maintaining the same percentage targets, whereas others are increasing targets for REITs, Rehan says. It also takes time to deploy capital into private real estate ventures. REITs provide a liquid alternative that allows pensions to put money to work immediately. So, REITs could be on the receiving end of an outsized share at the initial stage of an increased allocation to real estate, he says. “The question is how sticky that money will be when they do find other real estate opportunities,” he adds.

Pensions also take different approaches to how they use REITs within investment portfolios. REIT allocations can fall into either public equity or real assets allocations. “The increased funded status we have seen in recent years has given corporate DB plans incentives to increase allocations to income-generating assets as part of the growth portfolio as it ultimately reduces surplus volatility as the risk profile of REITs are more closely aligned to liabilities,” Rehan says.

Various corporate plans, for the first time in a long time, are sitting on surpluses and are willing to de-risk their equity allocation by putting money into REITs, Rehan says. In portfolios where REITs are part of the real assets allocation, plans that are more liquidity constrained, due to large upcoming payments or a high commitment to illiquid assets in their overall portfolio, pensions are viewing REITs as a liquidity solution, he says.

“Pension plans are increasingly using REITs as a way to complement their private real estate investment,” says Kurt Walten, Nareit’s senior vice president, investment affairs & investor education. For example, Dutch pension services provider APG, one of the largest investors in real estate worldwide uses a fully integrated strategy combining REITs and non-listed real estate to build and manage a portfolio of global real estate investments. Currently, its portfolio is split about 60-40, with the majority in private real estate and the balance in listed REITs.

Although average pension fund allocations to real estate hover at around 10% of the total investment portfolio, Nareit analysis suggests the optimal allocation is 15%. Nareit also contends that pension plans can benefit from a minimum investment ratio of at least 25% of their real estate allocation to public REITs. That translates to significant opportunity for growth in REIT investments across the pension fund industry.

“For a lot of pension plans, putting an allocation into REITs doesn’t have to mean taking an allocation away from private real estate,” Worth adds. 

You can get a very quick allocation solution to some of the best-in-class operators in those emerging growth sectors in the public market, and we think that is going to continue.

Joe Smith, chief investment officer, listed strategies at CBRE Investment Management

Austin Pension’s 50-50 Strategy

REITs are an important part of the investment strategy for the City of Austin Employees’ Retirement System (COAERS). Following a 2019 strategic review, the pension fund opted for a 50/50 split between REITs and private real estate. Currently, the fund’s Strategic Asset Allocation to real estate equity has a neutral allocation of 10%, which represents approximately $350 million as of Dec. 31, 2021. COAERS Interim CIO David Stafford, recently shared insights on his team’s investing strategy.

How do REITs fit into your overall real estate allocation and real estate investment strategy?

One of the guiding investment beliefs adopted by the COAERS board states that implementation of the Strategic Asset Allocation should occur passively and in public markets, unless a high likelihood of success could be expected from other approaches. As such, this allocation can be implemented either through public markets REITs or private markets strategies, with passively implemented REITs as the default and benchmark. 

Historically, this allocation was implemented solely through an open-ended, core, private markets fund. However, during a 2019 strategic review of the structure and implementation of the system’s real estate exposure, the COAERS investment team noted that this implementation could be improved dramatically by adding a portfolio completion strategy of REITs, which could provide additional benefits to the total fund. 

As a result of the strategic review, the board adopted changes to the implementation of real estate, including splitting exposure between the existing core, private markets fund and adding a passive, completion index of REITs such that now this exposure is roughly evenly split between REITs and private real estate.

Can you share insights into your REIT strategy?

David Stafford, COAERS Interim CIO

Another foundational principle of the system’s investment beliefs is an emphasis on diversification in pursuit of the system’s goals. In recommending a new allocation to REITs, my colleagues and I noted that improved diversification, among other benefits, could be had by implementing in public markets securities. Given our core real estate exposures to office, industrial, multi-family, and retail were well implemented in private markets, we worked with FTSE NAREIT and our investment manager, Fidelity, to create a completion index of REIT sectors that the system didn’t have exposure to through this fund in order to increase diversification across property types. 

The customizable nature of such an approach allowed us to start with the FTSE NAREIT All Equity REITs index and from there exclude shopping centers, office, industrial, apartments, and infrastructure. This approach resulted in an index that gave broad exposure to property types that the system had limited exposure to previously and had become increasingly important, such as data centers and cell towers. 

Additionally, this index gives exposure to properties in the U.S., consistent with analysis that suggests these markets are the most developed and provide the best diversification in the total fund context. Our analysis also indicated that such an approach would likely lead to a variety of positive outcomes for the system, including stronger historical performance, lower costs, and significantly better liquidity. 

Given that these expected benefits are broadly consistent with best-in-class fiduciary practices, the COAERS investment team and I felt strongly that the best approach would combine the benefits of core, private markets real estate (inflation hedging, low volatility) with publicly-traded REITs to create a strongly performing and highly diversified allocation. 

Do you have any plans to continue raising your REIT allocation?

We continue to assess the relative benefits of publicly-traded REITs to those available in private markets. Given current market dynamics, we believe that a mixture of both implementation styles offers important benefits in the total fund context. 

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