11/2/2015 | By Ralph Block
Published in the November/December 2015 issue of REIT magazine
What’s the best way to invest in commercial real estate – REITs or directly? This topic has been debated seemingly forever in trustee board rooms, financial planning seminars and even on golf courses.
The right answer is clear for the vast majority of individual investors: Only stock exchange-listed REITs provide the diversification among geographies and property types, liquidity, professional management and transparency that they want and need.
But the debate continues among institutional investors. According to a Cohen & Steers study, U.S. corporate and public pension funds have allocated only about 5 percent of their real estate allocations to listed REITs. Based on REITs’ performance over the years relative to diversified core real estate funds, that is shockingly small.
A June 2014 study by CEM Benchmarking and sponsored by NAREIT concluded that “listed Equity REITs outperformed other alternative assets with 11.3 percent annualized net total returns” for the 14-year period covered by the research. These alternatives included private real estate. Furthermore, CEM’s study determined that increasing the allocation to listed Equity REITs would have had “the largest positive impact on plan performance.”
REIT stocks versus directly owned commercial real estate is not purely an apples-to-apples comparison. REITs use modest debt leverage, and some engage in property developments, which increase risk and reward. However, REITs’ business is owning and managing (and sometimes selling) real estate, and the values of REIT stocks are normally very closely aligned with the values of REITs’ real estate.
Those fund advisors who counsel direct investing have made numerous supporting arguments, but they have become increasingly less persuasive. Here are a few of them:
REIT stock performance isn’t highly correlated with real estate properties and the stocks are much more volatile than commercial real estate prices. Real estate values shouldn’t be determined by hedge funds and traders.
Correlation changes with the measurement period. REIT stocks are subject to stock market forces over the short term. However, Green Street Advisors has shown that in the longer term, REIT stocks, on average, are valued with little premium or discount to their NAVs. Also, even though pension funds don’t adjust their real estate values daily, that doesn’t mean that underlying values aren’t moving. Besides, appraisals are backward-looking, while REIT prices tend to look forward.
Owning properties directly allows institutional funds to select specific properties, property types and geographical locations.
Almost any property type can be owned with REIT stocks. Furthermore, REITs’ outperformance has shown that the ability to pick properties in specific markets has been as valuable an asset as that old bone that my Golden Retrievers have buried in the backyard.
REIT stocks aren’t liquid enough to enable a large institutional investor to build a meaningful position.
That was probably true many years ago. Today, however, REIT stocks, which have an aggregate equity market cap of $846.4 billion and have an average trading volume of close to $7 billion per day (per NAREIT data), can accommodate all but truly gigantic investors.
REITs bear substantial public company G&A costs.
Due to REITs’ increasing size, these costs are becoming much less as a percentage of assets. Furthermore, pension funds also pay substantial fees. The CEM study showed that fees, measured by investment costs, amounted to only 51 basis points for REITs versus 113 basis points for private real estate.
But the bottom line, of course, is performance. The Cohen & Steers study and the CEM report noted earlier show that REITs have clearly outperformed core private real estate funds over many decades and cycles. Large institutional investors may not want to put all their real estate assets into REIT stocks. But an allocation between 5 percent and 10 percent is laughable, even to my Golden Retrievers.
Ralph Block is the author of “Investing in REITs” and “The Essential REIT” blog. Views expressed are solely those of the author.
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