Be Active: Dedicated REIT Managers Continue to Outperform

Since the late ‘90s, listed equity REITs have consistently ranked near the top of all asset classes when it comes to performance.

In fact, a recent study by CEM Benchmarking on the performance of more than 200 public and private pension funds from 1998-2014 found listed equity REITs to be the top performing asset class out of the 12 studied. Knowing that REITs have the potential to improve fund returns, the next question is where to allocate within the asset class – active management or passive indexing?

Despite the growth of passive funds, do they make sense for every sector? During the past ten years, the answer is no.

As the debate between active versus passive management continues, those in favor of passively managed vehicles tout the advantages of passive management. Some will even argue that most, if not all, investors should invest in passively managed vehicles. We don’t think this is the case when investing in REITs.

What investors need to remember is that there is no free lunch. If we take passive investing to its extreme and assume all investors are passive, the markets cease to function. In a capital intensive industry like real estate, this is a lose-lose situation for companies and investors alike. The premise behind passive investing is based on the ideas of the efficient-market hypothesis (EMH), which states that stocks properly reflect all available information because self-interested investors are motivated to acquire information and profit from it. With so many market participants doing the same thing, stocks reflect all the available information. If there are no active participants left in the markets, the entire capital allocation process breaks down. The great irony is that the increase in passive management is only serving to make the markets less efficient.

The Super Investors of REITville

Now, let’s fully admit that, by definition, the market return is the capital weighted average of all participants’ returns gross of expenses and fees, so the land of active management is not a magic place where all investors can be above average and beat the market. But that doesn’t mean there aren’t certain areas of the market where investors do consistently outperform the market. Perhaps Warren Buffett said it best when he wrote about The Super Investors of Graham-and-Doddsville in 1984:

I would like you to imagine a national coin-flipping contest. Let’s assume we get 225 million Americans up tomorrow morning and we ask them all to wager a dollar. They go out in the morning at sunrise , and they all call the flip of the coin. If they call correctly, they win a dollar from those who called wrong. Each day the losers drop out, and on the subsequent day the stakes build as all the previous winnings are put on the line. After ten flips on ten mornings, there will be approximately 220,000 people in the United States who have correctly called ten flips in a row … [and] in another ten days we will have 215 people who have successfully called their coin flips 20 times in a row and who, by this exercise, each have turned one dollar into a little over $1 million.

The majority of REIT managers have consistently outperformed their benchmarks

At this point, Mr. Buffett points out that this is where the academic professors step in to bring up the fact that if 225 million coin flipping orangutans performed the same exercise the result would be the same. See the markets are efficient! But what if, argues Buffett, of the remaining 215 winning orangutans, 40 came from one particular zoo in Omaha? You might think something was going on at that zoo that made the results not appear to be random. Buffett uses this argument to highlight the extraordinary investing record of so many of the students of legendary value investor Ben Graham. Today, though, you can also see that same pattern among another group of investors: REIT-dedicated investing teams.

Analyzing 10 Years of REIT Investing

If we look at the competitive set of REIT-dedicated managers of the past 10 years of global investing, we find that the median manager has consistently outperformed their passive benchmarks, typically above and beyond standard institutional account fees.

But is this pure stockpicking skill, or are managers just getting lucky and using risk (i.e., beta) to generate excess returns? To answer this we looked at the ranges of alpha for the same set of managers, and the results are even better than simply using excess returns.

The majority of REIT managers have outperformed and have demonstrated stockpicking skill. But how can this be? The EMH tells us managers can only use beta to alter return profiles, whereas alpha is elusive. And, yet, REIT managers defy this and appear to be consistently skillful in identifying and exploiting alpha opportunities.

REIT Specialists vs. Generalists

We believe there are two reasons why REIT-dedicated managers have shown to be skillful – specialization and the two markets for commercial real estate.

REIT managers appear to be consistently skillful in identifying and exploiting alpha opportunities

The first reason centers on the idea of specialization. The phrase “jack of all trades, master of none” applies to managing investment portfolios. When real estate became its own sector within the GICS classification system, it became the 11th sector for generalist investors to cover. The investment universe is broad and varied for generalist equity investors, whereas REIT dedicated managers can demonstrate their specialized expertise and deep knowledge of the real estate investment landscape.

Being specialized experts in real estate ties directly to the second reason that REIT-dedicated managers have consistently outperformed passive benchmarks: the tale of “two markets” for real estate investing. REITs, while owning some of the highest quality properties around the globe, are still a minority owner in the massive stock of commercial real estate that is primarily owned and transacted privately. Dedicated REIT managers born out of the private market have expertise and focus, allowing them to immediately access detailed and oftentimes proprietary data in order to analyze the valuations, operating trends, and inefficiencies in the private markets that could impact REIT assets. This tale of two markets is unique to real estate and allows REIT managers the opportunity to do the in-depth research required to identify alpha opportunities.

REIT managers have expertise and focus, allowing them to access and analyze the valuations and operating trends

While passively managed strategies have gained traction across a variety of asset classes in recent years – the data for listed REITs shows that active management has consistently outperformed passive benchmarks. While not all active management is equal, specialization in one sector and the abundance of data from the private market are two reasons why active REIT managers have consistently been able to identify and exploit alpha opportunities. While the average investor might not be able to beat the market by definition, as Warren Buffett noted in calling out the disciples of Ben Graham, there are areas to exploit the benefits of active management, starting with REITs.


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