As investors monitor the current market cycle, many are taking a closer look at how they can best structure their real estate portfolio allocation.
Those with the flexibility to do so are finding a unique opportunity in REITs due to a meaningful disparity between private market and public market pricing. Though private real estate pricing is strong and we are late in the cycle, fundamentals remain strong and REITs are comparatively inexpensive. Our view is that they are on track to outperform over the next several years.
Some investors who are new to REITs may be concerned that REITs do not provide the same returns as private real estate, or that they will enter the market at the wrong time. In this paper, we examine how REITs behave, their performance over the last two market cycles, their relationship to changes in interest rates, and why we believe that we are at a favorable point in the market cycle to invest in REITs.
REITs are Real Estate
REITs have historically offered a blend of yield and appreciation that is similar to investments in private real estate
We know that investing in real estate securities is a more liquid alternative to investing in direct real estate, but a myth that REITs are not real estate persists. While it is tempting to think of REITs as pure equities, data shows that over the long term they behave quite differently than other equities. REITs have historically offered a blend of yield and appreciation that is more similar to investments in private real estate than to investments in other equities.
We examined the correlations between REITs and the broader equities universe over an investment horizon of one to 20 quarters. At the onset of the horizon, the correlation between REITs and the broader public equity market is high. However, over time, we see that REITs start to exhibit their inherent qualities as real estate investments, showing strong correlations with private real estate, as seen in the following charts.
CORRELATIONS BETWEEN REITS AND RUSSELL 3000 US TOTAL MARKET INDEX
CORRELATIONS BETWEEN REITS AND NCREIF ODCE INDEX
Source: NAREIT® analysis of monthly returns data for January 1990 through December 2016 from Interactive Data Pricing and Reference Data accessed through FactSet.
While public market correlations are strong at the outset, asset returns increasingly differ as spillover (mispricing) effects are corrected. Further, underlying return drivers are fundamentally different – that is, REITs and non-REIT stocks represent different asset classes. This is further demonstrated in the correlations with private markets over the long-term investment horizon, as REIT mispricing and appraisal errors are corrected. That REITs are fundamentally real estate is evident in long-term valuations. Investors who make short-term investments in REITs will generally not observe these private market correlations. However, if they invest over a full cycle, data shows that they will generate returns that look like private real estate. Historically, REITs have provided higher total returns compared to private real estate, as illustrated in the following chart.
REIT Returns Vs. Other Asset Types
Twenty Years as of December 31, 2018
US Stock: Standard & Poor’s 500
US REIT: Wilshire Real Estate Securities Index
US Real Estate: NCREIF ODCE
US Bond: Merrill Lynch Government/Corporate Bond Index
Past performance is no guarantee of future results.
A Tale of Two Pricing Markets
While REITs present an attractive opportunity for investors, the question remains: When should an investor buy and sell to achieve the strongest possible returns? To best answer this question, we examined pricing differences between public and private markets over the course of two economic cycles (nearly 20 years) to identify any predictive factors or patterns. We considered many different factors, including capital markets data, such as financial conditions and credit spreads, as well as real estate valuations, such as NAVs and implied cap rates. While many factors had some predictive value, the implied cap rate spread between private and public markets proved to be the most predictive. This is also the most intuitive and easy-to-measure factor. Long-term investors can profit from pricing differences between public and private markets using the implied cap rate spread.
Long-term investors may be able to profit from pricing differences between public and private markets using the implied cap rate spread
Our view is that combining actively managed REIT portfolios with proper timing of entry into the market significantly enhances both returns and return per unit of risk. To test our theory, we created an investment allocation model to determine optimal timing with respect to adding and removing REITs from a portfolio. We examined the addition of REITs to a portfolio when REITs trade at a discount of 50 bps to private real estate on implied cap rate comparison (using a trailing 4Q difference), and holding until the REITS trade at a premium implied cap rate to private real estate.
Taking this into account over the past two cycles as well as the correlations between the public and private markets described above, our analysis indicates that if an investor had added REITs during the late 1990s when REITs were cheap because of the TMT bubble, then removed REITs in 2005 when REITs were expensive due to the start of the M&A/privatization boom, and finally added REITs in early 2008, a year after REITs had started to correct ahead of private real estate, the investor would have attained positive performance while mitigating the return per unit of risk over this period.
CAP RATE SPREADS VS. 3-YEAR FORWARD RETURNS
Source: ODCE; Green Street; and Heitman
As illustrated in the chart, three-year forward returns, which indicate how REITs are performing versus the private market, follow the cap rate spread. In the current environment, the implied cap rate spread is trending up, which leads us to conclude that REITs will outperform over the coming years. The spread is now at one of the widest levels outside of recessions or crisis. Further, at this stage in the cycle, real estate valuations still appear to be favorable in comparison to other asset classes, as tenant demand remains strong, and economic conditions indicate the likelihood of rents continuing to increase.
Why Be Active? It Works
We took our analysis one step further and examined the differences between four scenarios. Our base case was investing in private real estate over the course of the past two cycles. We then added a static 20% allocation to REITs, consistent with NAREIT models. The third scenario was a 20% allocation to REITs using the previously described investment model, and we completed our analysis with a 20% allocation using active management along with the investment model.
As illustrated in the following chart, when using a passive strategy to invest in REITs, the annual return is greater than that of private real estate, but the return per unit of risk is lower. By entering/exiting the market three times, as we did in the investment model, returns are increased and the standard deviation is lowered. In this illustration, an investor’s portfolio benefits most when active management is used, as both annual return and return per unit of risk are the highest under active management vis-à-vis all considered scenarios. Over time, applying active management appears to provide strong returns and gains for investors.
1. NFI-ODCE Value Weighted Index
2. Wilshire US RESI Index
Source: ODCE; Bloomberg; and Heitman
REITS have typically exhibited strong property fundamentals during periods of rising interest rates
A common investor concern is the impact of interest rates on REITs. As an active manager, we examine how REITs behave against a variety of interest rate scenarios. A misperception is that interest rates are negatively correlated with REIT pricing. However, the numbers demonstrate that this is not necessarily the case.
History has shown that interest rates typically increase due to improving macroeconomic conditions or rising inflation. In line with those improving conditions, REITs have typically exhibited strong property fundamentals during periods of rising interest rates. But when comparing REIT performance relative to the S&P 500 with changes in interest rates over an investment horizon of over 20 years, we do not see any discernible relationship over time between returns and changes in interest rates.
REITS VERSUS S&P 500 AND RATE CHANGES: 1992-2016
Source: NAREIT® analysis. NAREIT All Equity REIT and S&P 500 total returns indices via FactSet, GDP and 10 Year Treasury Constant Maturity Rate s via FRED. Quarterly intervals of 12 month rolling returns, rate changes and GDP growth.
REITs are versatile investments that can serve as a complement to a private real estate strategy
We have provided historical analysis as a way to demonstrate that investors with real estate allocations can strengthen performance through actively managed investment in REITs. The implied cap rate spread between public and private markets is shown to be a more predictive factor with respect to optimal timing of entry into and exit from the REIT market to achieve enhanced real estate investment returns and returns per unit of risk. In the current environment of rising implied cap rate spreads, which are now at one of the widest levels since the financial crisis, we believe that REITs are in position to outperform over the coming years.
REITs are versatile investments that can serve as a complement to a private real estate strategy and allow an investor to access a diversified real estate portfolio without committing to multiple private real estate investments. To achieve effective REIT portfolio construction and management, investors will likely benefit from managers who possess the necessary sector focus and expertise derived from in-depth experience in both public and private real estate investment.
Although the written materials contained herein were prepared from sources and data presumed by Heitman to be reliable, Heitman makes no representation or warranty, express or implied, with respect to their accuracy, timeliness, or completeness. You are additionally informed that any information contained herein is always subject to change without notice. Finally, any statements contained herein that are “forward-looking statements” or otherwise are not historical facts but rather are based on expectations, estimates, projections, and opinions of Heitman involve known and unknown risks, uncertainties, and other factors. Actual events or results may differ materially from those reflected or contemplated in such statements. Accordingly, Heitman expressly disclaims any responsibility or liability for any loss or damage that may be incurred by any party who relies on the written materials contained herein.
The information contained herein is confidential and shall not be copied, reproduced, used, or disclosed, in whole or in part, without the express written consent of Heitman, which may be withheld in Heitman’s sole and absolute discretion.