REITs: A powerful tool for customizing real estate allocations

May 08, 2023 09:21
Photo: Reuters

Allocations to real estate have long been an important building block for constructing multi-asset portfolios, offering investors meaningful long-term return potential, inflation protection, and diversification benefits. While fundamentally similar, REITs differ from their private counterparts in terms of liquidity, geographic, and sector breadth. Investors can therefore use REITs to complement private real estate in building a diversified portfolio in a cost- and resource-efficient manner.

REITs merit a place in an allocation to real estate, providing important levers to create complete and efficient real estate allocations in institutional portfolios. However, Real Estate Investment Trusts (REITs) are often overlooked by institutional investors. Equity investors often avoid them - even when present in their benchmarks, claiming they are too expensive or lack the growth potential of their other equity sectors, while direct real estate or alternative investors often dismiss REITs as too volatile when compared to direct real estate or private real estate funds.

REITs play important roles in an institutional portfolio construction
From a strategic allocation perspective, REITs can be used in conjunction with private real estate on a long-term basis to achieve the desired sectoral, geographic, and property type mix. REITS can also be used to temporarily complete real estate allocations while capital is still in the process of being deployed into private properties.

An investor may own or contemplate owning direct real estate assets. They may be concentrated in a particular region or property type as real estate investors often specialise in certain geographies or property types. For example, if the investor is based in the Asia Pacific region and predominantly owns mainly direct assets in Hong Kong and Singapore, they may be looking for diversification via investments in other regions.

If this investor would prefer to have global real estate exposure but lacks expertise outside of their home market or lacks the ability to scale, they could use REITs to gain exposure to the regions they wish to add, possibly Europe or the Americas in this case. Given the large number of countries from which REITs are available, this strategy can be used not only at the regional level, but also to gain exposure country-by-country or even at the city level in some instances.

REITs can also be used to meet a target mix of property types. If an investor’s direct real estate assets primarily include office and apartments assets, but they seek wider diversification by property type, then REITs can be employed to gain exposure to industrial, retail, healthcare, or other property types. REITs can be combined with direct real estate, not just for the purpose of diversifying by property type, but also to concentrate exposure to a specific property type for long-term strategic purposes.

From a dynamic allocation perspective, REITs can provide investors access to tactical opportunities over the short-term, creating additional value. As REITs offer daily liquidity with minimal transaction costs, investors can use them to make tactical adjustments to their overall real estate allocation. REITs can also offer real estate arbitrage-like opportunities between public and private markets.

Australian investors, for example, have started investing in REITs since the early 1970s. They consider REITs as substitutes for pure direct property investing because REITs offer easier liquidity and a chance to own part of a large range of properties. APAC investors also use REITs to supplement direct property investing as a way to capture market opportunities in between property transactions.

REITs share characteristics of both equity and real estate
REITs are fundamentally real estate. They own, acquire, develop, sell, and lease properties while their cash flows come primarily from the rents they receive. REITs benefit (or suffer) when their properties’ values increase (or decrease) in the same way as direct real estate investors or private real estate funds. Over the longerterm periods, REITs behave very much like real estate. In fact, the returns of REITS and private real estate are highly correlated over the long-term when adjusted for leverage and liquidity factors.

However, in the short-term, the returns of REITs and direct real estate can diverge, sometimes materially. Over the shortterm horizon, REITs exhibit equity-like volatility and drawdowns. REITs trade on stock exchanges and are readily available to investors that otherwise would not be able to purchase property. The intraday liquidity offered by REITs is one of their greatest benefits when compared to direct real estate as the latter takes time to sell - often months or years.

It is also worth noting that REITs can issue debt and preferred securities in addition to common equity. These debt or fixed income-like instruments may even be registered and traded on major exchanges. These too can be used to complete a portfolio and offer different income, volatility, and risk profiles.

While still subject to the daily pricing of the markets, these securities may offer a higher level of income with less volatility than common REIT equity, but generally they give up much of the potential for capital appreciation. Thus, an investor could combine private real estate with REIT debt (with or without common equity of REITs) in the hopes of de-risking their overall real estate portfolio. Customised solutions to achieve an expected risk profile for an overall real estate allocation may include private equity, private debt, public equity, and public debt.

REITs can enhance existing private real estate allocation
It is possible that the combination of listed and private real estate can help increase the expected returns of an investor without changing the expected volatility. However, regardless of any changes to volatility or expected returns, using REITs to complement private real asset allocation does increase a portfolio’s liquidity profile. This liquidity advantage and the potential to expand an investor’s real estate opportunity set are just two benefits which REITs can provide institutional investors.

The combination of private real estate and REITs is a powerful tool for customising real estate allocations. In fact, our analysis suggests it may even be possible to add listed real estate to a private allocation and increase the overall expected return without changing the expected volatility. However, regardless of any changes to volatility or expected returns, combining listed real estate with direct real estate does increase a portfolio’s liquidity profile in comparison to holding only direct real estate. The liquidity of listed real estate is one of its primary benefits within an overall real estate allocation. This liquidity advantage, along with the potential to expand an investor’s real estate universe to meet allocation targets or complete a portfolio and combined with the signals listed real estate securities may present on potential future direct real estate returns leads us to recommend that all real estate investors should consider including listed real estate within their overall real estate allocation.

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Head and CIO of Liquid Real Assets, DWS