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Study shows returns of listed REITs topped other asset classes

Private equity came in a close second

Real estate investment trusts offered the highest net return of all asset classes for 900 corporate and public defined benefit plans between 1998 and 2011, says a soon-to-be-released study by research firm CEM Benchmarking Inc.

Listed equity REITs, with an average annual net return of 11.31%, just edged out private equity, at 11.1% during the study period. Real assets other than real estate — including commodities, infrastructure and natural resources — was the next best performing asset class with 9.85%, said the study, commissioned by the National Association of Real Estate Investment Trusts, Washington.

On a gross return basis, private equity was the best performing asset class with 13.31%, followed by REITs at 11.82% and “other” real assets, 10.88%, the study showed.

But research published last October by Private Equity Growth Council, a Washington-based trade group, shows public pension funds' “investments in private equity outperform other asset classes based on the median pension's 10-year annualized return,” said James Maloney, spokesman for the council.

CEM's survey period started in 1998 because that is when the Toronto-based firm first separated REITs from stocks in its surveys. The period ends with 2011, the most recent data available to CEM because of the delay in calculating returns of private alternative investments.

Costs matter, noted Alexander D. Beath, an analyst at CEM and author of the study. The average fee over the period for REITs was 51.6 basis points, vs. 238.3 basis points for private equity and 102.6 basis points for the “other” real assets.

U.S. broad fixed income was the asset class with the lowest cost over the period; it provided an average annual net return of 6.56% with a cost of 17.3 basis points. U.S. long-duration fixed income had an 8.97% net return with average fees of 17.4 basis points.

Asset allocation matters, too. Changes in asset allocation during the survey period affected pension fund performance, depending on the size of the allocation.

For example, small public-sector plans that had above-average allocations to REITs had a lower average annualized compound portfolio net return, 5.43%, than small public plans with below-average allocations to listed equity REITs at 6.29%. The reason is that much larger allocations to other asset classes had a greater impact on overall portfolio returns.

Another example of how asset allocations affected returns was the performance of large corporate plans. Over the survey period, large corporate plans performed best because of switching to long-duration U.S. bonds from domestic large-cap equities beginning in 2007 after adopting liability-driven investing strategies, Mr. Beath said. Large corporate plans had an average annualized compound net return of 7.54%, outperforming the 6.61% earned by all defined benefit plans during the period. Large public-sector funds earned an average of 6.21%.

Large corporate plans also had relatively low allocations to alternatives including real estate, private equity, other real assets and REITs, which Mr. Beath called a missed opportunity. Public pension plans had a higher average allocation to alternatives.

Meanwhile, relative to the average pension fund, large public plans were underweight long-duration U.S. fixed income — especially after 2007 — as well as small-cap U.S. equities and tactical asset allocation/hedge funds. Large public pension plans on average were overweight broad U.S. fixed income and large-cap U.S. stock.

While REITs provided some of the highest net returns at relatively low cost, the asset class remains one of the most volatile, at 20.17%, the study found.

Non-U.S. stocks had the highest volatility, at 24.02%, followed by U.S. small-cap stocks with 20.58%.

Volatility is important because it can produce a drag on returns, Mr. Beath said.

Private equity “had the highest gross returns, and they got that by taking riskier positions,” Mr. Beath said. “If you subtract costs, REITs becomes the best-performing asset class.”

However, REITs were not significantly more volatile than private real estate when the return data are adjusted for real estate's reporting lags and appraisal smoothing, Mr. Beath said. After such adjustments, private real estate had a net return of 7.61% with 112.6 basis points of cost and a standard deviation 16.48%. Indeed, the adjusted private real estate returns and REIT returns have a correlation of more than 85%, the study showed.

CEM executives were not surprised by the correlation because both own and generate their investment returns from the same assets — commercial real estate. Correcting for the reporting lag of private real estate “gets the lion's share of the correlation back,” Mr. Beath said.

Appraisal smoothing also affects volatility. Appraisers sometimes arrive at current valuations by taking the old valuation, cutting it in half and appraising the property halfway between the new and old valuations, he said.

“Placing an investment in a private marketplace doesn't make it less volatile,” he said. “The lack of volatility is not real.”

The study also analyzed how potential shifts in asset allocations could have affected net total returns during the survey period. CEM estimated U.S. long-duration fixed income, equity REITs and other real assets would have provided the biggest increase in total portfolio annualized average net returns.

If the pension plans had increased their allocations to U.S. long-duration fixed income by one percentage point per year, net returns would have been 4.4 basis points. The same annual increase in equity REITs would have provided 3.9 basis points and ”other” real assets would have been 3.8 basis points.