PREA: Since '94, REITs have outperformed equity realty

Real estate investment trusts have outperformed property investments since pension funds were allowed to invest in REITs in 1994 — but REITs are riskier than real estate, according to research by the Pension Real Estate Association.

And even though a dollar invested in REITs in 1994 produced more income than a dollar invested in property, equity real estate outperformed when returns were adjusted for the added risk, the research paper stated.

“REITs had higher returns, but higher volatility,” Greg MacKinnon, director of research, said in an interview.

PREA, Hartford, Conn., used returns of the FTSE/NAREIT Equity REIT indexes vs. returns of private real estate as measured by the MIT Center for Real Estate's Transaction Based Index for its research.

According to the research, REIT returns have bested equity real estate returns by 159 basis points per year between the second quarter of 1994 and the second quarter of 2010.

However, REIT volatility reduces returns, Mr. MacKinnon said. The average REIT return per quarter of the study period was 3.14%, but the volatility of returns was 11.37%.

For equity real estate, the average return per quarter was 2.13%, while the volatility of returns was 3.58%, Mr. MacKinnon said.

The Sharpe measure, which represents the excess return earned per unit of volatility, was 0.35 for private real estate but 0.20 for REITs, according to the paper.

And dashing a widely held belief, Mr. MacKinnon said, PREA's research showed REITs are not a proxy for equity real estate.

According to the paper, REITs are more closely related to equities, corporate bonds and hedge funds than they are to equity real estate.

Transparency and liquidity do make REITs look better, he said.

“One argument is that there is more volatility in the short run, but in the long run that all washes out ...” Mr. MacKinnon said. “But keep in mind as soon as you say you are worried about liquidity, you are thinking there is some chance you will sell on short notice, which is to say that you should worry about short-term volatility.”

But the folks at the National Association of Real Estate Investment Trusts beg to differ. They say not only do REITs outperform equity real estate investments, but they also are safer.

REITs reduce the volatility of the equity real estate portfolio, said Brad Case, vice president of research and industry information at NAREIT, Washington.

REITs enter a downturn before equity real estate but also recover first, Mr. Case said. REIT returns began to fall in February 2007, hitting bottom on March 13, 2009, he said. The equity real estate slump didn't begin until about a year later and has yet to recover, he said.

“The reality is that over the last year, REITs have had a clear advantage over private equity real estate funds because of their ability to access significant amounts of relatively cheap capital in the public markets,” said Scott Farb, managing principal in the Los Angeles office of real estate consulting and accounting firm Reznick Group PC.

“REITs have issued more than $15 billion in debt in 2010 through August of this year. In the last weeks of July and in early August, REITs raised $4 billion in equity and $1 billion in new IPOs (initial public offerings).”

Mr. Farb added that REITs “currently are attractive as investors are looking for yield and REITs provide that yield.”

REITs are up close to 100% from their bottom while equity real estate is at the bottom, said Michael C. Hudgins, real estate strategist in the New York headquarters of J.P. Morgan Asset Management.

“It is very apparent to me that private real estate funds ... have not rebounded. Most other asset classes have already rebounded,” including REITs, said Mr. Hudgins, who researches both REITs and equity real estate. “What that means going forward is that return expectations favor private real estate.”

The perceived value of REITs has not been lost on at least one pension fund. Officials at the $8.2 billion New Mexico Educational Retirement Board, Santa Fe, are poised to invest the lion's share of their 5% real estate allocation in REITs, said Bob Jacksha, chief investment officer.

Last month, plan officials launched a search for a manager to run a portfolio of either global or active domestic REITs. The exact amount that would be assigned has not been determined, he said. The board already has 3.8% of total assets invested in a domestic REIT index strategy managed in-house that will be moved to the new manager, he said.

Plan officials like the liquidity and long-term performance of REITs, Mr. Jacksha said. “REITs have outperformed private real estate over the long-term period,” he said. About 1% of the fund's allocation will be in equity real estate.

In the past year, a number of other invest-ors also have announced they are bumping up their REIT investments. They are the $19.86 billion Iowa Public Employees' Retirement System, $11 billion Kansas Public Employees Retirement System and the $96.7 billionTexas Teacher Retirement System.

In August, the $5.3 billion San Bernardino (Calif.) County Employees' Retirement Association added a 20% target suballocation to global REITs as part of its 9% target real estate allocation, Don Pierce, investment officer, said at the time. He said the new suballocation will be a way to more easily rebalance the fund's existing $445 million equityreal estate portfolio.

This is a long-term goal and was added by the board at its Aug. 9 meeting as a way to more easily rebalance the fund's existing $445 million real estate portfolio, Mr. Pierce said.

The PREA paper found the most optimal portfolio contains both equity real estate and REITs. Amounts depend on the investor's risk appetite.

Conservative investors should invest more in equity real estate, while aggressive investors should look at boosting REIT exposure, Mr. MacKinnon said.