REIT investments remain calm despite virus storm

For such a small component of defined contribution investment menus, real estate investment trusts can play multiple roles ranging from allocation diversification to inflation protection to a proxy for direct real estate.

And because REITs are woven into a diversified fabric of DC plans, often through target-date funds, consultants and providers said prevailing plan structures mean the benefits of REITs are retained — even when the REIT industry in general has taken a coronavius-induced beating this year. Interviewees said they didn't detect panic among sponsors or providers.

"We haven't seen any movement to date" of target-date managers changing REIT exposure or strategies due to the coronavirus-caused volatility in the real estate industry, said David O'Meara, the New York-based director of investments at Willis Towers Watson PLC.

Noted Denise Burns, the New York based vice president and head of investments at Cammack Retirement Group Inc.: "It hasn't really changed that much for our clients. They "are not leaving the sector. Sponsors are staying the course."

One reason is that participants may not be aware they are investing in REITs. For example, if they invest in mutual funds that track the S&P 500 index, they also are investing in the 31 REITs that are part of the index.

The year-to-date S&P 500 Index total return was 9.74% through August. By contrast, the year to date FTSE Nareit All Equity REIT index return was down 9.87% this year through August, according to Nareit, the real estate investment trust industry trade organization.

If DC plan participants invest in a target-date fund, the REIT component is integrated into diversified holdings accounting for perhaps as much 5% of total target-date fund assets, Mr. O'Meara said.

For DC clients of Cammack Retirement, for example, REITs represent an estimated 4% to 5% of total plan assets, Ms. Burns said. Many Cammack clients offer broadly diversified stand-alone REIT funds.

And consultants say that if DC participants invest in a stand-alone REIT fund, sponsors likely offer a diversified fund featuring multiple REIT sectors to help offset the volatility of specific sectors.

"We're long-term investors," said John Worth, Nareit's executive vice president for research and investor outreach, adding that REITs today have stronger balance sheets than REITs during the 2008-2009 crisis. "REITs are quite resilient."

REITs accounted for $29.8 billion in DC assets at year-end 2019, according to Pensions & Investments annual survey of DC money managers covering U.S. institutional tax-exempt DC assets managed internally.

Last year's assets rose 35% from the $22.1 billion in 2018. Between 2014 and 2018, the annual amounts ranged from $21.2 billion to $24.6 billion. Total DC manager assets were $7.9 trillion by year-end 2019; internally managed assets were $6.94 trillion, according to P&I data.

As sponsors seek to trim investment lineups and increase the use of target-date funds as qualified default investment alternatives, stand-alone REIT funds' impact on total DC assets has declined.

Quarterly reports on DC plans by Callan LLC illustrate the trend. During the quarter ended March 31, 2006, Callan found that 7.5% of plans offered stand-alone REIT funds, which accounted for 5.7% of total plan assets when a plan offered this option.

However, as the prevalence of stand-alone REIT funds in plans has risen, the average allocation has dropped. Quarterly results over the last five years show that stand-alone REIT prevalence in plans has ranged between 18% and 27%, including 22.9% at March 31, 2020. During this period, the asset allocation to stand-alone REITs ranged from 1.5% to 2%, with the March 31, 2020, allocation at 1.7%. The Callan DC index for March 31 covered 105 plans with $247 billion in total assets.

Vanguard Group Inc. data show that even when stand-alone real estate funds are offered, relatively few participants invest — a trend that has been consistent over several years of annual reviews of record-kept clients and participants. Last year, 32% of plans offered a stand-alone real estate fund affecting 23% of participants. Of those participants, only 6% invested in it.

For sponsors thinking about offering stand-alone funds, "each one has to determine if participants really understand the asset class as part of their portfolios," said Mr. O'Meara of Willis Towers Watson. Because REITs are liquid and daily priced, they "are a relatively easy asset class to incorporate" into DC plans via target-date funds or multiasset funds, he added.

"The REITs funds are more popular in a target-date fund setting," said Greg Ungerman, senior vice president and defined contribution practice leader for consultant for Callan in San Francisco. "This will be the case in the future."

He noted that a June report of the Callan Target Date Index showed that of 86 glidepaths tracked by Callan, 51 offered a REIT component.

"I believe over time most asset allocators like private real estate," he said. In a DC environment, "they settle on REIT funds as a proxy" for direct real estate in target-date funds even though REITs are "more volatile than their underlying assets."

Target-date fund providers take different approaches to offering REIT exposure; Vanguard Group Inc., Malvern, Pa., and BlackRock Inc., demonstrate the contrast. BlackRock offers a separate REIT sleeve — an index fund — in its $290 billion LifePath target-date franchise.

When equities play the dominant role in the glidepath — such as a 2065 fund or 2060 fund — the REIT sleeve represents an average 4.8% allocation of total target-date fund assets. Over time, as fixed income plays a bigger role in the glidepath, the REIT role shrinks to 1.6% at retirement.

Two main issues for REITs are how they correlate to equities and whether they offer some inflation protection.

"It depends on your time horizon," said Nick Nefouse, managing director, co-head of the LifePath target-date business and head of the defined contribution investment and product strategy at BlackRock.

To illustrate correlation between equities and REITs, Mr. Nefouse said BlackRock uses the FTSE EPRA/NAREIT Developed Total Return index for the broad global REIT exposure and the MSCI World index for global equity exposure.

Comparing total returns for one year showed a high correlation. After comparing for five years, "the correlation breaks down," he said.

A seven-year comparison shows that REITs are "more correlated with private real estate." (REITs can serve as a proxy for DC managers that don't want illiquid direct real estate in their plans.)

BlackRock doesn't use direct real estate in its off-the-shelf target-date funds, and it has no plans to do so, Mr. Nefouse said.

If sponsors and participants are worried about short-term inflation (less that one year), then REIT funds "aren't the best exposure for them," Mr. Nefouse said. "REITs are sensitive to economic risks in the short-term." If their investment horizon is medium term (five years) or long term (seven or more years), then REITs offer some inflation protection, he said.

Vanguard's internal research shows that REITs' correlation to U.S. equities can depend on when REIT returns are measured. For example, the correlation between REITs and U.S. equities was 0.54 between 1971 and 2008; but it was 0.72 between 2008 and 2016, according to data from Thomson Reuters Datastream. A score of 1 means the asset categories investments are exactly correlated; a score of zero means there is no correlation.

Vanguard doesn't insert a specific REIT fund into the $887 billion Vanguard Target Retirement Fund family. Instead, its total stock fund and total international stock fund — both index funds in the target-date series — contain a REIT allocation. (Vanguard also offers a stand-alone REIT index fund and a REIT exchange-traded fund, neither of which is part of its target-date series.)

For the Vanguard Target Retirement Funds, REITs represent 2.7% of total target-date fund assets for the vintages when equities dominate, eventually falling to about 0.9% of assets as the equity component is reduced.

"We believe REITs are part of a broadly diversified portfolio," said James Martielli, head of investment solutions within Vanguard's institutional investor group. "If you have a portfolio with a target-date fund or a broad-based equity fund, you are getting exposure. An age-appropriate and broadly diversified portfolio is the best for most participants."