Real estate has earned a place in institutional portfolios because of its capacity to deliver attractive long-term returns. But individual real estate assets–land and structures–exist over time horizons well beyond the strategic planning and investment process of most investors, and this presents a few challenges. For example, the need to take profits, rebalance portfolios, pay benefits or provide institutional support demands periodic liquidity that individual physical assets cannot easily provide. In addition, the slow yet constant change in demand for various geographies and sectors means that investors would benefit from transactional flexibility and liquidity to optimize their portfolio exposures over time.
Large, diversified real estate investors can manage around these challenges within their portfolios, although at a measured pace that reflects the need to buy and sell individual properties. To reach a higher level of liquidity, financial markets have solved this challenge by transforming these illiquid assets into liquid securities that can be freely traded. The real estate investment trust (REIT) structure was created decades ago for precisely this purpose: It offers liquid exposure to underlying real estate assets that are diversified across sectors and geographies as well as up and down the capital structure (Exhibits 1A and 1B).
REITs offer liquid exposure to real estate assets that are diversified across sectors as well as up and down the capital structure
Exhibit 1A: U.S. public real estate sector distribution Exhibit 1B: U.S. public real estate capital structure
Despite these benefits, REITs represent only a modest percentage of the capital allocated to real estate–approximately 15% of the total; the remainder is private. This suggests that real estate investors are comfortable with illiquidity and see value in traditional private vehicles, as they should. Yet at the same time, the lack of liquidity has been a constraint on the size of real estate in institutional portfolios: Few investors have more than a 10% to 20% allocation to real estate, despite historically attractive returns.
This preference for private vehicles is particularly interesting because investors have the liquid option of REITs at their disposal; there are also some benefits of REITs that cannot be easily replicated in traditional private funds. In this article, we articulate the strong case for an active public real estate strategy serving as a complement to existing private allocations and therefore as a strategic asset class in its own right.
Complementing traditional private approaches
The baseline approach for most real estate investors is to participate in the equity ownership of real properties via a private fund manager with skill in developing, managing and transacting in these assets. This model achieves a balance between the extended time horizon required to realize value from the assets and the investor’s own need for a somewhat predictable return of capital.
Private real estate investors use two common approaches, either separately or in combination:
- Internally diversified open-end funds can invest across geographies and sectors. This approach is more commonly used with stabilized core assets, where income is the primary source of the expected return rather than a future sale. Although not as liquid as public market securities, open-end funds do allow greater flexibility around the timing of investment and redemption.
- Diversified portfolios of closed-end funds invest independently across sectors and geographies. With substantially less liquidity, closed-end funds are better suited to value-add or opportunistic investments that derive returns through an eventual exit at a higher valuation. These strategies offer little or no liquidity to investors beyond the timing of distributions at the conclusion of the investment period.
We suggest that there should be a third path to including real estate investments in a portfolio, one that leverages the transparency and liquidity of the public markets, allows for dynamic diversification across sectors and geographies, and incorporates flexibility to move across the capital structure. This is active REIT investing, and it offers a natural complement to moderately liquid open-end and illiquid closed-end private vehicles.
REIT volatility can be a source of opportunity for focused real estate investors
Whether the long-term trend of valuations in real estate is up or down, publicly traded REITs will exhibit greater volatility around the trend line than private investments (Exhibit 2). This is sometimes characterized as a shortcoming of the REIT asset class, as investors tend to prefer less volatility to more. But it is critical to recognize that this price volatility can actually be a valuable attribute because it offers a level of price discovery and transactional flexibility that private investments cannot match.
While exhibiting greater short-term volatility, long-term returns for public real estate are consistent with private real estate returns
Exhibit 2: Public real estate market (WILRESI1) vs. private real estate market (NFI-ODCE2): 10-year cumulative returns
For a skilled manager, this flexibility can be deployed to optimize real estate exposures in real time rather than across the months or years needed to make similar changes at the underlying asset level. The potential for alpha is enhanced further because many players in the public markets are not seasoned real estate investors, and this can lead to frequent–and sometimes substantial–deviations between REIT share prices and the value of the underlying real estate assets.
Optimizing REIT allocations
The transparency and flexibility of the public real estate market can help investors optimize their REIT allocations in the context of broader real estate investments. We explore how investors can gain insights into valuations by looking across several dimensions of the public real estate market.
Public vs. private
Public and private real estate transactions can be directly compared on a number of levels: the discount (or premium) of REIT shares to the net asset value (NAV) of the underlying assets (Exhibit 3); the relative performance of public vs. private funds; and the relative level of cap rates and the spread to Treasuries of public and private assets. Collectively, these metrics can provide a nuanced view of REIT valuations that can guide investors in the timing and sizing of public market investments.
The discount or premium of REIT shares to the NAV of the underlying assets provides insight into REIT valuations that can be useful in allocation decisions
Exhibit 3: Premium or discount to NAV for all property types
REITs offer investors access to various entry points across the capital structure, including equity, preferred (mezzanine) and senior debt. This flexibility allows public market investors to optimize their exposure with higher or lower risk positions in response to changing valuations and perceptions of risk. For instance, an active REIT investor looking to reduce risk could shift capital from equity to preferred or senior debt instead of simply moving defensively to cash. Examining current yields and spreads on preferred and senior debt, relative to historical levels and each other, assists in the tactical repositioning of a portfolio toward the most attractive portions of the capital structure.
Sector and geography
Because many REITs target specific sectors of the real estate market, active investors can adjust positions relative to various market sectors and specific REITs in real time. Comparing REIT and private valuations across each sector, along with the discount to NAV at the sector and individual security level, can highlight areas where public markets may have adjusted prior to private markets, either in terms of tighter valuations (a potential sell signal) or relative cheapness (a potential buy signal). Further, while REIT investors cannot select the underlying assets themselves, they can use the high level of transparency around specific property locations to make informed judgments about the geographic distribution of their capital.
The common thread across each of these dimensions of allocation flexibility is that the liquidity of REITs, along with their dynamic valuations and the granularity of the investible universe, creates a steady flow of investment opportunities for a skilled manager.
Public real estate as an asset class
Investors looking to justify a permanent, strategic role for public real estate in their asset allocations can point to several benefits that persist across market cycles.
First and foremost, the flexibility and transparency of REIT pricing across sectors, geographies and the capital structure offer exposure to real estate beta and a powerful alpha opportunity that is differentiated from traditional private strategies. This is not a replacement for the skill of private managers but a complement to it.
Second, the ability to shift from equity to less risky senior securities (such as preferred equity or debt) can de-leverage a REIT investment to a level of risk comparable to traditional private core real estate. This liquid version of a core exposure can be deployed tactically to move capital into and out of core investments as market opportunities change–without a lengthy investment or redemption process.
Third, a diversified REIT strategy can serve as a liquid “staging portfolio” for both private real estate and other core real asset sectors, such as infrastructure or transportation. By providing a shock absorber for capital calls and distributions, a REIT allocation can allow investors to hold less cash and keep their capital invested productively.
Enhancing a real estate portfolio
For many investors, REITs are closely linked to the equity allocation because they trade on equity exchanges, but this narrow, vehicle-focused perspective undervalues the benefits that a diversified strategic allocation to active REITs can deliver.
When viewed alongside the value drivers of traditional private real estate investments, the additional benefits of liquidity, transparency and diversification are clear. Long-term assets need long-term capital, but the vehicle through which that capital is deployed need not be limited to illiquid private funds. Public markets exist in part to solve the challenge of liquidity transformation. A dedicated REIT strategy–alongside legacy private strategies–allows a real estate allocation to grow while becoming more nimble and efficient over time.