Understanding the role real estate plays in defined contribution plans
David Lebovitz: Welcome to the Center for Investment Excellence, a production of JP Morgan Asset Management.
The Center for Investment Excellence is an audio podcast that provides educational insights across asset classes and investment teams.
Today’s episode is on the benefits of real estate in DC plans and has been recorded for institutional and professional investors.
I’m David Lebovitz, Global Market Strategist and host of the Center for Investment Excellence.
With me today are Jani Venter and Jaclyn Beck, executive directors from our DC Funds Management Team.
Welcome to the Center for Investment Excellence.
Jani Venter: Thanks for having us.
Jaclyn Beck: It’s really great to be here. Thanks, David.
David Lebovitz: To recap for our listeners, over the last several weeks, we’ve been delving into various asset classes amidst the market volatility. We’ve been exploring how investors can best position themselves to withstand current market conditions and prepare for those in the future. Today we’ll be discussing the benefits of real estate in a DC plan. So let’s jump right in.
Jaclyn, let’s start with you. From a high level, can you walk us through some of the benefits of adding direct real estate to DC plans? And in particular, I’d be interested in hearing about why private real estate and why not just an allocation to REITs.
Jaclyn Beck: Yes of course. And when you really think about it, private real estate first and foremost is a portfolio of survivor. Right? So if you think about what it’s meant to do in a strategic asset allocation or multi-asset portfolio, it’s meant to mitigate drawdown on a downside and it’s meant to support stronger risk-adjusted returns over the long term. And so what it’s really focused on is diversification with the goal of strengthening participant outcome for plan sponsors.
The reason (unintelligible) is because it exhibits lower correlations to both asset classes that have traditionally been utilized by the DC space. So think of things like fixed income and equities, I always like to say that in that context, real estate tends to (unintelligible) when the rest of the world (unintelligible) historically.
So it’s really the beta of asset class that helps to support that dynamic within a multi-asset portfolio.
Now answering your question about REITs. When we start thinking about REITs, we start getting into a conversation around volatility, specifically. Right? And so volatility in a sense that REITs tend to exhibit higher correlations to the equity market.
But moreover than that, they do exhibit just that different risk return metrics. They really address a portion of the investable real estate universe and have an important role in portfolio construction. Right? It’s just different than private real estate.
And for that reason, we don’t think it’s one or the other. A lot of folks we talk to think it’s one or the other. Really they’re best suited as comp income. And I think that the industry has coalesced around that concept as well.
David Lebovitz: Yes. I think that’s a really key point. And one of the conversations that I tend to have with investors is, you know, it’s not necessarily about one or the other. It’s really about the combination of the two. And one of the charts that we show in our Guide to Alternative actually listed the correlation of REITs and direct real estate with the equity market and it shows exactly what you just laid out that when you’re going for diversification, direct real estate is really a good diversifier; whereas REITs are going to be more reflective of what’s going on in the public equity market.
So, Jani, I’d love to bring you into the conversation here. From your vantage point, what has supported the growth for DC private real estate solution? And how does the industry manage daily liquidity and the daily valuations that DC investors require? I think in the past, that’s been one of the big challenges. So we’d love to get your thoughts on how they manage that dynamic at the current juncture.
Jani Venter: So, David, that is a very good point. And there have been two factors that are supporting the environment where DC plans could successful allocate and include an allocation to private real estate. The first was a shift in DC plans to multi-asset professionally managed portfolios such as target-date funds after the Pension Protection Act in 2006. Now this allows real estate to be included for a specific asset-class benefit and not as the first stop for liquidity.
The second was actually an evolution in the real estate fund structures and industry that address the historic concerns relating to liquidity, valuation and pricing frequency that you mentioned. If we look back today, DC plans have successfully included allocations to private real estate since the mid-2000. So we have an established solution that has weathered through the Great Financial crisis and seven significant Target Date Fund drawdowns (unintelligible).
And in terms of liquidity, as Jackie mentioned earlier, most of the DC real estate solutions offer blended exposure to private and public real estate. It is the reallocation that essentially satisfies the daily liquidity need for these investors.
But there’s also a second layer of liquidity management because these DC real estate funds generally limit their inclusion to professionally managed plans only. So this reduces the liquidity concern because the professional manager has several options other than real estate to initially satisfy that need.
And there’s also the question of daily valuation as a historic concern. REITs like daily NAV. So the question is really looking at private real estate and how viable that NAV is for investors. There’s industry best practices but there’s a couple of ways of calculating the daily NAV for private real estate.
Essentially investors take the total return. They break it into income and appreciation. Income is contractual. A portion of a portfolio is valued every day and fully recognized combined with the income, combined with the REITs and provides a viable daily NAV for the DC investor.
Jackie, thoughts on your side there.
Jaclyn Beck: Yes. What I would say is that the industry takes different views on valuation and liquidity. But just like Jani said, the industry has coalesced around this concept of including some type of liquidity buffer with a private allocation. And it’s also coalesced around this idea of having some recognition of appreciation on a daily basis, whether it’d be forecasted or actual.
And so the combination of that in conjunction with the contractual income, that is predictable and steady in the core real estate allocation, which is what we’re talking back for the purposes of today has ultimately come together to allow this to be delivered to the marketplace in a very actionable way.
David Lebovitz: Excellent. That was very helpful and I know a key question that is on a lot of folks’ minds when they think about merging a private asset with a DC plan.
So now that we’ve kind of set the stage, let’s just do one of the questions that probably front of mind for all of our listeners, which is the current market environment.
And, Jani, maybe going back to you, how have DC real estate solutions been performing as COVID-19 has spread around the world? And have you seen any volatility in client behavior in addition to the volatility that we’ve seen across the variety of types of assets here over the past couple of weeks?
Jani Venter: So, David, year-to-date, private real estate has delivered the stability that is expected from the asset class in a multi-asset portfolio. And if you look back at the first quarter, target-date funds without real estate returns ranged negative 14% to negative 19%.
Now on the other hand, private real estate delivered a positive total return for the quarter. The bigger question is what do we expect for Q2 and Q3? And really it is too soon to know but we try and look back at history. And as we look back to 1978, there has been only two periods where core real estate total returns turned negative during the Great Financial crisis and during the early 90s recession.
So that is important to look at if we think about the consideration for stability that is important in a multi-asset portfolio today. And if we look at client behavior, I think it’s important to think about the fact that the majority of these vehicles are not available to retail investors, which limits the participant-driven volatility.
And the behavior that we did see during Q1 were in line with behavior during historic periods of volatility, for example the first quarter of 2018 where equity markets declined while real estate returns remained fairly stable, and as a result, investors held an overweight to the asset class. Redemptions were submitted to rebalance back to target I think as traditional investor behavior.
Jackie, any thoughts on your slide on the volatility and the performance?
Jaclyn Beck: So, Jani, David, you obviously know that we have an extraordinary body of research with regard to participant activity from our Retirement Insights team. And what that has found is that participant activity is extraordinarily steady over periods of time and even over volatile periods of time.
Now these are extraordinary circumstances. This period of time is really navigating unchartered waters. And there’s a few things that we’re watching. Specifically one, the easing of penalties associated with drawing on retirement funds for a lot of these participants. And number two, we’re really paying a close eye at those industries that are most affected by, be it furloughs or layoff, et cetera, to understand how that will affect participant behavior.
And so just a few dynamics that are back in the industry right now that historically haven’t necessarily been there and that we’re watching just to understand how it ultimately plays out.
The other piece of that is - and if I could, David, just go back to your question about REITs at the beginning, if you’ve seen of what REITs have done over the course of this latest distraction, it’s been pretty significant in terms of volatility. I mean, you saw highs in the REITs market in mid-February dropping fairly drastically and fairly swiftly as well alongside the equity market.
And so it really does bring into the forefront - the correlation of REITs fundamentally to the equity market. And the fundamental difference that an investor or multi-asset portfolio would see from a private allocation where in the first quarter (unintelligible), we saw returns be fairly steady as opposed to REITs exhibiting higher volatility.
Right now, we’re often getting the question, you know, REITs have fallen significantly; does that mean that real estate valuations are going to fall significantly? And what we would say right now is that directionally, we think sure, yes, we think real estate will ultimately (unintelligible). We think on an absolute basis, REITs have overshot what the private market is going to see.
So our expectation is that you wouldn’t see a valuation friction. (Unintelligible) that you’ve seen REITs cross more so around the tune of about 10% to 15%.
David Lebovitz: Excellent. That’s very helpful and I think definitely addresses a key question that’s on the minds of many of our listeners.
So I want to bring things to a close here. And, you know, we’ve talked about some of the benefits of using direct real estate alongside REITs within the context of a DC plan. We’ve talked about some of the technical hurdles to getting private investments in DC plans and some of the solutions that we leverage in order to successful do so. We’ve touched on what’s been going on with the spread of COVID-19 and how the global economic lockdown has impacted not only the assets themselves but also client behavior.
So to wrap things up here, you know, I’d love to get each of your thoughts for any plans that are considering real estate as we move forward here, why should they - and for those who are already invested in real estate, you know, I know we’ve shared a lot but would you add anything else to the message that we sent today?
Jani, maybe we’ll start with you. And then, Jackie, you can bring us home.
Jani Venter: So, David, I think the bigger question is if we take a step back and we talk to plan sponsors, what is their participant’s need from their retirement over the next 10, 20 or 30 years?
If you think about where we are in the cycle today and the risk that it might present over that time period, there’s a very strong rationale for including private real estate and blended real estate into DC plans. Currently, we’re early in the correction. The inclusion of private real estate could mitigate the impact of continued volatility, broader market drawdowns on portfolios. So essentially, it might preserve value for participants.
There’s also the risk of inflation from the US stimulus package at some point. And private real estate is the only asset class that provides the potential for inflation protection and also has the potential to lower the overall volatility in the portfolio. And over the long term, as we move through this recession into a recovery, including real estate may support stronger risk-adjusted returns that create value in retirement portfolios.
So, Jackie, do you have thoughts here?
Jaclyn Beck: Yes. I would say number one, I hope the investors who already have real estate allocations are pleased with the fact that they stabilized their first quarter returns. And number two, I would say it’s (unintelligible), right? And so we are in an uncertain environment. We’re in a new environment and we are navigating new waters.
And so Jani earlier spoke about history and past precedent of real estate drawdowns, real estate historically has been supported by a very strong income profile. And that income profile is being thrown into question right now, quite frankly, with the rent conversation, how many tenants are paying their rents, whether they continue to pay their rents. And the answer is we just don’t know yet. And so it’s critical to consider quality of income, quality of assets as we continue through this cycle because those are ultimately going to be the bonds and the proof that we’ll be able to weather the storm the best.
The other thing I would say to those investors considering an allocation to real estate is this is a strategic allocation. Right? Or we see it as a strategic allocation rather. We don’t necessarily see it as tactical. So there will be periods of time where real estate will help you, just like what we saw in the first quarter. There will be periods of time where real estate will take away some of your upside, just like what you see in elongated cycle.
But really the goal here with the strategic real estate allocation is long term, participant outcomes that are in the best interest of the constituents of the individual’s plan sponsors and what asset allocation gets you there.
Diversification is not going away. The benefits of diversification are not going away. And real estate has proven to be a diversifier in the past. And as the storm continues to rage, we will continue to see whether or not it meets its mandate during the cycle. But we certainly hope it will be able to.
David Lebovitz: Excellent. Yes. I think during times like this it is so important to remind clients that sometimes the best approach is perhaps a relatively simple approach. And even into things like diversification at the current juncture, I think we’ll drive better participant outcomes over the medium for the longer term.
So we want to thank you both very much for joining in today on the Center for Investment Excellence.
Jaclyn Beck: Thanks, Dave.
Jani Venter: Thanks for having us, Dave.
David Lebovitz: Thank you for joining us today on JPMorgan Center for Investment Excellence.
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