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Why Institutional Investors May Favor Office REITs in a Late-Cycle Environment

The longer the cycle lasts, the more attractive REITs look to institutional investors.

With late cycle uncertainty emerging as the market slows, institutional investors are allocating more capital to REITs than private equity funds, as REITs have historically outperformed broad equities in late-cycle periods. For examples, California State Teachers’ Retirement System (CalSTRS), a $227.8 billion pension fund, recently announced a $100-million commitment to REITs, its first-ever entry into the sector.

While office REITs performed poorly in 2018, down 14.5 percent year-over-year, they were up 17.8 percent at the end of May, notes John Worth, executive vice president, research and investor outreach with Nareit, an industry trade group. While institutional investors tend to favor private equity funds when the market is expanding, he says that REITs outperform them by 2.5 to 3.0 percent over the long term.

In fact, a 19-year CEM Benchmarking study of pension fund investment performance reported that REITs delivered 11.04 percent in returns compared to 8.98 percent for the private equity model. Volatility was comparable, and there was a 0.89 correlation of REITs to private equity real estate, indicating similar diversification value in a portfolio.

REITs also have an advantage in speed to deploy capital, since private equity funds must fundraise until they hit their target, which can take up to two years, Worth notes. Quick deployment of capital is also important to pension funds, as no return on investment (ROI) is available until deals close.

“There are fundamentally different incentives and time structures,” Worth says. “The fundraising cycle encourages buying high, because the easiest time to raise money is during peak years. In a long bull run (like this one), money gets deployed at high prices.” REITs, however, have greater flexibility and tend to sell high during peak years and buy at the bottom.

A recent Insights Report from Cohen & Steers, a global investment manager specializing in liquid real assets, noted that private real estate fund asset managers are sitting on a record $300 billion of capital and looking for the types of assets REITs own, which potentially provides a floor of support for REIT valuations. Worth notes that REITs tend to own high-quality, class-A office assets, including trophy buildings, like Salesforce Tower in San Francisco and the Empire State Building in New York City.

Report author Tom Bohjalian, head of U.S. real estate and senior portfolio manager at Cohen & Steers, suggests that longer the cycle goes, the more institutional investors will get onboard, as U.S. REITs have outperformed the S&P 500 by more than 7 percent in late-cycle periods since 1991. They have also offered downside protection in recessions, underscoring the value of lease-based revenues and high-dividend yields in an environment of heightened uncertainty.

Evan Serton, Cohen & Steers senior vice president and portfolio specialist for real estate securities, says while REITs had been the performance underdog over the last five years, this began to change last year, amid growing investor concern over tariffs and the pace of overall economic growth. In slow-growth markets, investors consider REITs less risky and more predictable than other investment types, as they deliver stable, foreseeable earnings and cash flow from leases.

This is combining with two other factors that may help office and other kinds of REITs outperform other investment types in the late cycle, he adds. Since REITs are obliged to pay out nearly all taxable income to shareholders, the returns they deliver are typically higher than those of other equity securities. In addition, the Fed recently relieved anxiety over rising interest rates with its more dovish approach, creating a more benign financing environment, at least for the next 12 to 15 months.  Serton notes that some of the $300 billion of capital raised by private real estate investors may help to take certain REITs private, as transactions could result in meaningful share price appreciation for REIT investors.

According to Nareit data, office REITs reporting annual returns higher than 20 percent, as of May 28, included CIM Commercial Trust Corp. (33.25 percent), TIER REIT (28.60 percent), NorthStar Realty Europe Corp. (24.28 percent) and Alexandria Real Estate Equities (20.86 percent).

The backdrop for REITs is expected to remain positive in 2019, as property supply/demand fundamentals are healthy, balance sheets are stronger than ever, equity correlations are low and earnings multiples are at discounts to broad equities, according to Bohjalian. The report cites data centers and rental housing properties are among the top REIT opportunities currently.

Serton cautions, however, that office REITs have very different prospects, depending on their geographic focus. The East Coast has a glut of new supply, especially in New York City and Washington, D.C., while the barriers to entry imposed by certain municipalities on the West Coast have limited supply and boosted rental income, especially in the urban cores of San Francisco, West Los Angeles and Seattle. 

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