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A Long-Term CEM Study Shows REITs’ Power to Deliver for Pension Funds

The 21-year study shows pension funds have been missing out on healthy returns by under-allocating to REITs.

With more than 10,000 Americans reaching retirement age every day, pension funds are coming under increasing pressure to maximize returns and generate steady income to meet their growing financial obligations to America’s retirees. For pension funds working to meet this challenge, effective asset allocation is vitally important. But a recently updated study by pension research firm CEM Benchmarking, sponsored by Nareit, shows that, in their real estate asset allocations, these investment professionals and their consultants could be making better choices to boost their returns.

The study examines the asset allocations and investment performance of 200 public and private U.S. pension funds representing nearly $3.9 trillion in combined assets under management. It provides a comprehensive review of investment allocations and actual investment performance across 12 asset groups over a 21-year period, 1998-2018.

The study highlights a compelling “disconnect” in these funds’ real estate portfolios: they have consistently made much higher allocations to private real estate investment vehicles than they have to REIT investments, in spite of the fact that private real estate net investment returns have consistently underperformed those of REITs.

Alex Beath, senior research analyst at CEM Benchmarking, who authored the study, said, “The results show that, over the past 21 years, pension funds have been missing out on the substantially higher returns that they could have been earning with higher allocations to REITs in their real estate portfolios. They also show that some of the often-cited advantages of private real estate over REITs, such as reduced volatility and superior diversification benefits, don’t really exist.”

Key takeaways from the study, entitled “Asset Allocation and Fund Performance of Defined Benefit Pension Funds in the United States” include:

REITs outperformed all styles of private real estate

REIT investments delivered an average annual net return of 10.2 percent over the study period—nearly 270 basis points higher than the 7.5 percent average annual net return of private real estate. Every type of private real estate, both direct and LP/GP-style funds, underperformed REIT investments. Average annual net returns for internally managed core real estate were 9.2 percent; returns for opportunistic and value-added funds were 8.4 percent; returns for core funds were 7.8 percent; and returns for real estate fund-of-funds were 6.3 percent.

Private real estate’s share: six times that of REITs

Despite lower performance, private real estate consistently was given larger allocations of total pension fund portfolios than REITs received throughout the study period. REITs’ average allocation over the period was 0.62 percent compared to 3.62 percent for private real estate. In 2018, the most recent year of the study period, total portfolio allocations to REITs were 0.78 percent compared to 5.19 percent for private real estate.

REITs and private real estate have comparable volatilities

The true volatility of private real estate investments is not fully measured and can’t be viewed as readily as that of publicly-traded REITs, but it exists, and it is quite comparable to the volatility observed in the REIT market. Further, private market real estate investment returns are reported with a lag. CEM’s methodology adjusts for the lag in reporting of private market asset investment returns, including real estate at the pension fund level. When adjusted for the reporting lag, the CEM study revealed that REITs and private real estate had volatilities of 19.2 percent and 18.0 percent respectively. The similarity in volatilities makes sense, given that REITs and private real estate invest in essentially the same underlying assets.

With comparable volatility and higher returns, REITs demonstrate higher risk-adjusted returns than private real estate as measured by the Sharpe ratio, with REIT investments measuring .41, compared to .30 for private real estate. The Sharpe ratio is a measure of reward to risk; the higher the Sharpe ratio, the higher the reward (return) for each level of risk.

REITs provide full diversification benefits

The study showed that, with their high correlation to private real estate and low correlations with stocks and bonds, REITs do provide the well-recognized diversification benefits of the real estate asset class.

Both REITs and private real estate investments provide portfolio diversification benefits, as their returns had relatively low correlations with other portfolio assets. Notably, REIT and private real estate returns, when adjusted for reporting lags, are highly correlated at .84. The high correlation isn’t surprising, again, given the similarity of the underlying assets.

The case for REITs

REITs’ higher returns compared to private real estate, combined with their comparable volatility and diversification benefits, together beg the question: why are pension plans’ REIT allocations so low, and why aren’t more investment managers taking advantage of REITs’ outperformance? The answer isn’t apparent, but this 21-year study makes a convincing case that pension funds seeking ways to boost returns to meet their commitments to their plan participants should take a closer look at REITs.

John Worth is executive vice president for research and investor outreach at Nareit.

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