It’s no secret that publicly traded REITs are one way to add real estate exposure to complement other investments and diversify portfolios. But some larger investors have added a new wrinkle to the equation in how they allocate to REITs by using them to gain access to property types like data centers, life sciences and other sectors that are harder to reach through other vehicles.
This tactic, which investors have dubbed the “completion portfolio” strategy, is primarily used by large institutions, but given that REITs are publicly traded, it could be employed by any investor looking to round out their real estate exposures.
One prominent example highlighted by Nareit, the association that represents the listed real estate industry, is Norges Bank Investment Management. That group manages the Government Pension Fund Global (Norway’s oil fund) on behalf of the Norwegian people. The fund allocates $58 billion to real estate globally, equally divided between public and private structures. Notably, its private sleeve primarily includes office, logistics and retail, while its investments in public real estate are more diversified, giving it an overall portfolio that is more balanced to reflect the overall shape of the investable commercial real estate universe.
In another example of a sovereign wealth fund using REITs in a completion portfolio, PGIM advised an Australian superannuation fund to use REITs globally to complement its pre-existing Australian portfolio, which only focused on domestic office, retail and industrial properties.
In another development, the spread between private and public real estate valuations, which has persisted for years and contributed to a prolonged slowdown in the transaction market, has finally narrowed. Combined with a normalizing interest rate environment, this could finally lead to an uptick in deal activity.
WealthManagement.com spoke with Ed Pierzak, Nareit senior vice president of research, about the case studies and the narrowing spread between public and private real estate valuations.
This interview has been edited for style, length and clarity.
WealthManagement.com: Walk me through the Norges example first. What are your takeaways from what they have done?
Ed Pierzak: They are one of the most sophisticated real estate investors in the world. And as an investor with very long-term obligations, they see no difference between private real estate REITs. With their real estate portfolio they have a 50/50 allocation to both. That’s somewhat unique.
They have a massive investment portfolio overall, with total assets of $1.7 trillion. So, real estate is only a small piece of the portfolio, but $58 billion is still a massive number in absolute terms.
When they explore an opportunity, whether it’s local, regional or global, they will look at what is the best way to access that opportunity, both in terms of investment and pricing.
Say, they want exposure to apartments. They will assess whether to buy public or private at that moment and then move forward. On the private side, you are largely limited to the four traditional property types. With REITs, you have a larger menu and access to modern economic sectors. When you bring them together, you can build a portfolio that is well-diversified by sector and geography.
One thing that is striking with Norges is that when you look at the private side, it’s 50% exposure to office. By combining in REITs, they have dropped office to 28% of the combined portfolio.
WM: And what about this second example of the Australian superannuation fund?
EP: With superannuation funds, money is always rolling in, and real estate has always been a big portion of their investments. But if you are only buying local assets in Australia, at some point, you’re going to run out of what you can buy. Oftentimes, Australian investors have had global horizons.
This example shows that mix. For this fund, you started off with the typical/legacy Australian private real estate portfolio, which focuses on three traditional property types: office, retail and industrial. PGIM came in and helped them execute a completion portfolio and take a global perspective.
In this process, they get exposure to other geographies while also doing a bit of doubling down locally by investing in some local companies. Overall, they got exposure to geographies and property types that weren’t available or not readily available on the private side.
WM: Pivoting to recent REIT performance, in October, REIT total returns declined a bit, with the FTSE all-equity REIT index down 3.6%, which reversed a little of the momentum. Can you put that performance into a larger context?
EP: We are still in this trade with the 10-year Treasury. It dates back to 2022. As the Treasury yield goes up, REIT performance goes down and vice versa. At the end of the third quarter, the yield was declining, and REIT performance was going up. Since that time, the yield has gone back up around 50 basis points, so not surprisingly, REIT performance has come back down a little bit.
In giving a bit of perspective on where REITs stand today, we will have our third quarter T-Tracker shortly and can talk about the balance sheet situation. Overall, REITs continue to be in fantastic shape. Leverage ratios have dropped to closer to 30% from 35%. The weighted average cost of debt remains about the same, a little over 4%. The weighted average term to maturity stands at six-and-a-half years. And 80% of REIT debt is unsecured and 90% of it is fixed rate.
I bring those points up because what we are seeing in terms of cap rates with this rise in performance is that REIT implied cap rates have come down while the private cap rate has held steady, so the cap rate gap has finally narrowed to a point where it will likely sit at about 60 basis points. That’s an important number because that’s a range historically that’s close enough for the transaction market to have a revival.
WM: That seems like a big deal. We’ve talked a lot in the past about that divergence and how wide its been and compared that with past periods. So, what you’re saying is that we’re finally at the point where even though they are not fully synced, it’s close enough for transaction markets to function?
EP: That’s right. When the spread exceeds 100 basis points, it tends to be an issue. If you’re below that and the spread is 50-ish, markets can act as if they are in sync.
That brings us back to the balance sheet position. As the transaction market picks up, REITs are in an excellent position to acquire. They don’t have leverage concerns. They have access to debt. It’s cost-effective, and we have seen with unsecured issuance that REITs have a competitive advantage over their private market counterparts.
WM: Lastly, are there any ramifications the election results have for REITs?
EP: There is the fact that now there is some certainty with a President-elect, that’s calmed things down a bit. But beyond that, I can’t speak to any potential impacts.