Publicly-traded REITs straddle a line. As equities, their performance sometimes is affected by broader market trends, but the underlying assets are real estate. As a result, chief investment officers for RIAs and institutions are divided on whether to consider REITs as part of their alternatives or equities allocations.
For its part, Nareit, the association that represents listed real estate companies, maintains that REITs should be part of alternative allocations alongside private real estate. And a recent study from CEM Benchmarking seems to bulwark that claim. The study, which examined 25 years’ worth of asset allocation and fund performance of defined benefit pension funds, found that REITs outperformed all other asset classes save private equity in that span. Moreover, it found that REIT performance is more closely correlated with private real estate than it is with stocks. (REITs edge private real estate performance over the time span in part due to lower fees.)
In other REIT news, however, a rough December in which total returns dropped 8.0% meant the FTSE Nareit All Equity REITs Index finished the year up 4.92% after it had been on pace for a double-digit annual total returns entering the month.
WealthManagement.com spoke with Ed Pierzak, Nareit senior vice president of research, about the REITs’ 2024 performance and the CEM study.
This interview has been edited for style, length and clarity.
WealthManagement.com: Can we start with REIT results. It looks like December was a rough month. Where do things stand?
Ed Pierzak: It was a bit challenging. The All Equity REITs Index ended the year up just under 5%. If you look at quarter-to-date vs. the monthly results, on the index level and in the individual sectors, the lion’s share of the results took place in December. For the quarter, the index was down 8.05% and in December it was down 8.00%.
The natural next question is “Why?” There’s an inverse relationship between the 10-year Treasury yield and REIT total returns and there was a significant rise in the yield from the beginning of the quarter that’s continued into January. So, the results aren’t that surprising.
Across some sectors, however, there was some very strong performance. Office is in the mix finishing the year at over 20% total returns. Specialty, data center REITs and healthcare also all finished with total returns up over 20%.
This is consistent with themes we’ve talked about in the past, driven by supply and demand fundamentals. With data centers, there is such tremendous demand and expected future demand. That’s pushing things forward. And specialty REIT performance, when you break it down, falls on one particular stock and company that in fact has also been focused on data centers.
WM: Can you put the 2024 results into context in comparison with other indices?
EP: We often will compare with the S&P 500 and the Russell 200. Both of those posted total returns on the year of 25%. For December, both were down, but more in the 3% range.
WM: That said, it does seem that takeaway, given what you said about the inverse relationship with Treasury yields, that much of REIT performance has been driven by macro factors and not by REIT fundamentals. Is that right?
EP: Yes, there is the inverse relationship. However, I should note that historically this has not been a permanent relationship. Historically, REITs have performed quite well in high-rate environments.
WM: Pivoting to the CEM study, what stands out?
EP: CEM has done this for a number of years. The most recent study gives us now 25 years of history from 1998 to 2022. It’s through 2022 in part because of the methodology. For certain asset classes, such as private equity and private real estate, CEM de-lags the data since those sectors tend to report out results on a delay. But by making the adjustments at the pension fund level covering more than 200 private and public pension plans managing collectively over $4 trillion AUM it’s a good, deep data set.
With annual net total returns—which factor in expenses—the big news is that REITs rank second only to private equity. More importantly, if you compare REITs to private real estate, there is a 208 basis point difference in net return. Expenses loads differ dramatically, with REITs at 49 basis points vs. private real estate at 1.2%. That’s a huge difference in the cost of managing what are ultimately similar investment strategies.
If you get into real estate investment styles, last year REITs outperformed all other categories. This year, internally managed direct investors led REITs by 2 basis points. These are properties managed by pension funds themselves. It’s a theme you hear with trustees scrutinizing feeds. Some have taken management in-house. But this option is only available to the largest of investors.
Also, interestingly, REITs at 9.74% outperformed value-added and opportunistic funds and core funds. And when you look at those results, value-added and opportunistic funds at 8.16% and core funds at 7.69% don’t have much of a material difference, which is not something you would think based on how the funds are pitched. You often find that value-added and opportunistic funds don’t deliver on initial expectations. Lastly, fund of funds have the lowest returns, because you often see multiple layers of fees, which detracts from total returns.
WM: Another aspect of this analysis is the de-lagging. Can you explain what that means?
EP: In more illiquid assets, such as private real estate and private equity, the underlying asset value changes, but when that change is reported can take some time. With private real estate, we’ve talked about the appraisal lag often and the spread that emerged between REITs and private real estate in recent years. Appraisals tend to be backward-looking, and it takes some time to catch up.
When CEM takes the lags into account and looks at the correlations, they find that REITs and private real estate have a correlation of 0.90. So, they are very positively correlated, which would lead us to say that “REITs are real estate.”
WM: With the implication being that REITs should not be seen as part of equities allocations but instead as a real estate allocation?
EP: That hits it on the head. When we talk about REITs with sophisticated investors, some include them in their real estate allocation while others say it’s part of their equity allocation. Looking at correlations tells us that REIT returns and private real estate returns move in relation to one another and see they are have a higher positive correlation compared with other asset classes. Both are real estate.
REITs should be part of a real estate portfolio. Our view is that it shouldn’t be a public or private real estate decision, but a public and private allocation. They can be complementary. REITs can be used strategically and tactically.
We had another study with CEM earlier in 2024 that gauged the ability of real estate to create alpha. REITs and private real estate provide alpha, but when you account for fees, the alpha on the private side is gone while with REITs it remains.
We have this discussion with lot of investors and when we point this out at times we get responses saying “We only invest in top quartile of private managers. They surely outperform REITs.” But CEM broke it down different quartiles and deciles and found whether at the 90th percentile or the bottom, REITs outperform.