Low correlations to stocks and bonds and other investment features can make REITs a prudent investment alternative for defined contribution plans.
KEY TAKEAWAYS
- Plan sponsors often overlook REITs for inclusion in DC plans due to misperceptions about the asset class.
- The potential for enhanced returns and diversification with REITs tends to offset periodic volatility.
- Though a home can be a valuable asset, it is not a substitute for including income-producing real estate in portfolios.
An analysis by Fred Reish and Bruce Ashton, Faegre Drinker Biddle & Reath LLP
Misperceptions about real estate have led to under-representation in DC plans
Retirement plans must be diversified, according to both the Employee Retirement Income Security Act of 1974 (ERISA) and generally accepted investment principles. In 401(k) and similar participant-directed plans, this diversification requirement applies to the plan’s investment lineup. But beyond this basic concept, there is little consensus on how to develop a diversified lineup—that is, which asset classes should be included.
Most investment professionals who handle large defined-benefit pension plans, endowments and foundations already understand the potential benefits of including allocations of real estate, and frequently include real assets strategies in their portfolios. However, this view is not yet widely shared by defined-contribution plan sponsors.
Why? Some plan sponsors may be concerned about including asset classes such as real estate investment trusts (REITs) in their plan due to a lack of familiarity. Others may think it’s unnecessary, since many participants already own real estate in the form of their home. In our view, neither of these are valid reasons for excluding real estate from DC plans.
EXHIBIT 1
Growth of $100 and annualized returns since 1991
At August 31, 2023. Source: Morningstar, Cohen & Steers.
Data quoted represents past performance, which is no guarantee of future results. An investor cannot invest directly in an index, and index performance does not reflect the deduction of any fees, expenses or taxes. The information presented above does not reflect the performance of any fund or other account managed or serviced by Cohen & Steers, and there is no guarantee that investors will experience the type of performance reflected above. See page 2 for index associations, definitions and additional disclosures.
REITs’ potential benefits tend to offset periodic volatility
Reservations about REITs often stem from the argument that REITs are too volatile. We believe this fear fails to take into account factors that favor the inclusion of REITs in a diversified portfolio:
- The market movement of real estate investments has historically not been highly correlated with stocks and bonds.
- Long-term historical returns indicate that REITs have the potential to enhance risk-adjusted returns.
- REITs offer daily liquidity through trading on public stock exchanges.
But what about volatility? There have been times over the last 30+ years when REITs have been more volatile than other investments. But in the context of retirement plans, it’s important to remember that REITs typically make up only a small portion of an overall portfolio—generally 5% to 10%—so an allocation to real estate is unlikely to increase the volatility of an overall portfolio significantly. In addition, the strong historical returns of real estate suggest that the benefits of an allocation to real estate will tend to offset the volatility over the time horizon for 401(k) investing (Exhibit 1).
Homeownership is not a substitute for real estate in portfolios
What about the second factor? If a participant owns his or her own home, shouldn’t that be considered a real estate investment?
Home ownership may be desirable for many people, and a home can be a valuable asset over time. But a house is generally considered a consumption item, not an investment. Rather than generating income, a primary residence consumes it in the form of mortgage interest, real estate taxes, insurance payments, utility expenses and the costs of repairs and maintenance. In contrast, REITs generate rental income from real estate such as commercial, industrial and multi-family residential, which is then distributed to shareholders via tax-advantaged dividends. It’s the opposite of a personal home, which consumes income and which may not be liquidated in a person’s retirement to produce income or gains.
Unlike a home, REITs are liquid investments in income-generating real estate, providing access to many property types and geographies.
Furthermore, publicly traded REITs, like mutual funds, are highly liquid investments. A REIT fund will also typically be diversified across companies that focus on different types of properties and geographic locations, typically representing thousands of underlying properties. By contrast, a home is a relatively illiquid asset whose investment risk is not diversified. Instead, it is highly concentrated, making it vulnerable to unexpected changes in demand within its neighborhood, whether due to shifting demographics, natural disasters or the local business environment.
For fiduciaries looking to provide diversifying alternatives in their investment lineup, real estate offers the prospect of enhanced risk-adjusted returns. We discuss this issue in more depth in other white papers published in coordination with Cohen & Steers, Inc.
FURTHER READING
The Real Estate Reel: The listed REIT selloff, valuations, and the private CRE correction
We see a regime change in what’s driving the recent listed REIT selloff. REIT valuations appear cheap. And the pattern in the decline in private real estate is reminiscent to what occurred in the wake of the 1990s S&L crisis, indicating the selloff and recovery could be a slow grind. Watch this month’s Real Estate Reel to find out what these data points mean for real estate investing.
Putting the recent selloff in U.S. listed REITs into perspective
We’ve argued over the course of this year that markets presented attractive entry points for listed real estate. Recent declines in listed REIT valuations, driven by macroeconomic uncertainty, do not alter this view.
The Real Estate Reel: We’re watching institutional allocations, CRE debt and property price disconnects
Institutional investors have increased their allocations to real estate, CRE debt delinquency rates are increasing but remain relatively low, and CRE valuations are down more than 16% so far this year. Watch this month’s Real Estate Reel to find out what these data points mean for real estate investing.
Before investing in any Cohen & Steers fund, please consider the investment objectives, risks, charges, expenses and other information contained in the summary prospectus and prospectus, which can be obtained by visiting cohenandsteers.com or by calling 800 330 7348.
Index Definitions / Important Disclosures
An investor cannot invest directly in an index and index performance does not reflect the deduction of any fees, expenses or taxes. Index comparisons have limitations as volatility and other characteristics may differ from a particular investment.
U.S. REITs: FTSE Nareit All Equity REITs Index is a free-float adjusted, market capitalization-weighted index of all tax-qualified REITs with more than 50% of total assets in qualifying real estate assets other than mortgages secured by real property. U.S. stocks: S&P 500 Index is an unmanaged index of 500 large-cap stocks that is frequently used as a general measure of stock market performance. U.S. bonds: Barclays Capital U.S. Aggregate Bond Index is a broad-market measure of the U.S. dollar-denominated investment- grade fixed-rate taxable bond market, and includes Treasuries, government-related and corporate securities, mortgage-backed securities, asset-backed securities, and commercial mortgage-backed securities. Global real estate: FTSE EPRA/Nareit Developed Real Estate Index (net) is an unmanaged market-capitalization-weighted total-return index, which consists of publicly traded equity REITs and listed property companies from developed markets. Global stocks: MSCI World Index (net) is a free-float-adjusted index that measures performance of large- and mid-capitalization companies representing developed market countries. Global bonds: Barclays Capital Global Aggregate Bond Index provides a broad-based measure of the global investment grade fixed-rate debt markets. Data quoted represents past performance, which is no guarantee of future results. The information presented above does not reflect the performance of any fund or other account managed or serviced by Cohen & Steers, and there is no guarantee that investors will experience the type of performance reflected above. There is no guarantee that any historical trend illustrated herein will be repeated in the future, and there is no way to predict precisely when such a trend will begin. There is no guarantee that any market forecast made in this document will be realized. The views and opinions presented in this document are as of the date of publication and are subject to change without notice. This material represents an assessment of the market environment at a specific point in time and should not be relied upon as investment advice, does not constitute a recommendation to buy or sell a security or other investment and is not intended to predict or depict performance of any investment. This material is not being provided in a fiduciary capacity and is not intended to recommend any investment policy or investment strategy or to account for the specific objectives or circumstances of any investor. We consider the information to be accurate, but we do not represent that it is complete or should be relied upon as the sole source of appropriateness for investment. Cohen & Steers does not provide investment, tax or legal advice. Please consult with your investment, tax or legal professional regarding your individual circumstances prior to investing. Risks of Investing in Real Estate Securities. The risks of investing in real estate securities are similar to those associated with direct investments in real estate, including falling property values due to increasing vacancies or declining rents resulting from economic, legal, political or technological developments, lack of liquidity, limited diversification and sensitivity to certain economic factors such as interest rate changes and market recessions. Foreign securities involve special risks, including currency fluctuations, lower liquidity, political and economic uncertainties, and differences in accounting standards. Some international securities may represent small- and medium-sized companies, which may be more susceptible to price volatility and be less liquid than larger companies.
No representation or warranty is made as to the efficacy of any particular strategy or fund, or the actual returns that may be achieved.
Fred Reish and Bruce Ashton, the authors of this analysis, are partners in the Benefits & Executive Compensation Practice Group of Faegre Drinker Biddle & Reath LLP. They are not affiliated with Cohen & Steers but have been compensated by us to provide this discussion. Cohen & Steers has also provided factual descriptions, charts, and investment information for their analysis.
The summary of law and analysis by the authors contained in this white paper are current as of May 2021, are general in nature, and do not constitute a legal opinion of the authors that may be relied on by third parties. Readers should consult their own legal counsel for information on how these issues apply to their individual circumstances and to determine if there have been any relevant developments since the date of this paper.
Cohen & Steers Capital Management, Inc., (Cohen & Steers) is a registered investment advisory firm that provides investment management services to corporate retirement, public and union retirement plans, endowments, foundations and mutual funds. Cohen & Steers U.S. registered open-end funds are distributed by Cohen & Steers Securities, LLC, and are available only to U.S. residents.