REIT investing and the active advantage

REIT investing and the active advantage

Jason A. Yablon

Head of U.S. Real Estate

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14 minute read

May 2021

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The diversity and complexity of the modern REIT market give specialist managers a wide field of opportunities to potentially enhance returns.

  • REITs have historically been fertile ground for active managers leveraging their information advantage to add potential value for investors.
  • The modern U.S. REIT market spans more than a dozen property types, providing a diverse universe for identifying opportunities.
  • REIT investing requires an understanding of both real estate fundamentals and listed equity markets, underscoring the importance of fundamental research.

REITs have historically been fertile ground for active managers

When it comes to actively managed investments, not all asset classes are created equal. Among mutual funds rated 4 or 5 stars by Morningstar, which typically oversee the vast majority of investor assets, funds that specialize in real estate investment trusts (REITs) and other real estate securities have generally had a higher rate of outperformance than those providing broad equity exposure (Exhibit 1).

As the track record of the full fund universe shows, delivering outperformance is not commonplace (even in real estate), underscoring the importance of choosing the right manager. However, we have found that a well-resourced manager specializing in REITs can leverage the potential for better-quality information, more accurate and localized forecasts, and faster implementation of investment ideas—simply by being more attuned to shifting market trends. As we will show, this potential is magnified by the many distinct property types represented in the REIT universe, each with its own investment characteristics and economic sensitivities.

EXHIBIT 1
REIT managers have a track record of delivering value

% of global and U.S. real estate funds that outperformed their benchmark

The modern REIT market offers a diverse opportunity set

When investors think of commercial real estate, they may envision office buildings, malls, shopping centers and apartments. REIT ownership of these kinds of assets exists, of course. However, REITs have become increasingly specialized in new property types over the past 20 years, shifting the REIT market’s composition away from traditional sectors (Exhibit 2).

For well-resourced managers, these new sectors provide a broad selection of REIT- owned assets for constructing portfolios: 200-foot cell towers disguised as trees that lease space to wireless carriers and first-responder networks; secure data centers where companies rent by the kilowatt to connect cloud servers; high-tech distribution hubs that facilitate next-day shipping on e-commerce orders; climate-controlled storage facilities; biotech research labs; and senior living centers, just to name a few.

EXHIBIT 2
Alternative property sectors make up over half of today’s U.S. REIT market

U.S. REIT index sector weights (%)

Capitalizing on distinct sector characteristics

REIT sectors and companies tend to respond to market conditions very differently depending on factors such as lease durations, types of tenants, economic drivers and supply cycles. These differences have historically resulted in a wide dispersion of sector returns in any given period (Exhibit 3).

More economically sensitive sectors with short lease terms, such as hotels and self storage, can adjust rents relatively quickly to capture accelerating demand in a cyclical upswing. By contrast, longer-lease sectors like net lease and health care have more defensive cash flows that may be more resilient during economic downturns. In 2020, the best and worst sectors were separated by 58 percentage points as the pandemic upended retail, hotels and offices, but benefited technology-related REITs amid acceleration in e-commerce and working from home.

EXHIBIT 3
Different characteristics often result in a wide dispersion of returns in any given year (left), while some sector trends can last many years (right)

Navigating secular growth opportunities and challenges

As the economic cycle progresses, we believe property types are likely to have different fundamentals, especially in an environment of potentially rising interest rates and inflation. Many sectors and cities may also feel lasting effects from the pandemic. Flexible work-from-home policies could change how and where people want to work and live. Many residents are moving from dense cities to suburban markets or lower-cost states.The pandemic has also accelerated the growth of e-commerce in a way that we believe is unlikely to be reversed, supporting demand for technology-related real estate.

Anticipating secular trends such as these is a key component of active management. For example, an active manager who understood the potential impact of e-commerce on different types of real estate could have sought to capitalize on diverging fundamentals in industrial and regional mall properties over the past five years, which contributed to a 245 percentage point difference in cumulative returns (Exhibit 3, right). By contrast, passive portfolios are, by design, not able to allocate assets to capitalize on potential secular growth opportunities, nor can they sidestep sectors that may be facing long-term headwinds. (Of course, there is no guarantee that active management can successfully navigate these trends.)

Investing in the two worlds of real estate and listed equities

Generalist fund managers tend to give little attention to real estate, which accounts for just 3% of the MSCI World Index. This lack of deep analysis, combined with a typically high level of REIT ownership by generalist investors and passive vehicles, may create potential pricing inefficiencies that REIT specialists can exploit. REIT managers commit time and resources to understanding both real estate fundamentals and the factors that may affect listed equity performance.

For example, in a typical year, Cohen & Steers may conduct 300 property visits and 1,300 meetings with U.S. REIT management teams, seek local perspective from independent brokers, and leverage proprietary data sets, such as web scraping tools that provide unit pricing information in real time. Using inputs such as these, we can often take a differentiated view on the direction of property cash flows and asset values, identifying securities with upside potential that other equity investors may have underestimated.

Focusing on results vs. costs

Despite the popularity of exchange-traded funds, we continue to see growing interest in active REIT management. We see this as a recognition that certain markets such as real estate may be better suited for adding potential value. For example, Cohen & Steers Realty Shares, one of the first REIT open-end mutual funds, has delivered a net return of 11.5% per year since its inception in July 1991, outperforming its benchmark as well as stocks and bonds (Exhibit 4). Although managing investment expenses is important, we believe an active REIT strategy in an overall asset allocation may actually be in an investor’s best interest.

EXHIBIT 4
A skilled active REIT manager has the potential to enhance returns over time

Growth of $100K since 1991

ABOUT THE AUTHORS
Author Profile Picture

Jason A. Yablon, Executive Vice President, is Head of U.S. Real Estate and a senior portfolio manager for U.S. real estate securities portfolios and oversees the research process for U.S. real estate securities.

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