REITs: Answering the call for DC plan diversification

REITs: Answering the call for DC plan diversification

Jon Cheigh

Chief Investment Officer and Head of Global Real Estate

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28 minute read

March 2022

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For fiduciaries looking to enhance diversification in defined contribution plans, we believe REITs can be a simple and effective addition to investment lineups.

  • REIT characteristics can be a good fit for defined contribution plans
    Compared with other alternatives, real estate investing is relatively straightforward, transparent and liquid, qualities that make REITs well suited as a plan diversifier.
  • Adding REITs can enhance potential risk-adjusted returns
    REITs can improve portfolio efficiencies given their history of strong returns, attractive income and low correlations with stocks and bonds. They also offer the potential for inflation protection.
  • REITs provide access to next-generation property types
    REITs, once dominated by the office and retail sectors, are now led by new-economy property types such as cell towers, data centers and logistics, along with other non-core sectors like health care and self storage.

REIT characteristics can be a good fit for defined contribution plans

Institutional investors have long recognized real estate for its history of attractive returns, stable cash flows and low correlations with other asset classes. For these investors, real estate has typically been a significant long-term allocation, generally in the 5–15% range.

By contrast, the defined contribution (DC) market has been slower to adopt real estate and other diversifiers, focusing predominantly on core equity and fixed income strategies. Depending on the core equity fund used in the DC plan, participants may have no exposure to real estate at all, and many plans do not offer a standalone real estate option.

According to financial data firm BrightScope, less than half of DC plans with 100 or more participants offer real estate in their investment menus. As a result, real estate allocations across all DC plans are well below levels found among institutionally managed defined benefit (DB) plans and other large investors (Exhibit 1).

We believe this presents an opportunity for DC plan sponsors to provide both broader availability and greater participant education on the potential benefits of real estate exposure, bringing DB best investment practices to DC plans.

A desire for diverse alternatives

As the DC industry continues to evolve, many plan sponsors are recognizing the need to give participants access to more diversified investment choices to increase the chances of achieving their retirement income goals. This task has taken on greater urgency in recent years, as many participants are finding themselves behind in their savings targets, yet faced with the prospect of substandard market returns, low bond yields and higher volatility.

Real estate is prevalent in retirement portfolios but underrepresented in
DC plans
EXHIBIT 1
DC REIT adoption disconnected from other retirement plans

Average real estate allocation

Average real estate allocation
REITs have compelling diversification features

To help address the need for broader diversification, many investors have turned to REITs and other real estate securities. Since the 2008 financial crisis, global assets under management (AUM) in listed real estate portfolios have risen fivefold, benefiting from increasing awareness of the historical benefits of REITs and a broader trend toward real return strategies (Exhibit 2).

We believe real estate securities can be appropriate as a diversifier in defined contribution plans for several reasons:

  • A long track record: Most alternatives offer relatively little historical data, limiting the scope of risk/return analysis. By contrast, real estate securities indexes go back 45 years in the U.S. and 31 years globally, providing extensive evidence of historical long-term benefits to investors.
  • Diversification potential: REITs have historically helped to enhance portfolio efficiency over full cycles, providing strong, low-correlated returns relative to stocks and bonds.
  • Liquidity: REITs trade on public stock exchanges, meeting the daily liquidity and pricing needs of most defined contribution plans.
  • Simplicity: Compared with other alternatives, real estate investing is relatively straightforward and transparent, so participants may be more likely to understand and utilize real estate in their portfolios.
A growing recognition of REITs’ diversification features has driven higher allocations to the asset class
EXHIBIT 2
REIT allocations have risen fivefold since the financial crisis

Global AUM in real estate securities strategies, $ billions

Global AUM in real estate securities strategies, $ billions

Adding REITs can enhance potential risk-adjusted returns

Listed real estate’s historical investment attributes provide a potentially compelling reason for allocations—particularly in the current environment of yield scarcity, rising inflation concerns and the growing concentration of equity markets in high-duration, large-cap growth stocks.

1. Strong historical returns

Since the start of the modern REIT era in 1991, listed real estate has delivered strong absolute and relative returns, averaging 11.6% per year in the U.S. and 8.5% globally (Exhibit 3). This track record has been underpinned by REITs’ stable business models, which focus on acquiring and developing high-quality assets that generate recurring income tied to leases.

Furthermore, a process of natural selection over decades has prompted the adoption of best practices in investment strategy and corporate governance, generally to the benefit of shareholders. REIT management teams, unconstrained by a finite fund life, may focus on generating long-term shareholder value and investing in their platforms (which include people, process, data and culture). All of this, in our view, can help drive growth and improved financial returns.

EXHIBIT 3
Annualized returns since 1991 ($)
Annualized returns since 1991 ($)

2. Attractive income with growth potential

REITs tend to pay attractive dividends, with yields currently well above those of stocks and bonds (Exhibit 4). REITs are cash flow–oriented businesses and are required to pay out nearly all taxable income to shareholders. In the U.S., for example, REITs must distribute at least 90% of their annual net income. By meeting this requirement, REITs gain exemption from corporate taxes, allowing them to efficiently pass through income to shareholders, who then pay taxes depending on their specific tax status.

Furthermore, REITs have an embedded mechanism for increasing dividends. For a REIT to remain above the minimum distribution threshold, it must typically raise its dividend concurrent with any growth in rents and net income. This dynamic has historically resulted in sustained dividend growth.

EXHIBIT 4
Current yields
Current yields

3. Diversifying correlations

Listed real estate may exhibit elevated correlation with stocks in the short term, influenced by market factor that affect publicly traded securities broadly. But in the long run, listed real estate’s performance is largely driven by the underlying property markets.

Exhibit 5 shows this relationship through listed real estate correlations over different time horizons, from quarterly observations to rolling five-year periods. Historically, correlations with stocks decline dramatically as the holding period is extended, indicating that an allocation to REITs offers potential long-term diversification benefits within a traditional stock-bond portfolio.

By contrast, REITs exhibit little similarity with private real estate in the short term, as share prices are marked to market in real time, whereas private property values are based on slow-moving appraisals. Over longer observation periods, the performance patterns of listed and private real estate converge. In other words, REITs are, in fact, real estate.

EXHIBIT 5
Listed real estate correlations by holding period
Listed real estate correlations by holding period

4. Historical inflation protection

Listed real estate has historically performed well in inflationary environments (Exhibit 6), benefiting from attributes that impact both short-term and long-term performance:

Historical inflation protection
EXHIBIT 6
Real estate has historically outperformed in inflationary environments

Average annual returns in periods of…

Average annual returns

A diverse and growing global market

The global listed REIT market has evolved substantially over the past several decades, providing access to new property types and new markets.

REITs are global

As capital has moved from private investors to the public market, global listed real estate has grown from a market capitalization of $300 billion in the early 2000s to nearly $2.2 trillion today, representing 21 developed economies and more than 350 companies (Exhibit 7). Increasing adoption of the REIT structure has contributed to this growth, as governments have sought to expand access to real estate to a broader range of investors. Today, 38 countries have REIT-like securities, and more are at various stages of implementing REIT legislation.

EXHIBIT 7
Listed real estate is a $2.2 trillion market
Market capitalization (billions)

Distinct regional characteristics

Each region’s listed real estate market has evolved differently, resulting in meaningful structural differences.

United States

The U.S. REIT structure has evolved into the world’s most efficient real estate operating model, in our view. The size and scope of the U.S. market has allowed REITs to develop dominant sector- specific platforms, allowing them to focus their business strategy, simplify their investment story and strengthen their negotiating position with tenants.

Europe

Many European and U.K. landlords have adopted reforms to help improve corporate governance, business models and shareholder returns; these reforms include simplified sector strategies, less leverage and a greater emphasis on cash flow and active property management. Improvements in governance and board incentives are designed to drive better capital allocation discipline—an issue that has constrained external growth prospects in the past.

Asia Pacific

Asia Pacific has been the fastest- growing real estate market over the past few years, both in terms of its market capitalization and number of new listed companies. Initially dominated by developers, the region now has a substantial landlord presence. In the region, as in the U.S. and Europe, REITs have expanded into logistics, health care, data centers and hospitality.

Access to alternative property types

The modern listed REIT market has expanded into property types beyond the traditional sectors that dominated the market 20 years ago (and still dominate core private real estate funds).

The most notable change has been the growth of tech REITs.
Over the past decade, many cell tower companies have converted into REITs, creating what is now the largest sector in the U.S. REIT market. Data center REITs have also grown alongside the demand for cloud computing and IT outsourcing. The industrial property sector now consists largely of smaller distribution centers for online retailers such as Amazon. These three sectors have been instrumental in providing the infrastructure for remote working, e-commerce and streaming entertainment.

Alternative property types now make up more than half of the U.S. REIT market and a quarter of the global listed real estate universe (Exhibit 8). We believe this has made the listed real estate market structurally less cyclical, driven more by secular trends such as the growth of e-commerce and the need for health care services and housing for aging populations.

In addition, enhancements to REIT rules are creating new opportunities. For example, U.S. health care REITs that own senior housing are now allowed to operate properties with a third party, giving them a stake in the operating business and providing new avenues for growth.

EXHIBIT 8
Alternative sectors are a driving force of the modern REIT market
Alternative sectors are a driving force of the modern REIT market
Alternative sectors are a driving force of the modern REIT market _2
Return dispersion creates opportunities for active managers

Across countries and continents, real estate performance may vary widely depending on differences in property cycles, macroeconomic conditions and interest rate policies. At the sector level, some companies are affected more by cyclical factors such as job growth, consumer spending and trade, while others are tied more to secular trends such as demographics and the growth of e-commerce. This diversity often results in a wide range of returns in any given period (Exhibit 9).

The effects of sector differences were in plain view in 2020. Many offices emptied out, most enclosed shopping malls had to shut down and hotel vacancies rose dramatically due to travel restrictions. By contrast, logistics landlords benefitted from increasing e-commerce adoption as consumers shifted activities online. Meanwhile, self storage businesses boomed as people cleared space for home offices and moved to new neighbourhoods in search of more space. This gap in fundamentals created a 58% return spread between the performance of the data centers and regional malls sectors globally. The differences were even wider in 2021, as the effects of the pandemic continued to reverberate across sectors.

REIT specialists with the resources and experience to understand the market and position portfolios appropriately may enhance potential risk- adjusted returns.

Regions and property types have distinct economic sensitivities and cycles that active managers can exploit to potentially enhance risk-adjusted returns

EXHIBIT 9
Wide range of returns highlights opportunity. Active managers may exploit different conditions among countries and sectors to potentially enhance returns
Wide range of returns by country
Wide range of returns by US property type

Case study: The potential benefits of implementing REITs in defined contribution plans

Given real estate’s attractive investment features, we believe adding REITs to defined contribution plan investment lineups can be an effective way for fiduciaries to help plan participants diversify their portfolios and improve their potential outcomes. Using data since 2000, shifting 10%
of a stock-and-bond portfolio to REITs has historically led to higher total returns, similar volatility and better risk-adjusted performance.

Case study- The potential benefits of implementing REITs in defined contribution plans

REITs…

Can be a good fit for defined contribution plans

Listed real estate offers a transparent and more liquid way to broaden plan diversification via alternative asset classes, in our view.

Offer potential for better risk-adjusted returns

REITs offer the potential to improve risk-adjusted performance, with a long history of strong total returns, attractive dividend income, low correlations to other asset classes, and the inflation-hedging characteristics of real assets.

Provide opportunities to access secular growth themes

Today’s REIT market features an increasing diversity of opportunities, including new property types that provide infrastructure for the accelerating digital economy.

ABOUT THE AUTHORS
Author Profile Picture

Jon Cheigh, Executive Vice President, Chief Investment Officer and Head of Real Estate, leads the investment department and oversees the real estate team.

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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