The active advantage in listed REITs

The active advantage in listed REITs

Jason A. Yablon

Head of Listed Real Estate

More by this author

14 minute read

May 2024

Share

Sign up to get our insights
Subscribe

The diversity and complexity of the real estate market give specialist active managers a wide field of opportunities to potentially enhance returns.

KEY TAKEAWAYS

  • 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

Index investing reached a milestone in early 2024, with assets in passive investment vehicles surpassing those in actively managed strategies for the first time. On the surface, the appeal of index investing is compelling: passive exchange-traded funds (ETFs) offer lower costs. And, in the case of broad-based equity and bond categories, active managers frequently fail to consistently outperform their benchmarks. But cheaper is not always better, and not all markets are alike.

Real estate is one area of the equity market that lends itself to active management. REIT managers who commit time and resources to understanding current property fundamentals, shifting market trends and factors that may affect listed equity performance can potentially spot pricing inefficiencies and rapidly implement plans to generate excess returns. We believe this advantage is reflected in the performance of the largest active REIT mutual funds relative to passive investment vehicles, despite active funds typically having greater expense ratios (Exhibit 1).

EXHIBIT 1
Active REIT managers have a track record of delivering value

Weighted-average total returns top 10 active funds vs. top 10 passive funds

Active-REIT managers have a track record of delivering value

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 since 2000, 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, many of which have secular growth drivers. These include data centers where companies rent by the kilowatt to connect cloud servers; cell towers that lease space to wireless carriers for 5G networks; high-tech distribution hubs that facilitate next-day shipping on e-commerce orders; climate-controlled food storage facilities; biotech research labs; and senior living centers, just to name a few.

EXHIBIT 2
Alternative sectors make up over half of today’s U.S. REIT market
Alternative sectors make up over half of today’s U.S. REIT market
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 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 2023, returns between the best and worst sectors were separated by 38 percentage points. In other years, the dispersion has been considerably greater.

We have observed that the difference in returns at the security level within each sector is often similar to the variance at the sector level. We believe this dispersion highlights the opportunities active managers have to enhance returns through both sector and stock selection.

EXHIBIT 3
Different characteristics result in a wide dispersion of returns in any given year (left), while some sector trends can last many years (right)
Different characteristics 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 economic cycles progress, property types are likely to have different fundamentals. For instance, the pandemic upended retail, hotels and offices, but benefited technology-related REITs amid acceleration in e-commerce and working from home. And many sectors and cities continue to feel the lasting effects of the pandemic as flexible work-from-home policies have changed how and where people want to work and live, creating an uncertain outlook for offices. Consequently, high-quality offices may continue to see healthy demand, while lower-quality assets may experience soft demand for years to come—a distinction not likely to be reflected in passive portfolios.

Active managers can also add value by capitalizing on regional differences and trends. Many U.S. residents are moving from dense, high-cost Northern and Coastal cities to lower-cost markets in the Sunbelt. In global portfolios, REIT managers may assess geographic regions to understand local property supply and demand fundamentals, economic trends, monetary policy and other factors that may affect the operating performance of different real estate companies, as well as the markets valuation relative to other regions.

Anticipating secular trends such as these is a key component of active management, since they can present opportunities for active managers to capitalize on diverging fundamentals. For example, the divergence in industrial and office properties (Exhibit 3).

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.

REIT managers may also invest based on relative value, seeking to allocate portfolio assets based on merit rather than market capitalization, as is often the approach for many passive index funds.

Investing outside the benchmark—participating in special opportunities such as recapitalizations, private placements, initial public offerings (IPOs) or pre-IPO investments—is another way for active managers to add value. These activities are not within the scope of passive index-tracking strategies—a notable disadvantage in recent years due to the inability of passive vehicles to get out of the way of the secular declines in retail and offices.

Sign up to get our insights delivered to your inbox

The active information advantage

Active REIT managers seek to understand both real estate fundamentals and the factors impacting equity performance to generate excess returns, or alpha. 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 develop a differentiated view of 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 ETFs, interest in active REIT management is increasing. We see this as recognition that real estate is better suited for adding potential value. For example, Cohen & Steers Realty Shares, one of the first REIT open-end mutual funds, has delivered an annualized return net of fees of 10.7% since its July 1991 inception (Exhibit 4). While managing investment costs is crucial, we think an active REIT strategy in an overall asset allocation should be considered.

EXHIBIT 4
Top-quartile performance over multiple cycles

Percentile ratings: Cohen & Steers Realty Shares vs. Morningstar category peers

Top-quartile performance over multiple cycles
ABOUT THE AUTHORS
Author Profile Picture

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

FURTHER READING

Capital Market Assumptions

Capital Market Assumptions: Expectations for the next 10 years amid a generational change for markets

June 2024 | 22 mins

We expect higher fixed income and real asset returns alongside lower U.S. equity returns for the next decade.

REITs’ rare earnings multiple discount to stocks is historically compelling

REITs’ rare earnings multiple discount to stocks is historically compelling

June 2024 | 10 mins

U.S. equities have outperformed U.S. listed REITs substantially over the past few years. But history suggests that the resulting valuation gap between equities and REITs indicates a likely reversal.

The Real Estate Reel: What recent listed vs. private returns mean for allocations

The Real Estate Reel: What recent listed vs. private returns mean for allocations

May 2024 | 4 mins

Listed and private real estate tend to be correlated over the long term, but correlations turned negative recently, and we believe investors should embrace this relationship as a diversification tool.

3582089