The Real Estate Reel: The potential benefits of blending listed REITs and private CRE

This month we are digging deeper into the potential benefits of adding listed REITs to private commercial real estate portfolios as we take a closer look at total returns, volatility of returns, and max drawdowns.

First, listed REITs have meaningfully outperformed private real estate historically.

In fact, listed REITs generated average net returns of 10.9% from 1998 to 2021 compared to 8.6% for private real estate according to a CEM Benchmarking study.

While listed REITs are similar to externally managed direct strategies (10.9%), they are superior to value add / opportunistic strategies (9.3%) and core funds (8.7%).

There are a couple of reasons for this, including lower fees and better appreciation returns given more efficient deployment of CapEx.

Listed REITs have generally produced similar income returns net of fees to open ended funds that own core commercial real estate (known as ODCE funds), but they have much better appreciation returns over various periods of time (Exhibit 1).

At June 28, 2024. Source: Bloomberg, NCREIF, Costar, Green Street, Cohen & Steers. Data quoted represents past performance, which is no guarantee of future results. CAGR is defined as Composed annual Growth Rate. CAGR is defined as Compound Annual Growth Rate.

Bottom line, investors seeking to maximize total returns in core real estate may be well served to increase their allocations to listed REITs.

At certain levels of listed allocations, portfolios blending private with listed real estate allocations may also reduce volatility and mitigate drawdown risk, which leads to our second point.

It is true that listed REITs have higher volatility of annualized quarterly total returns than private CRE.

But while it may seem counterintuitive at first glance, adding listed REITs to a private portfolio at certain levels has been shown to reduce volatility.

Keep in mind that listed REITs and private real estate have lower correlations over short time frames.

One typically zigs when the other zags. This can be used to an investor’s benefit.

Consider that since 1990 the annual standard deviation of quarterly listed REIT returns is 19.1% vs 6.1% for ODCE funds.

Over the prior 10-years, it’s 17.2% for listed REITs vs. 5.6% for private.

This is because listed REITs are more correlated to the broader equity market over the near term while private valuations are inherently smoother given the lagged nature of appraisals.

However, listed REITs and private CRE have much higher correlations over the long term (Exhibit 2).

Correlations of rolling 1-year returns for private real estate and listed U.S. REITs

At June 28, 2024. Source: Morningstar, Bloomberg, NCREIF and Cohen & Steers. Listed U.S. REITs represented by the FTSE Nareit All Equity REITs Index. Private Real Estate represented by NCREIF Fund Index—Open-End Diversified Core Equity Index (NFI-ODCE) – Net Total Returns.

This makes sense given they have similar underlying fundamental drivers.

Some investors may consider the lower near-term volatility of private a feature rather than a bug. To reduce volatility even further, however, we think adding a listed REIT allocation to private CRE portfolios is appropriate.

For instance, a 10% allocation to listed within a private portfolio reduces annualized volatility of total returns to 5.3% over the prior 10-years compared to 5.6% mentioned previously for a portfolio of 100% private.

The third data point I think is important is that listed REIT allocations in a private portfolio have been shown to limit drawdowns.

To mitigate drawdown risk of a portfolio, we think a 30% allocation to listed REITs within a private portfolio is warranted.

For example, since 2014, the max drawdown of a portfolio with a 30% listed allocation is 13.9% vs. 19.9% for a 100% private portfolio and –29.2% for a portfolio of 100% listed (Exhibit 3).

At June 30, 2024. Source: Bloomberg, NCREIF, Cohen & Steers.
Data quoted represents past performance, which is no guarantee of future results. Listed U.S. REITs represented by the FTSE Nareit All Equity REITs Index. Private Real Estate represented by the NCREIF Fund Index—Open-End Diversified Core Equity Index (NFI-ODCE) – Net Total Returns. Private real estate had positive returns in 1Q22, 2Q22 and 3Q22. A 30:70 portfolio had positive returns in 1Q22.

We also note that Sharpe ratio with a 30% allocation is unchanged compared to a 100% private portfolio, as higher volatility is offset by higher returns.

Again, this may seem counterintuitive since listed REITs have greater max drawdown risk than private CRE, but remember that listed REITs are leading indicators to private in both downturns and recoveries.

This is exactly what has occurred since the private CRE market peaked in 3Q22 (Exhibit 4.)

Listed REITs have outperformed private CRE by more than 33 percentage points as listed has generated cumulative total returns of 13.4% over the prior seven quarters while private CRE has declined nearly 20%.

At June 28, 2024. Source: Bloomberg, NCREIF, Cohen & Steers. Data quoted represents past performance, which is no guarantee of future results. Listed REITs represented by the FTSE Nareit All Equity REITs Index. Private Real Estate represented by the NCREIF Fund Index-Open End Diversified Core Equity Index (NCFI-ODCE) – Net Total Returns.

These are simplified examples, and these metrics could be improved even more through active management of listed REITs.

But we believe it helps to illustrate that there is an illiquidity return discount in core private real estate (unlike other private assets that typically trade at premiums to their public peers).

It also shows, we believe, that investors should embrace listed REITs as a diversification tool that can potentially meaningfully enhance results. This analysis holds true over longer time periods as well.

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Watch July 2024 The Real Estate Reel: Is office really as problematic as you think?

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