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Institutional demand for real estate has been exceptionally strong in recent years, driven by a desire for broader diversification and the need for yield in an environment of economic uncertainty and ultra-low interest rates. Managers who oversee private real estate funds have been raising capital at a rapid clip and can’t put the money to work fast enough. According to alternative assets data provider Preqin, idle capital targeting real estate purchases recently hit record levels, totaling more than $250 billion.
And yet, despite a bull market in real estate fundamentals both in the U.S. and in many overseas markets, we have seen a shift away from listed REITs over the past year, driven in part by concerns of rising interest rates. However, history shows that REITs tend to perform well over full market cycles, as the benefits of economic growth outweigh the effects of higher rates, which are a byproduct of growth.
For long-term investors, we believe U.S. REITs can be an attractive way to allocate to real estate, offering the potential for competitive risk-adjusted returns, along with attractive income and diversification benefits. In fact, due to the unique supply-and-demand cycles of commercial property, REITs have exhibited a relatively low 0.55 correlation to the broad market since 1990—less than any of the major sectors in the S&P 500 Index except utilities.
This distinctive risk/return profile is based on the relationship between REITs and the physical property market. As listed entities, REITs tend be more correlated to other stocks than to private real estate in the short term. However, a REIT’s long-term capital appreciation and dividends are tied directly to the cash flows of its real estate holdings. As a result, returns for listed REITs should generally track the returns of the underlying real estate market over full market cycles, adjusted for differences in leverage.
This concept is important because it is sometimes easy for REIT investors to become too focused on the short-term swings of the stock market, while losing sight of the underlying real estate fundamentals that drive long-term performance.
To examine the relationship between listed and physical property, the Cohen & Steers Quantitative Strategies team studied nearly 40 years of quarterly returns for REITs and private real estate funds. Comparing returns first requires an adjustment to account for the inherent smoothing of private real estate returns, which can result in artificially low measured volatility. Our research showed that this smoothing can be parsimoniously modeled using a simple moving average of five to six periods (each period is one quarter). In other words, the return profile of private funds is consistent with a rolling average of about a year and a half.
Once this process is understood, REIT returns can be similarly adjusted to obtain a more accurate correlation reading. We can also reverse the moving-average process for private real estate to estimate the actual investment risk of the underlying assets. The results: adjusted correlation increased to 0.58 compared with 0.14 on an unadjusted basis, while volatility for private real estate increased significantly, from 5.5% to 12.8%, in range with listed REITs on a risk-return basis.
Furthermore, using an econometric technique called cointegration, we found strong evidence that listed and private real estate converge around an equilibrium level. Cointegration is particularly useful in identifying long-run relationships in assets that may appear to move independently in the short term. We believe the existence of a cointegrating relationship with a 90% confidence level offers a powerful indication that the real estate exposure is the principal driver of return and volatility in both the listed and private markets. This analysis also helps reaffirm to us that REITs are compelling based on their own merits as well as compared with private real estate.
Contact Information
Stephen Dunn
(212) 446-9187
email: sdunn@cohenandsteers.com