Real estate seems to be a ‘staple investment’ for the community of institutional investors. In fact, after fixed income and equities, it is the most commonly held asset among ‘fiduciary managers’ in the United States (e.g., pensions, endowments, foundations, etc.). Some estimates even suggest that these funds are holding as much as 10 percent of their AUM in real estate. That’s a lot.
That’s such a large number, in fact, that the economic geographer in me immediately wonders how this much liquidity can be deployed into what is otherwise quite an illiquid and locally managed asset class. In other words, how are these long-term investors actually putting their capital to work in real estate? We know full well that most of these funds don’t have the capacity to make direct investments. So are they allocating to REITS? Are they using external managers? Are they resorting to fund-of-funds? (Lord, have mercy.) In short, what are the best access points?
I have answers.
Well, truth be told, it’s Aleksandar Andonov, Piet M. A. Eichholtz, and Nils Kok that have the answers. They just wrote a new paper that deals with many of these questions. But I’ve read their paper, and I’m ready to report what they found.
But before we get to the findings, let’s first get everybody up to speed on the options that most investors have when considering real estate:
- Funds can own the asset on a direct basis (i.e., actually hold the deed to the asset) or they can buy into Real Estate Investment Trusts (REIT).
- The investment decisions (whether direct or through REITs) can be made by internal teams or outsourced to managers.
- Finally, investors can completely give up any and all responsibility for investment decisions and use a fund-of-funds.
So, what’s best? Here are some blurbs:
“...The average gross return of pension funds in real estate during the 1990-2009 period is about 7 percent. REITs delivered a higher return (10.92 percent) compared to direct real estate (6.70 percent).”
“Interestingly, the gross returns on internally managed assets (7.77 percent) are higher than the returns on external mandates (6.82 percent).”
So it would appear that in-house teams investing in REITs is the best way (based on past returns at least) to access this asset class. That’s a bit surprising isn’t it? I would have thought that direct investments through in-house teams would be best, but that’s not the case.
Anything else to take note of?
“Investing through fund-of-funds results in substantial underperformance compared to other investment approaches. This is at least partly due to multiple layers of fees, but neither do the fund-of-funds seem to have good skills in selecting investment managers, since their gross benchmark-adjusted returns are significantly negative.”
No surprise there. Fund-of-funds are not advised.
“Another notable finding in this paper is that U.S. pension funds perform relatively poor as compared to international counter-parts. They face much higher costs than their peers in Canada, Europe and Australia/New Zealand, and their performance is worse. This is partly explained by the fact that U.S. funds are less likely to opt for internal management...”
So the Americans pay higher fees to external managers for worse outcomes. Ugh. Here we go again. What else?
“...money managers in the U.S., like private investors, seem to have engaged in ”irrational exuberance” during the most recent real estate bubble. Excessive use of leverage may be responsible for the initial outperformance of the benchmarks by the U.S. pension funds, as well as for the subsequent collapse in their real estate returns.”
In other words, the 1999-2009 time period may not be the ideal time period from which to draw a bunch of conclusions because of the housing bubble...
In sum, there’s a lot of interest in real estate. And, in my view, institutional investors should spend as much time thinking about the ‘access point’ as they do the underlying strategy and assets. And the big lesson from this paper is that REITS offer a very cost-effective way for small and medium sized pension funds to access this asset class.
