U.S. REITs October 2015
REITs Are a Permanent Allocation Thomas Bohjalian, Executive Vice President and Portfolio Manager Edited by Mark Adams
Are you a strategic or a tactical investor? If your goals are long term, we believe REITs should be part of your portfolio at all times, through all types of markets— providing valuable diversification and return potential driven by the distinctive characteristics of commercial real estate.
Highlights • REITs have historically served as effective diversifiers, with a track record of strong returns, attractive yields, and low correlations with stocks and bonds.(1) • While interest rate concerns have affected short-term performance lately, our research shows that returns are ultimately driven by the cash flows of the underlying real estate. • With real estate becoming a dedicated GICS sector in 2016, we identify ways the move may improve REITs’ risk-return profile and bolster the case for a strategic allocation.(2)
Real estate has a long history of helping investors build and protect wealth, while generating relatively steady dividend income that tends to grow with inflation. Demand for real estate has been especially strong in recent years, enticing investors with predictable, contract-based cash flows and attractive yields in an environment of economic uncertainty and ultra-low interest rates. And yet, over the past year, despite a bull market in commercial real estate fundamentals, investors have shifted away from real estate investment trusts (REITs) amid concerns over higher interest rates. We disagree with this sentiment, as jobs and economic growth have historically tended to outweigh the impact of rising rates. While shifts in monetary policy may unsettle markets in the short term, we believe performance will ultimately be driven by the underlying property markets. Too often, we find that investors try to time their real estate allocations. Unfortunately, some of the largest gains occur in volatile periods, when investors tend to be the most cautious. Recent history offers a prime example of the difficulties of trying to predict returns: in 2013, many investors sold U.S. REITs on fears of higher bond yields amid the so-called Taper Tantrum, only to see REITs generate a 30% return in 2014.(3) It’s time to change the conversation and get back to fundamentals. Real estate is not a short-term investment. By making REITs a permanent allocation, investors are tapping into the potential for enhanced risk-adjusted returns over full market cycles, based on the distinctive long-term characteristics of commercial real estate.
Benefits of Allocating to REITs Strong total-return potential: Since 1976, U.S. REITs have delivered average returns of 13.6% per year, or 9.5% after inflation, outperforming both stocks and bonds (Exhibit 1). We believe this compelling history is supported by REITs’ attractive business models, which tend to provide predictable, growing cash flows in addition to offering inflation-hedging characteristics. To illustrate the potential benefit, we show that adding REITs to a simple stock/bond portfolio may result in improved risk-adjusted performance. (1) Correlation is a statistical measure of how two data series move in relation to each other. (2) GICS: Global Industry Classification Standard. (3) U.S. REITs represented by the FTSE NAREIT Equity REIT Index. See page 7 for index definitions.
Making REITs a Permanent Allocation
Looking at REITs through a multidecade lens provides a sense of the asset class’s overall potential, but a lot can happen over shorter time horizons. The bottom chart shows that over rolling 10-year periods, REITs have produced relatively consistent returns, generally ranging between 8% and 16%. Even in the depths of the financial crisis in the first quarter of 2009, REITs maintained a 4% annualized total-return average on a 10-year basis, whereas stocks had given back all of their returns from the past decade and then some.
Exhibit 1: Historical Performance of REITs, Stocks, and Bonds Risk/Return Analysis 1976 to Present(a) Nominal Annualized Return 13.6% 11.3% 7.7%
REITs Stocks Bonds
Standard Deviation(c) 17.0% 15.0% 5.4%
Hypothetical Portfolios of Stocks/Bonds/REITs (%)(e) 60/40/0 10.2% 55/40/5 10.4% 50/40/10 10.5% 45/40/15 10.7%
9.7% 9.5% 9.3% 9.2%
Real (Inflation-Adjusted)(b) Sharpe Ratio(d) 0.80 0.76 1.43
Annualized Return 9.5% 7.3% 3.9%
1.06 1.10 1.13 1.16
Standard Deviation(c) 17.1% 15.0% 5.6%
6.3% 6.4% 6.6% 6.7%
Sharpe Ratio(d) 0.56 0.49 0.68
9.8% 9.6% 9.4% 9.3%
0.64 0.67 0.70 0.72 REITs Stocks
Annualized Returns, 10-Year Rolling Average(f)
Bonds
25% U.S. REITs have averaged 8–16% annual returns in 84% of rolling 10-year periods
20% 15% 10% 5% 0%
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
2014
Source: Bloomberg, Morningstar, and Cohen & Steers.
Performance data quoted represents past performance. Past performance is no guarantee of future results. (a) At August 31, 2015. (b) Nominal return less inflation, as represented by the U.S. Consumer Price Index, which measures changes in the prices paid for a representative basket of goods and services. (c) Standard deviation is a statistical measure of volatility, representing the dispersion of returns from the mean. (d) For this report, Sharpe Ratio, a measure of risk-adjusted return, assumes a risk-free rate of zero. (e) Hypothetical portfolios based on index representations indicated below to illustrate the general relationships between broad equities, fixed income, and REITs. Assumes that REIT allocations will generally be funded from an investor’s equity allocation. (f) At June 30, 2015, quarterly data. REITs represented by the FTSE NAREIT Equity REIT Index; stocks represented by the S&P 500 Index; bonds represented by the Barclays Capital U.S. Aggregate Bond Index. See page 7 for index definitions and additional disclosures.
2
Dynamic income: REITs have historically generated more investment income than stocks with similar risk profiles, with dividend yields currently averaging 4.3%, compared with 2.2% for the S&P 500 Index.(1) This yield advantage is the result of REITs’ cash-flow-oriented businesses and the requirement that they distribute nearly all taxable income to shareholders. REITs also have a history of consistent dividend growth due to barriers to supply and the consequent inflationary nature of rents and cash flows. We believe the combination of high current income with growth makes REITs a potentially attractive alternative to bonds, especially in the face of rising interest rates and the unknown inflationary impact from years of quantitative easing.
Since mid-2007, correlations for many asset classes, including REITs, have been materially affected by extreme monetary policy conditions. As shown in Exhibit 3, REITs had a very low correlation with the broad stock market prior to the financial crisis, at just 0.36 between 1990 and the start of U.S. monetary easing in 2007. Over the next six years, amid historically low interest rates and aggressive monetary stimulus, REIT returns converged with other stocks. However, these patterns have swung dramatically in the other direction following the Taper Tantrum in May 2013, when the Federal Reserve first indicated its plans to scale back its bond purchases, signaling a shift toward a tightening bias. Since then, REITs have traded closely with bonds amid uncertainty surrounding interest rates.
Low correlations with stocks and bonds: REITs have historically served as effective diversifiers due to their tendency to react differently to market conditions than other asset classes and businesses. Since 1990, REITs have had a 0.55 correlation with the broad stock market and a 0.19 correlation with bonds. In addition, REITs have been less tied to the broad equity market than most other sectors of the economy (Exhibit 2). This divergence is driven by distinct economic sensitivities and supply-anddemand cycles of the underlying property markets, with the added stability offered by commercial leases.
In our view, these distorted behaviors won’t last: eventually, REIT performance must reflect the dynamics of the underlying commercial real estate markets. As investors adjust to higher interest rates, we expect the effects of crisis-era policies to gradually fade, providing a backdrop for correlations to once again reflect the fundamental differences in the asset classes.
As monetary conditions normalize, we expect REITs will exhibit more traditional relationships with stocks and bonds.
December 31, 2012 September 30, 2013
Exhibit 2: Sector Correlations to the S&P 500 Index 1990–August 2015
Exhibit 3: REIT Correlations and the Impact of Monetary Policy Health Care
Industrials Consumer Discretionary Financials Technology Materials Health Care Consumer Staples Telecom Services Energy REITs Utilities 0.00
0.90 0.89 0.84 0.80 0.78 0.67 0.66 0.64 0.61 0.55
Self Storage
Shopping Center
Regional Mall
1.00
Office
Apartment
Industrial
Hotel
U.S. Total
Full Period
Pre-Financial Crisis
Historic Monetary Easing
Since the Taper Tantrum
0.82
0.80 0.60
REITs vs. Stocks REITs vs. Bonds
0.80
0.55
0.40
0.36 0.28
0.20
0.19
0.16
0.18
0.43 0.20
0.40
0.60
0.80
1.00
1990–Aug 2015
1990–Jul 2007
Aug 2007–Apr 2013 May 2013–Aug 2015
At August 31, 2015. Source: Morningstar and Cohen & Steers.
Performance data quoted represents past performance. Past performance is no guarantee of future results. Based on monthly returns. REITs represented by the FTSE NAREIT Equity REIT Index; equity sectors based on sector-level returns of the S&P 500 Index; stocks represented by the S&P 500 Index; bonds represented by the Barclays Capital U.S. Aggregate Bond Index. See page 7 for index definitions and additional disclosures. (1) At August 31, 2015. Source: Bloomberg.
3
Making REITs a Permanent Allocation
Real Estate Ultimately Drives REIT Returns Despite short-term similarities with other stocks, REITs have shown a meaningful connection to private real estate over the long run.
Most investors inherently understand that real estate is a long-term investment, since commercial properties tend not to change hands very often. However, because listed REITs trade on stock exchanges, investors may be tempted to trade in and out of REITs more frequently. This is a mistake, in our view. REITs may trade similarly to other stocks over short time periods, but over full market cycles, their capital appreciation and dividends are tied directly to the cash flows of the underlying properties. In order to realize the full benefits of owning real estate, we believe REIT investors must be willing to take the same long-term view as investors in private real estate do. To study the relationship between REITs and real estate, the Cohen & Steers Quantitative Strategies team examined quarterly returns for listed REITs and private real estate funds going back to 1978. In our view, the results provide strong evidence that real estate exposure is the primary driver of returns and volatility in both markets. REITs and private real estate are “cointegrated�: Correlation is commonly used to measure whether two assets move similarly in response to market events. However, a high correlation is no guarantee of a long-run relationship. In fact, correlated assets may drift far apart as time goes on. This is where cointegration analysis can be useful. Cointegration is an econometric technique that measures whether two assets track each other over time based on a common underlying factor. In other words, cointegrated assets may move independently in the short term, but will eventually correct back to each other and generally remain parallel over time. Our analysis revealed strong evidence of cointegration between listed and private real estate, with the two markets converging around an equilibrium level (Exhibit 4). The analysis factors in differences in magnitude through a cointegration factor, which we found to be consistent with the difference in leverage between the two markets. Exhibit 4: Cointegration of Listed and Private Real Estate Indexed to 100 at 1/1/1978
Listed REITs Private Real Estate
Private Real Estate (adjusted for cointegration factor)
10,000 Cumulative Return (log scale)
Cointegration analysis shows that REITs and private real estate track each other over time, correcting back if values stray too far.
1,000
100
1978
1981
1984
1987
1990
1993
1996
1999
2002
2005
2008
2011
2014
At December 31, 2014. Source: NCREIF, Bloomberg and Cohen & Steers. Cointegration confidence interval: 90%.
Performance data quoted represents past performance. Past performance is no guarantee of future results. Listed REITs represented by the FTSE NAREIT Equity REIT Index; private real estate represented by the NFI-ODCE Index. See page 7 for index definitions and additional disclosures.
4
Adjusted correlations and volatility: In order to compare short-term relationships, it is first necessary to account for significant differences in how the two markets are measured— namely, that REITs are valued in real time, whereas private real estate returns are based on an appraisal process, which embeds significant smoothing and produces artificially low measured volatility. Our analysis revealed that this smoothing effect is consistent with a five- to six-quarter simple moving average, exhibiting the same patterns as if a rolling average were applied to a stream of underlying returns. By applying the same moving-average process to REITs, we level the playing field, providing a clearer picture of the underlying relationships. The result: correlation rose from 0.14 on an unadjusted basis to 0.58, suggesting to us a much stronger short-term relationship than what is generally perceived in the market.(1) The moving average can also be used to back out the smoothing of private real estate, providing an approximation of the actual investment risk of the underlying assets as opposed to the reported volatility. After this adjustment, volatility for private real estate increased from 5.5% to 12.8%, in range with listed REITs on a risk-return basis.
GICS Changes Will Put REITs in the Spotlight For the first time since the GICS was created in 1999, a new sector classification will be added, elevating real estate to a separate category from its current place in the financials sector. The change is likely to have significant implications for portfolio planning and research, as GICS is widely used for categorizing and analyzing equity sectors, and it defines equity categories for benchmarks such as the S&P 500 Index and the MSCI World Index. Increased demand: The change reflects a growing recognition in the market that real estate is fundamentally different than other businesses, with distinct investment characteristics. By not lumping real estate firms with banks and insurance companies, investors will be forced to consider REITs on their own merit. We believe the increased attention is likely to drive demand for REITs and attract more capital to the sector, broadening the investor base and incentivizing more REIT IPOs and REIT conversions. Potential for reduced volatility: We believe broader ownership of REITs should translate into greater liquidity, which should, in turn, have a dampening effect on short-term volatility. Also, REITs will no longer get caught up in the trading of financial sector exchange-traded funds (ETFs), which investors often use to speculate or hedge against risk in the global financial system.
Impact on allocations: Broad-market ETFs tied to GICSrelated benchmarks will own the same amount of REITs before and after the realignment, as the change will only affect how existing index constituents are categorized. For actively managed general equity portfolios, asset managers have historically been underweight REITs within their financials allocation. Some may make the effort to include more real estate in their portfolios, although we suspect many will continue their current practices. However, assuming a manager shifted to a market-weight position (about 3% of the broad market), an investor portfolio with 60–70% in stocks would hold about 2% in REITs. This means that an investor targeting a 10% allocation to real estate, for instance, would still be 8% short.
The Advantage of Working With a REIT Specialist In our view, real estate is not an asset class conducive to desktop analysis. To get a true sense of the properties and local economies, we believe analysts need to be on the road, talking with local leasing agents, property managers, and tenants. In our experience, this is typically not something investors get with generalist managers. We believe analyzing REITs also requires an understanding of the industry’s unique valuations metrics, such as funds from operations, net asset value, and net operating income, used in place of traditional measures like earnings per share, price-to-earnings ratio, and book value. Utilizing these processes has historically led to better results from stock selection, giving REIT managers a decided advantage over generalists. This success can be seen in the overall performance record of real estate mutual funds. According to Morningstar data, shown below, more than half of actively managed U.S. real estate mutual funds have outperformed their respective benchmarks on a net basis over the long term, whereas most core equity and fixed income active managers have struggled to achieve outperformance.
Percent of mutual funds that outperformed their benchmark over the past 20 years:(2) U.S. Real Estate: U.S. Core Equity: U.S. Fixed Income:
57% 31% 28%
(1) Based on the mean of separate calculations using five-quarter and six-quarter moving averages. Adjusted correlation measures the correlation of returns after applying the movingaverage process to REITs. Adjusted volatility measures the standard deviation of private real estate, multiplied by a normalization factor equal to the square root of the moving-average process. (2) At June 30, 2015. Source: Morningstar and Cohen & Steers. Based on actively managed mutual funds with a 20-year track record: U.S. real estate: 14 funds; U.S. Core Equity: 131 funds; U.S. Fixed Income: 329 funds. See page 7 for important disclosures.
5
Making REITs a Permanent Allocation
How Much Should Investors Allocate? Each year, UBS conducts a survey of institutional investors on trends in the global real estate securities market. The 2015 survey featured responses from 48 investors and consultants with more than $230 billion invested in real estate securities. When asked for their view of an appropriate real estate allocation (factoring in both listed and private investments), respondents generally recommended higher levels in 2015 than in recent years (Exhibit 5), including large increases in the 16–20% and 20%+ buckets. In total, 51% believed that an allocation of 11% or more was appropriate, 47% viewed a 5–10% allocation as reasonable, and only 2% indicated 0–4%.
Institutional investors and consultants are generally recommending higher real estate allocations in 2015.
Exhibit 5: UBS Survey: What Is an Appropriate Allocation to Real Estate? 100%
20%+ 16–20% 11–15% 5–10% 0–4%
80% 60% 40% 20%
2011
2012
2013
2014
2015
At May 7, 2015. Source: UBS.
An Asset-Allocation Approach to REIT Investing While investors may have a target range for their real estate allocation, it should never go to zero, in our view. Over full market cycles, REITs offer the potential to improve risk-adjusted performance, provide attractive levels of income, and diversify sources of volatility and return. These investment characteristics are underpinned by REITs’ direct ties to the underlying property markets, as demonstrated by their convergence with the private market over the long term. Despite the growing popularity of passive ETFs, we believe investors are best served by working with an active REIT manager who understands the nuances of REIT financial analysis and has expertise in both equity markets and real estate. While we acknowledge that allocations to real estate securities may vary depending on the investor type, we believe a 5–15% allocation is generally appropriate for most investors.
6
Index Definitions and Important Disclosures An investor cannot invest directly in an index, and index performance does not reflect the deduction of any fees, expenses or taxes. The Barclays Capital U.S. Aggregate Bond Index is a broad-market measure of the U.S. dollar-denominated investment-grade fixed-rate taxable bond market, and includes Treasuries, government-related and corporate securities, mortgage-backed securities, asset-backed securities, and commercial mortgage-backed securities. The FTSE NAREIT Equity REIT Index contains all tax-qualified REITs, except timber and infrastructure REITs, with more than 50% of total assets in qualifying real estate assets other than mortgages secured by real property that also meet minimum size and liquidity criteria. The NFI-ODCE (NCREIF Fund Index–Open-End Diversified Core Equity) Index is a capitalization-weighted report of historical and current results of open-end commingled private real estate funds pursuing a core investment strategy. The S&P 500 Index is an unmanaged index of 500 large-capitalization stocks that is frequently used as a general measure of U.S. stock market performance. Performance data quoted represents past performance. Past performance is no guarantee of future results. The information presented above does not reflect the performance of any fund or account managed or serviced by Cohen & Steers, and there is no guarantee that investors will experience the type of performance reflected above. There is no guarantee that any historical trend illustrated herein will be repeated in the future, and there is no way to predict precisely when such a trend will begin. There is no guarantee that any market forecast made in this commentary will be realized. The views and opinions in the preceding commentary are as of the date of publication and are subject to change without notice. This material represents an assessment of the market environment at a specific point in time, should not be relied upon as investment advice, is not intended to predict or depict performance of any investment and does not constitute a recommendation or an offer for a particular security. We consider the information in this presentation to be accurate, but we do not represent that it is complete or should be relied upon as the sole source of suitability for investment.
Please consider the investment objectives, risks, charges, and expenses of any Cohen & Steers fund carefully before investing. A summary prospectus and prospectus containing this and other information may be obtained by visiting cohenandsteers.com or by calling 800 330 7348. Please read the summary prospectus and prospectus carefully before investing. Risks of Investing in Real Estate Securities. Risks of investing in real estate securities include falling property values due to increasing vacancies, declining rents resulting from economic, legal, tax, political or technological developments, lack of liquidity, limited diversification, and sensitivity to certain economic factors such as interest rate changes and market recessions. The risks of investing in REITs are similar to those associated with direct investments in real estate securities. Foreign securities involve special risks, including currency fluctuations, lower liquidity, political and economic uncertainties, and differences in accounting standards. Some international securities may represent small- and medium-sized companies, which may be more susceptible to price volatility and lower liquidity than larger companies. This commentary must be accompanied by the most recent Cohen & Steers fund fact sheets if used in connection with the sale of mutual fund shares.
About Cohen & Steers Cohen & Steers is a global investment manager specializing in liquid real assets, including real estate securities, listed infrastructure, commodities, and natural resource equities, as well as preferred securities and other income solutions. Founded in 1986, the firm is headquartered in New York City, with offices in London, Hong Kong, Tokyo, and Seattle. Copyright Š 2015 Cohen & Steers, Inc. All rights reserved.
7
We believe accessing investment opportunities around the world requires local knowledge and insight into specialized and regional markets. Cohen & Steers maintains a global presence through the following offices: Americas NEW YORK
SEATTLE
Corporate Headquarters 280 Park Avenue, 10th Floor New York, New York 10017 Phone 212 832 3232 Fax 212 832 3622
Cohen & Steers Capital Management, Inc. 1201 Third Avenue, Suite 3810 Seattle, Washington 98101 Phone 206 788 4240
Europe LONDON Cohen & Steers UK Limited 21 Sackville Street, 4th Floor London W1S 3DN United Kingdom Phone +44 207 460 6350
Asia Pacific HONG KONG
TOKYO
Cohen & Steers Asia Limited Suites 1201-02, Citibank Tower Citibank Plaza, 3 Garden Road Central, Hong Kong Phone +852 3667 0080
Cohen & Steers Japan, LLC Pacific Century Place, 8F 1-11-1 Marunouchi Chiyoda-ku Tokyo 100-6208 Japan Phone +81 3 6860 8389
Cohen & Steers UK Limited is authorized and regulated by the Financial Conduct Authority with FRN 458459.
cohenandsteers.com
Advisors & Investors: 800 330 7348 Institutions & Consultants: 212 822 1620 VP634 MU 1015