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REITs Seek to Lure U.S. Pension-Fund Money From Private Equity

U.S. real estate investment trusts are seeking a bigger piece of the more than $500 billion of property investments from pensions, aiming to attract money from the private-equity funds traditionally favored by managers.

The National Association of REITs found that a portfolio 30 percent invested in commercial property shares delivered a higher return relative to one more heavily tilted toward private-equity funds, based on a study to be published today on the group’s website. Pension funds typically put less than 10 percent of their real estate allocations into publicly traded REITs to protect against stock-market volatility.

The Washington-based real estate association, which represents about 200 companies, says that what it calls “the REIT third” can help state and corporate pensions narrow a funding shortfall that totals almost $1.5 trillion, according to the Center for Retirement Research at Boston College. A bigger REIT allocation, and a smaller one in private equity, would offer better diversification and more consistent returns, said Brad Case, NAREIT’s vice president for research.

The trick is in the timing, he said.

“The public side is liquid, so therefore when investors start to get concerned about the future of asset values, they sell their REIT stocks, whereas they can’t get out of their private-equity real estate funds,” he said in a telephone interview. “That lag is what gives the institutional investor the diversification benefit.”

Three Fund Types

The NAREIT study analyzed 22 years of data encompassing both the 2008 credit crisis and the savings and loan collapse of the early 1990s. It examined REIT returns compared with the three main types of real estate private equity: so-called core funds, which buy properties with mostly cash; high-yield “opportunity” funds, which can use as much as 70 percent borrowed money and aim to boost returns beyond 20 percent; and “value-added” funds, which exist between the two.

The study found that a portfolio consisting of 30 percent REITs, 49 percent in core private funds and 21 percent in high- yield funds averaged an 8.2 percent annual return from 1992 to the third quarter of 2010. A portfolio with 9 percent REITs and 20 percent in value-added funds returned 6.7 percent a year for the same period. The NAREIT-preferred allocation also had a superior Sharpe Ratio, a measurement that seeks to balance volatility with return expectations.

The private and public sides of real estate are contending for slices of what NAREIT estimates is a half-trillion dollar pie, or about 10 percent of the $5.3 trillion in pension investments.

Increasing Leverage

A portfolio 30 percent in REITs may add too much risk to the investments, said Mark Roberts, global head of research at Dallas-based Invesco Real Estate, an asset-management company whose property-investment options includes private-equity funds.

“When you’re looking at that kind of composition of real estate, what investors need to be mindful of is that is starting to take the leverage level of their real estate portfolio upwards of 40 or 50 percent or more,” he said in a telephone interview. “Relative to, say, an unlevered real estate market, that amount of leverage will double the volatility of returns.”

Invesco research shows that about 15 percent invested in REITs maximizes returns without increasing risk, Roberts said.

The largest, best-known real estate private-equity funds are run by investment banks including Goldman Sachs Group Inc. and Morgan Stanley, as well as asset managers such as Blackstone Group LP, Starwood Capital Group LLC, and AREA Property Partners LP. Many of them made their reputations with high-yield opportunity funds that delivered annual returns of as much as 40 percent in the late 1990s.

Credit-Crisis Losses

There were 414 high-yield funds last year, down from a 2009 peak of 466, according to a March survey by Real Estate Alert, a trade newsletter that covers commercial property investment. After losses brought on by the 2008 credit crisis, those funds reduced their equity-raising goals and yield targets, which averaged 16.9 percent last year, according to the survey.

The Bloomberg REIT Index, a measure of 117 commercial property stocks, fell 77 percent from its February 2007 peak to its March 2009 low as credit dried up and real estate values plummeted. It has since rebounded 176 percent.

Pension funds are “clearly” adding REITs to their portfolios, said Anatole Pevnev, a principal with Cleveland- based Townsend Group, the biggest real estate consultant to public pension funds, advising on about $105 billion of property allocations. It’s “tough” to give numbers, since many funds assign REITs to their public securities category, alongside stocks such as Microsoft Corp. and Google Inc., instead of listing them as property investments, he said.

Investor Opportunity

“As REITs got hit hard, it did give an opportunity for investors to get into it,” Pevnev said in a telephone interview last month. “There was a massive blow to the financial system. The ability of the REITs to recapitalize themselves went a long way to convincing investors that REITs are a viable long-term investment.”

An October report by the Pension Real Estate Association found that since 1994, the dawn of that decade’s commercial real estate boom, private equity outperformed REITs when adjusted for risk. REITs beat private funds by 1 percent per quarter in return percentage, though with more than three times the volatility, according to the report.

“NAREIT agrees that REITs are certainly more volatile, and the fact of the matter is they’ve also had a higher return historically than private equity real estate,” said Greg MacKinnon, the association’s research director. “But if you do that risk-versus-return comparison, private real estate comes out on top. Really there’s room for both in a portfolio.”

Oregon’s Pension

Katy Durant, a member of the Oregon Investment Council and a retail property developer in Portland, Oregon, said she’s not inclined to push REITs at the expense of the private-equity funds that have served her state pension funds well. Oregon invests about 21 percent of its real estate allocation in REITs, and 39 percent in high-yield opportunity funds, including John Grayken’s Dallas-based Lone Star Funds, which has invested about $24 billion since its 1995 founding, according to its website.

What matters is which funds you choose, Durant said. Oregon has invested in seven Lone Star funds starting in 1996 and, as of the third quarter, only one had a loss -- a 1.64 percent loss in the 2005 fund, according to the state treasury website. Returns aren’t given for the two most recent funds, both from 2008, because it’s too early for the figures to be meaningful, said James Sinks, spokesman for the treasury. Returns on the earlier funds ranged from 7.4 percent to 32 percent.

“I would like to think that Oregon, by virtue of how long we’ve been playing private-equity and real estate partnerships, they can pick from the cream of the crop,” Durant said. “I would hate to have lowered our allocation to Lone Star and been in a bucket of REITs the entire time.”

To contact the reporter on this story: David M. Levitt in New York at dlevitt@bloomberg.net

To contact the editor responsible for this story: Kara Wetzel in New York at kwetzel@bloomberg.net

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