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Perspectives /

Delivering Value-Added Real Estate Solutions

Daniel Ong, CFA Daniel Ong, CFA

VICE PRESIDENT & SENIOR PORTFOLIO MANAGER

Jeromey Thornton, CFA Jeromey Thornton, CFA

Vice President & Senior Investment Director

Stocks and bonds often get the spotlight among investors, but real estate can also serve a valuable role in long-term asset allocations.

For example, real estate and rental income may provide a good long-term hedge to running inflation. Income derived from real estate investments may help investors fund spending needs over time or, combined with property value appreciation, contribute to long-term growth objectives.

Real estate can also provide diversification benefits in a total portfolio as it can behave differently, exhibiting different return patterns than stocks and bonds.*

REITs Can Offer Efficient Access to Broad Real Estate Exposure

Real estate investment trusts (REITs) are a common means for gaining exposure to real estate investments. First established in the U.S. in 1960 under the Eisenhower administration, REITs are companies that own or finance income-producing real estate but act as passthrough vehicles that distribute income to shareholders.

Companies operating as REITs don’t pay taxes on the earnings they distribute to shareholders, like funds and ETFs. For a company to enjoy the benefits of the REIT structure, U.S. regulations set certain requirements, including:

  • 75% of assets must be in real estate assets or cash-like securities.

  • 75% of taxable income must be from real estate-related income like rent on the property, interest on mortgages, gains on the sale of property, and dividends/gains from other REITs.

  • 90% or more of ordinary income and 95% of net capital gains distributed to shareholders.

REITs expand opportunities for everyday investors to pursue broadly diversified real estate investments. While many investors may own property through their primary residences, REITs can provide exposure to many different property types in various locations, such as single-family rentals, hotels and resorts, office buildings, storage facilities, retail shopping malls, and industrial facilities.

As of the end of 2020, about 250 U.S. REITs collectively owned more than 500,000 properties totaling $2 trillion in value.¹

The U.S. approach has also served as a model for many other countries to create REIT-like securities of their own. Hundreds of public, REIT-like companies operate outside the U.S., offering exposure to properties in more than 50 countries worldwide. See Figure 1.

Figure 1 | Global REITs Offer Exposure to Properties in More Than 50 Countries

Countries Where REITs Own Property
A map showing global REITs offer exposure to properties in more than 50 countries.

Source: Avantis, Bloomberg.

Understanding Public vs. Private REITs

Most REITs are publicly traded on stock exchanges. Investors can purchase shares of individual REITs or can invest through commingled funds like ETFs and mutual funds that invest in REITs.

REITs can also operate as private companies that don’t register with the U.S. Securities and Exchange Commission or trade on stock exchanges like public REITs. Private REITs are typically available only to institutional or accredited investors.

Figure 2 lays out similarities and differences. To start, to operate as either a public or private REIT, a company must meet the criteria required to qualify as a REIT. For both public and private REITs, the majority of total assets must be invested in real estate assets, and the bulk of income must be passed through to shareholders as dividends. In other words, the underlying exposure may be similar.

Figure 2 | Comparing Key Attributes of Public and Private REITs

PUBLIC REITs

PRIVATE REITs

75% of Total Assets in Real Estate

Yes

Yes

75% of Taxable Income From Real Estate-Related Income

Yes

Yes

Distributes at Least 90% Of Taxable Income Through Shareholder Dividends

Yes

Yes

Traded on National Stock Exchanges

Yes

No

Daily Liquidity Generally Available

Yes

No

Daily Market Pricing

Yes

No

Fees and Expenses Reflected in Net Asset Value (NAV)

Yes

No

Source: Avantis Investors.


Beyond these required features of REITs, we see two clear differences between public and private REITs.

  • Liquidity: Because private REITs aren’t traded in a public market, they offer shareholders no guarantee of daily liquidity. They are often considered illiquid investments. In contrast, public REITs can be bought and sold daily in the public market.

  • Pricing: Public REITs are priced each day as buyers and sellers transact in the market, reflecting the market’s current expectations of the underlying properties’ valuations, expected cash flows from rental income, and costs from expenses and management fees. Private REITs rely on appraisal-based pricing, meaning a REIT’s net asset value (NAV) is based on underlying property values that are often estimated quarterly or sometimes less frequently and, unlike public REITs, don’t reflect management fees and expenses.

One risk for investors to consider when evaluating private REITs is that appraisal-based pricing may mean private REIT prices are stale or, in other words, don’t reflect current information that may affect prices. Another comes from the price of private REITs not reflecting fees and expenses.

Let’s consider an example to compare market pricing versus appraisal-based pricing. Imagine two REITs (REIT 1 and REIT 2) that share the same properties at an even 50/50 split. REIT 1 has a lower, flat management fee (e.g., 0.50% of assets), and REIT 2 has a higher, flat management fee (e.g., 1% of assets) plus a performance participation fee (e.g., 15% of any appreciation).

If both REITs were priced in the market, REIT 2 should have a lower price than REIT 1. Investors would likely pay less for REIT 2, given that they would also receive less because of the higher fees. If both REITs were priced only by appraisal values, as for private REITs, each would have the same price since the NAV for each REIT is based on the same underlying properties and management fees aren’t part of the value of the properties.

So, if we paid full price for the properties based on the appraisal-based NAV but only received 85% of the appreciation (as in the case of REIT 2), then this would be like paying full price for only 85% of the properties.

Given these differences in liquidity and transparency in pricing, investors may wonder what drives the appeal of private real estate. It may come from a belief that private real estate can offer higher returns.

A recent University of Florida study explored this topic.² Researchers compared the estimated final internal rate of return (IRR) of 375 U.S. closed-end private real estate funds to the period-matched returns of U.S. public REITs over the 20 years from 2000 through 2019. The authors also estimated risk-adjusted returns in an attempt to account for differences in risk from typically higher leverage and lower liquidity for private real estate funds.

As shown in Figure 3, their results found no observable return advantage for U.S. private real estate funds for the sample studied. Whether adjusting for risk or not, public REITs outperformed more than half of the private real estate funds examined. The average unadjusted return difference for the private funds versus public REITs was -1.65%. The study found similar results for non-U.S. private real estate funds.

Figure 3 | Many Private Real Estate Funds Have Underperformed Public REITs

NON-RISK ADJUSTED

RISK-ADJUSTED

% of Private Funds to Underperform Public REITs

53%

68%

Average Annualized Excess Return for Private Real Estate Funds Over Public REITs

-1.65%

-5.90%

Data from 1/1/2000 – 12/31/2019. Source: Thomas R. Arnold, David C. Ling, and Andy Naranjo, “Private Equity Real Estate Fund Performance: A Comparison to REITS and Open-End Core Funds,” Journal of Portfolio Management 47, no. 10 (2021):107-126.


We can’t say with certainty what has led private real estate funds to underperform public REITs in this and other studies. However, differences in pricing and the level of fees between private and public funds may play a role.

Ultimately, if the goal is broadly diversified real estate exposure, we think public REITs, or funds that invest in public REITs, can be a potentially efficient way to get it while maintaining daily liquidity and pricing.

Identifying Differences in Expected Returns Within Public REITs

For investors seeking real estate exposure, we believe a broadly diversified portfolio of publicly traded, global REITs is a good starting point. But not all securities have the same expected return. By drawing on insights from financial science, we seek to systematically identify securities with higher expected returns to target improved outcomes versus global REIT market benchmarks.

Academic research has demonstrated two reliable effects prevalent among publicly traded real estate securities: leverage and momentum.

Leverage

As shown in Figure 4, empirical evidence shows that highly levered REITs tend to underperform.

The economic rationale behind this relationship is that in times of distress (at a company, sector or industry level), elevated leverage contributes to financial distress costs. Such a capital structure may force REITs with higher levels of debt to sell property or issue equity at depressed prices, likely negatively impacting existing shareholders. Due to regulations that consider REITs pass-through entities, they don’t retain earnings and instead finance their activities by raising capital in the equity or debt markets.

Figure 4 | Highly Levered REITs Have Historically Outperformed

Annualized Return and Risk from 1990-2012

MARKET RETURN

STANDARD DEVIATION

SHARP RATIO

Full Sample

Full Sample

REIT Bear Market

-

13.1%

-21.2%

-

28.7%

19.5%

-

0.330

-1.271

High-Levered Firms

Full Sample

REIT Bear Market

-

11.5%

-25.6%

-

30.3%

18.1%

-

0.258

-1.611

Low-Levered Firms

Full Sample

REIT Bear Market

-

14.8%

-16.7%

-

26.9%

19.9%

-

0.415

-1.017

Data from 1990-2012. Source: Emanuela Giacomini, David C. Ling, and Andy Naranjo, “REIT Leverage and Return Performance: Keep Your Eye on the Target,” (2016). Available at SSRN. See also: Sheridan Titman, Garry J. Twite, and Libo Sun, “REIT and Commercial Real Estate Returns: A Post Mortem of the Financial Crisis,” (2013). Available at SSRN.


Figures 5 and 6 offer further evidence of the leverage effect, extending the research of Giacomini, et al. on REITs in U.S. and non-U.S. markets.

Figure 5 | Extended U.S. Leverage Data

DEBT/MCAP

HIGHEST 25%

REST

Average Return

8.56%

10.61%

Compounded Return

5.02%

9.11%

Standard Deviation

26.69%

19.03%

Data from 1998-2022. Source: FactSet.


Figure 6 | Non-U.S. Leverage Data

NON-U.S.

AUSTRALIA*

UNITED KINGDOM**

EUROPE ex UK**

Top 50%

(Higher Leverage)

2.97%

1.94%

-7.85%

-1.73%

Bottom 50%

(Lower Leverage)

4.19%

2.83%

-1.57%

0.99%

Data from 2006-2022. Source: FactSet. Data is annualized compound returns. *Since May 2006. **Since May 2007 (inception of U.K. REITs).


Momentum

Momentum among REITs has been well-documented in academic literature since Jegadeesh and Titman (1993).³ Securities with extreme outperformance tend to continue to outperform, and securities with extreme underperformance tend to continue to underperform. Papers have shown that this behavior isn’t unique to equities but is also seen in REITs where, like equities, it’s well-studied and reliable (see, for example, Chui, Titman, and Wei 2003).⁴

Our Value-Added Approach

In designing real estate solutions, our goal is to provide efficient, broadly diversified exposure to REITs and REIT-like securities while considering the well-documented effects that can impact expected returns over various time frames.

We believe a systematic process that can help identify and sort securities based on the characteristics linked to higher expected returns in academic research can enhance a strategy’s ability to capture returns and manage risks.

Given the research on leverage and momentum, our weighting schema considers a company’s leverage, relative momentum and total market capitalization. In considering market leverage, we look at outstanding debt over the total market cap.

Our rankings drive each security's desired overweight or underweight relative to its market cap weight. By using the drivers of expected returns to modify market capitalization weights, we ensure that price plays a significant role in the weighting schema.

Weighting schemas that don’t include price and only incorporate fundamentals (i.e., fundamentally weighted or rank-weighted schema) are more likely to depend on stale information and ignore new information in current prices. Weighting schemas that only incorporate price and ignore fundamentals include no information about differences in expected returns.

Our weighting schema incorporates current market and security data with information about differences in expected returns among REITs in a sensible way that we believe allows us to systematically increase expected returns while minimizing turnover and mitigating risks.

Our approach excludes the most highly levered REITs from investment within each eligible market which we generally expect to lead to a lower weighted average market leverage than broad market indexes.

With respect to sectors, our approach includes specialized REITs, such as cell tower REITs, which are often not included in market indexes. We include these property types because we believe they can be good real estate businesses and broaden our opportunity set to generate returns for investors.

This approach aims to outperform market indexes through a well-defined investment process focused on systematically identifying and targeting REIT securities with a more attractive expected return profile within the eligible universe.

We seek to offer an approach that is transparent about the risks we are taking in pursuit of excess returns, conscious of what risks we can control and consistent in its execution. This means remaining fully invested, broadly diversified and focused on securities with higher expected returns.


* Diversification doesn’t guarantee a profit or protect against loss of principal.

Definition

Expected Returns: Valuation theory shows that the expected return of a stock is a function of its current price, its book equity (assets minus liabilities) and expected future profits and that the expected return of a bond is a function of its current yield and its expected capital appreciation (depreciation). We use information in current market prices and company financials to identify differences in expected returns among securities, seeking to overweight securities with higher expected returns based on this current market information. Actual returns may be different than expected returns, and there is no guarantee that the strategy will be successful.


Endnotes

¹ National Association of Real Estate Investment Trusts (Nareit).

² Thomas R. Arnold, David C. Ling, and Andy Naranjo, “Private Equity Real Estate Fund Performance: A Comparison to REITs and Open-End Core Funds,” Journal of Portfolio Management 47, no. 10 (2021): 107-126.

³ Narasimhan Jegadeesh and Sheridan Titman, “Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency,” Journal of Finance 48, no. 1 (1993): 65-91.

⁴ Andy C.W. Chui, Sheridan Titman, and K.C. John Wei, “The Cross Section of Expected REIT Returns,” Real Estate Economics 31, no. 3 (2003): 451-479.


Real estate funds may be subject to many of the same risks as a direct investment in real estate. These risks include changes in economic conditions, interest rates, property values, property tax increases, overbuilding and increased competition, environmental contamination, zoning and natural disasters. This is due to the fact that the value of the fund’s investments may be affected by the value of the real estate owned by the companies in which it invests. To the extent the fund invests in companies that make loans to real estate companies, the fund also may be subject to interest rate risk and credit risk.

The opinions expressed are those of American Century Investments and are no guarantee of the future performance of any American Century Investments portfolio.

This material has been prepared for educational purposes only and is not intended as a personalized recommendation or fiduciary advice. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.

Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.

The contents of this Avantis® investors presentation are protected by applicable copyright and trade laws. No permission is granted to copy, redistribute, modify, post or frame any text, graphics, images, trademarks, designs or logos.

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