31-Mar-23 DWS Research Institute
Geoffrey Shaver, CFA

Geoffrey Shaver, CFA

Portfolio Management Specialist – Liquid Real Assets
Annie Del Giudice

Annie Del Giudice

Senior Portfolio Management Specialist – Liquid Real Assets
Grace Qiu Tiantian, Ph.D.

Grace Qiu Tiantian, Ph.D.

Senior Vice President, Total Portfolio Policy & Allocation Economics and Investment Strategy GIC
Harry Huang Peng, CAIA, FRM

Harry Huang Peng, CAIA, FRM

Analyst, Total Portfolio Policy & Allocation Economics and Investment Strategy GIC

The Role of REITs in Real Estate Allocations

  • REITs are fundamentally real estate, exhibiting high correlations and similar returns over long periods. REITs offer investors greater liquidity than direct real estate, although prices may diverge in the short-term.
  • REITs offer an expanded opportunity set, providing diversified sector exposures at smaller capital outlays. REITs allows for efficient and timely capital deployment, to both complement and temporarily substitute private real estate.
  • Short-term divergences between REITs and private real estate provide tactical opportunities. When trading at a discount to their NAV, REITs have empirically demonstrated strong absolute and relative returns over subsequent 1, 3, and 5-year periods.
  • By combining REITs and private real estate, investors can improve upon their risk-adjusted returns. Empirical data suggests an optimal portfolio allocation to REITs of at least 10% of real estate investments.

Allocations to real estate have long been an important building block for constructing multi-asset portfolios, offering investors meaningful long-term return potential, inflation protection, and diversification benefits. Yet, real estate investment trusts (REITs) are often overlooked by institutional investors. Equity investors will frequently avoid them - even when present in their benchmarks, claiming they are too expensive or lack the growth potential of other equity sectors, while direct real estate or alternatives investors often dismiss REITs as too volatile when compared to direct property or private real estate funds.

Both GIC and DWS believe that REITs merit a place in an investor’s allocation to real estate, providing important levers to create complete and efficient real estate allocations in institutional portfolios. To that end, we endeavour to demonstrate how REITs share characteristics of both equities and real estate. REITs have real estate cash flows, but experience listed equity-like discount rate fluctuations. Over shorter time horizons, discount rates dominate, and REITs exhibit public equity-like volatility and drawdowns. Over the long-term, discount rates tend to mean revert and cash flows drive returns, resulting in a convergence to the underlying real estate.

With these characteristics in mind, we explore two important roles REITs can play in an institutional investor’s portfolio:

  • Strategic allocation: REITs can complement private real estate in building diversified portfolios in terms of geography and sector in a cost- and resource-efficient manner. They can be used to temporarily complete real estate allocations while capital is still in the process of being deployed into private properties.
  • Dynamic allocation: REITs’ pricing contains information about real estate markets (leading indicator). Relative value opportunities between REITs and private real estate exist. REITs add flexibility to quickly adjust an overall real estate allocation or the sectorial or risk profile of a real estate portfolio.

Finally, we demonstrate that by combining REITs with direct real estate holdings or private real estate funds, it may be possible to improve the overall risk-adjusted return profile of a multi-asset portfolio. We hope that readers will come away with an improved understanding of REITs, including their “hybrid” investment characteristics, where they fit and what gaps they can fill in an overall portfolio allocation, and the potential benefits they can offer investors in meeting their investment objectives.

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