Are REITs real estate?

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What is the relationship between REITs and direct real estate?

Firstly, REITs, or Real Estate Investment Trusts, are companies that own and manage real estate. Therefore, owning shares in REITs is a way for investors to access the risks and rewards of holding property assets without having to buy and manage property directly. REITs typically pay out all of their taxable income (90% in the UK) as dividends to shareholders and in turn, shareholders pay income tax on those dividends.

Since REITs and direct real estate both involve the ownership of properties, the cycles of the two types of investment should intuitively be similar. That is, both forms of ownership should track common real estate factors, mainly economic growth, the unemployment rate, occupancy or vacancy rates and new construction of commercial and/or residential property.

Do REITs really offer the same risks and rewards as holding property directly?

REITs resemble the returns on the stock market more than that of direct real estate in the short-run[1]. In the long-run (3-4 years), REIT market performance is closely related to direct real estate performance, given that both have the same underlying asset types.

However, comparing REITs indices, such as the FTSE EPRA/NAREIT against direct property indices, such as the MSCI/IPD do not form a fair basis for analysis, because REIT indices are geared and direct real estate indices are not. But after adjusting for gearing, property-type weights and transactions, public and private markets are much more similar even in the short-term, demonstrating that the risk/return characteristics of REITs and direct real estate are actually fairly comparable[2].

What are the pros and cons of REITs vs direct investment?

While direct real estate investment can provide significant diversification benefits in a mixed asset portfolio, liquidity is low and transaction costs are high. On the other hand, REITs offer investors a low-cost alternative to invest in the real estate market. However, REIT prices are affected by “noise” (generalist) traders or investor sentiment and thus deviate from fundamental real estate factors from time to time. Over the long-run they are both similar investments and will therefore offer the same diversification attributes.

In terms of investment management, REITs offer less control over the way properties are managed, with tenant and asset management  and the whole valuation process far less intensive. So REITs investment requires knowledge of who is making the decisions, the board set-up, how debt is managed and how strategies are implemented.

Although risk is often said to be higher in the stock market due to the volatility of price changes, REITs and direct real estate are measured differently: the former is forward-looking and geared, and the latter backward-looking and ungeared. For instance, when a new transaction takes place, say an office building is acquired at an equivalent yield of 5%, a REITs analyst will incorporate this new information immediately in their pricing model, including any debt or equity raised. On the other hand, this new transaction figure may take another 3 months to be added to valuation figures since appraisal-based values (IPD) rely on a whole set of comparables, which may not be evident from this single transaction or even taken into account at all for months afterwards. Therefore, appraisal-based values work as an averaged value (a.k.a. smoothed), whereas REITs are affected by the impact of new information on their daily prices. Generalist traders will also impact on the volatility of REITs, since they make decisions that may not be aligned with property fundamentals.

The 10-year volatility of European REITs is 31.3% (as measured by the MSCI European REITs Index) compared with 7.6% of the direct market (as measured by the IPD Pan-Europe Index).

Graph: Real Estate Indices (100 = 31 Dec 2000)*


*IPD Pan-Europe to 31 December 2015
MSCI Europe Real Estate to 28 September 2016

What could the new classification mean to REITs?

At the start of September, real estate was removed from the Global Industry Classification Standard (GICS) Financial Sectors and became the 11th industry sector in the equity indices, which is the reference for stock indices compiled by MSCI and S&P.

According to the European Public Real Estate Association (EPRA), as a stand-alone sector in benchmark global equity indices this could attract an estimated additional 75 billion euros of investment inflows into European property stocks alone in the coming years.

Another benefit of the new classification would be reduced volatility of REITs shares, since changing REITs’ status should reduce volatility to levels that are closer to that of the underlying direct property market.

Why should direct property researchers become more informed about REITs?

The impact of timing in price discovery in the public market is important for the direct market researcher. Announcements of transactions, valuations and analysts’ comments also make a very good source of information and should be closely monitored. For instance, UK REITs slumped 23 per cent on average in the immediate aftermath of the UK Brexit result, immediately affecting the non-listed sector as well.

In terms of strategy, REITs offer short-term liquidity which could provide relief in times of redemptions in open-ended, direct property funds, which is what is happening at the moment. Although redemptions tend to come when markets are uncertain and REITs prices lower, REITs could still provide a better returning cash management technique.

[1] According to Martin Hoesli and Elias Oikarinen in their article ‘Are REITs real estate, Evidence from International Sector Level Data’ published in the Journal of International Money and Finance, 31(7), 2012.

[2] As per Joseph L. Pagliari, Kevin A. Scherer and Richard T. Monopoli in their ‘Public Versus Private Real Estate Equities: A More Refined, Long-Term Comparison’ published in the Real Estate Economics, 33(1), 2005.