It's no secret that publicly traded REITs are a way to add real estate exposure to complement other investments and diversify portfolios. But some larger investors have added a new wrinkle to the equation in how they allocate to REITs, using them to gain access to property types such as data centers, life sciences and other sectors that are more difficult to reach through other vehicles.
This tactic, which investors have dubbed the “completion portfolio” strategy, is used primarily by large institutions, but given that REITs are publicly traded, it can be used by any investor looking to round out their exposures. real estate.
A prominent example highlighted by Nareit, the association representing the listed real estate industry, is Norges Bank Investment Management. This group manages the Global Government Pension Fund (Norway's oil fund) on behalf of the Norwegian people. The fund allocates $58 billion to real estate globally, split equally between public and private structures. Notably, its private arms mainly include office, logistics and retail, while its public real estate investments are more diversified, giving it an overall portfolio that is more balanced to reflect the overall shape of universe of commercial investable real estate.
In another example of a sovereign wealth fund using REITs in a completion portfolio, PGIM advised an Australian superannuation fund to use REITs globally to complement its pre-existing Australian portfolio, which focused only on domestic office, property retail and industrial.
In another development, the gap between private and public real estate valuations, which has persisted for years and contributed to a prolonged slowdown in the transaction market, has finally narrowed. Combined with a normalizing interest rate environment, this could ultimately lead to an increase in deal activity.
WealthManagement.com spoke with Ed Pierzak, Nareit senior vice president of research, about case studies and narrowing the gap between public and private real estate valuations.
This interview has been edited for style, length and clarity.
WealthManagement.com: Take me through Norge's example first. What are your results from what they have done?
Ed Pierzak: They are one of the most sophisticated real estate investors in the world. And as an investor with very long-term liabilities, they see no difference between private real estate REITs. With their real estate portfolio they have a 50/50 split on both. This is somewhat unique.
They have a massive investment portfolio overall, with total assets of $1.7 trillion. So real estate is only a small part of the portfolio, but $58 billion is still a massive number in absolute terms.
When they explore an opportunity, be it local, regional or global, they will look at what is the best way to approach that opportunity, both in terms of investment and pricing.
Say, they want exposure to apartments. They will evaluate whether to buy public or private at that point and then move forward. On the private side, you are mostly limited to the four traditional property types. With REITs, you have a larger menu and access to modern economic sectors. When you put them together, you can build a portfolio that is quite diversified across sectors and geography.
One thing that stands out with Norges is that when you look at the private side, it's 50% exposure to the office. By combining into REITs, they have reduced the office to 28% of the combined portfolio.
WM: What about this second example of the Australian superannuation fund?
EP: With survival funds, money is always flowing, and real estate has always been a big part of their investments. But if you are only buying local assets in Australia, at some point, you will run out of what you can buy. Often, Australian investors have had global horizons.
This example shows that mix. For this fund, you start with the typical/legacy Australian private real estate portfolio, which focuses on three traditional property types: office, retail and industrial. PGIM came in and helped them run a completion portfolio and get a global perspective.
In the process, they get exposure to other geographies, while also doing a bit of doubling up locally by investing in some local companies. In general, they were exposed to geographies and property types that were unavailable or unavailable on the private side.
WM: Referring to recent REIT performance, in October total REIT returns fell slightly, with the FTSE All Equity REIT Index down 3.6%, little changed since. Can you put that performance in a larger context?
EP: We are still in this trade with the 10-year Treasury. It dates to 2022. As Treasury yields rise, REIT performance falls and vice versa. At the end of the third quarter, yields were falling and REIT performance was rising. Since then, the yield has risen by about 50 basis points, so not surprisingly, the REIT's performance has dipped slightly.
Giving some perspective on where REITs stand today, we will have our third quarter T-Tracker soon and can talk about the balance sheet situation. Overall, REITs continue to be in fantastic shape. Leverage ratios have fallen to closer to 30% from 35%. The weighted average cost of debt remains about the same, just over 4%. The weighted average term to maturity is six and a half years. And 80% of REIT debt is unsecured and 90% of it is fixed rate.
I bring those points up because what we're seeing in terms of cap rates with this increase in performance is that REIT implied cap rates have decreased while the private cap rate has remained stable, so the cap rate gap the margin has finally narrowed to a point where it is likely to decrease to around 60 basis points. This is an important number because it is a historically close enough range for the transaction market to experience a revival.
WM: That seems like a big deal. We've talked a lot in the past about that divergence and how wide it was and compared it to past periods. So what you're saying is that we're finally at the point where even though they're not completely in sync, it's close enough for transaction markets to work?
EP: That's right. When the difference exceeds 100 basis points, it tends to be a problem. If you're below that and the spread is in the 50s, the markets may act like they're in sync.
This brings us back to the balance sheet position. As the transaction market picks up, REITs are in an excellent position to buy. They have no concerns about leverage. They have access to debt. It is cost effective and we have seen with the unsecured issuance that REITs have a competitive advantage over their private market counterparts.
WM: Finally, are there any ramifications of the election results for REITs?
EP: It is the fact that there is now some security with an elected President, that has calmed things down a bit. But beyond that, I can't speak to any potential impact.