By Tyler Wilton, DWS
Over the past several years, specifically after the Global Financial Crisis (GFC), passive investing has garnered significant attention from the investment community which has translated into increasing flows away from active management across the majority of asset classes in favor of passive. Even more nuanced and niche asset classes, including Real Estate Investment Trusts (REITs), have not been immune from the “active to passive shift”.
However, the real estate asset class itself has historically proven to be an effective area of the market for stock picking, with several tools for active managers to potentially “beat” the broader REIT market. Real estate securities are an inefficient asset class and this inefficiency may provide an opportunity for experienced active managers to identify and exploit value-add opportunities.
Active REIT managers seek to exploit inefficient pricing characteristics inherent within the REIT market. Pricing inefficiencies may arise for several reasons, including the fact that REITs often see less coverage from traditional “sell-side” Wall Street firms. Less institutional coverage may lead to inefficiently valued publicly-traded securities. Furthermore, active REIT managers are able to utilize several “market-beating” methods, such as stock and sector selection decisions, understanding local property cycles, managing asset quality exposure, positioning according to a specific theme or style, and adjusting duration exposure through deep fundamental analysis.
US REIT Investing – Looking at Active Management
First of all, a long-term strategic allocation to US REITs has historically provided attractive nominal returns as seen by the rolling 10-year return chart below for the MSCI US REIT Index. As depicted, the average 10-year return since 12/31/2000 for the US REIT market has been roughly +10%, importantly not falling into negative territory once over this period. Currently, the nominal 10-year return is at the low end of its historical average and below 1-standard deviation from the mean.
Active REIT funds have historically benefitted investors over the long-run, however, recent market turbulence and broader macro factors has made it increasingly challenging for active managers to outpace their respective benchmark over the short-run.
The simple fact of paying lower fees is one of the easier arguments against active managers, which may be further amplified during environments where equity markets are more heavily influenced by macroeconomic drivers and/or geopolitical issues.
The market environment subsequent to the GFC has prompted a sizable number of investors to shift away from active management in favor of passive solutions. Over the long-run, as seen in the chart below, the active US REIT manager universe* has consistently outpaced the MSCI US REIT Index by an average excess return of +64 basis points (“bps”) on a rolling 5-year basis since the start of 2000, net of fees. The chart below highlights “Rolling 5-Year Excess Returns” (orange shaded area) for the active US REIT universe relative to the MSCI US REIT Index.
Since the GFC, active REIT funds as a group have generally failed to generate returns in excess of the market after fees. As such, this has made it easy for investors to bypass conducting due diligence on active managers as “consistency” of outperformance has been the biggest issue plaguing the active management realm recently. However, as witnessed in more recent periods (e.g. during the past 6-12 months) we have seen active REIT managers more consistently add value over passive solutions as fundamentals are playing a greater role in security and sector level returns.
Case Against Passive REIT Investing
The unique return drivers of real estate affords capable active REIT managers the potential to add value over passive alternatives, specifically those managers with the dedication and experience of investing in alternative asset classes such as real estate, infrastructure, or commodities.
The rolling 5-year alpha for active managers shown above compares favorably to passive US REIT funds which are designed to track a broad-based index, such as the MSCI US REIT Index. Given the relatively concentrated nature of the REIT market compared to broader equity markets, active management can be important in the REIT space.
Passive investments remain indifferent to risk throughout an economic cycle, while active REIT managers have tools to manage risk exposures at different points of the cycle. Prior to the GFC, active REIT funds consistently beat the broader REIT market, but recent market events have had a notable impact on rolling 5-year returns over the past couple years. Importantly, the trend appears to be reversing course back in favor of active management.
The Long-Term Case for Investing in REITs
We believe REITs should be viewed as a long-term strategic investment within an overall portfolio. While active management has been challenged in recent years, we believe active managers can add significant value for long-term strategic REIT investors. The tide of the “active versus passive” debate we believe turns to favor active management when asset class correlations fall, stock performance dispersion rises, and company fundamentals ultimately dictates returns over time.
Fundamental property market and company factors is ultimately what active managers attempt to exploit in order to add value in excess of passive mandates and fees. While the past several years has been challenging for active management in the REIT space, we maintain our view that there is greater potential for active managers to gain an information advantage when dealing with specialty assets classes, such as real estate.
REITs may represent an essential asset class that have, historically, improved the risk/return aspect of a well-diversified portfolio. REITs also seek to offer lower correlation to more traditional stock/bond investments, a higher correlation to ‘private’ real estate markets, attractive dividend yields, a hedge against inflation, liquidity and flexibility. While there are no guarantees that this historical relationship will hold up in the future, we believe that immediate access to expert real estate management teams and stable cash flows from rental-based income structure can offer investors a possible avenue for diversification and return potential over the long-term that could be tough to match outside of the real estate world.
Tyler Wilton, CFA, is an Investment Specialist for Liquid Real Assets at DWS.