Assessing risk and reward – The REIT blend in real estate

Academic research provides some compelling evidence for blending direct real estate portfolios with real estate investment trusts (REITs). The potential benefits include increased returns, liquidity, diversification, access to a wide range of real estate sectors and reduced trading costs.¹

Tactically, we believe, there is also the potential ability to capitalise on mispricing - either within allocations, or the scale of allocations themselves - and an opportunity to use the signals gleaned from REITs to the benefit of direct property ownership and vice versa.

However, much of the literature predates the Brexit vote and the increased volatility experienced in recent years, which have witnessed a period of retail structural change, the pandemic and rising interest rates. This blog post looks at how such a strategy would fare for a UK-based direct investment portfolio, blended with a global REITs holding.²

Evaluating REITs in hybrid portfolios: A geographic perspective

We looked at various ‘hybrid’ portfolios, adjusting weights, geography, and time horizons. The results in the table below show a combination of UK direct real estate (MSCI) and global REITs.

A hybrid portfolio with 50% allocated to UK property (MSCI) and 50% to the S&P Global REIT (GBP) Index outperformed a portfolio solely invested in UK property (MSCI) over the longer term, with greater geographic and sector diversification driving outperformance. While the blended hybrid portfolio underperformed versus UK direct property over 2022 (driven by the sell-off in REITs), the above table shows significant outperformance over a 15-year horizon.

Performance versus volatility

This longer term outperformance came at the expense of higher volatility, an expected trade-off as direct property is infrequently valued and REITs tend to correlate more with equities in the shorter term. Global REITs in particular are much less correlated with UK direct property (a 0.2 correlation over the last 10 years), providing diversification benefits for hybrid portfolios, in our view. As such, risk-adjusted returns are shown to fall slightly for the blended portfolio over 15 years. Volatility, as measured by standard deviation, is just one measure of risk; we note the hybrid portfolio showed similar levels of downside risk, but better upside risk over three-month rolling return horizons.³ The probability of an entry point that is accretive to returns improves following such a sizeable correction.

A final consideration is the impact of leverage of returns within REITs. This is true for US REITs, which have an outsized influence on global REIT benchmarks. Leverage has significantly enhanced returns from REIT investments and although it may be detrimental currently, discounts to NAVs may allow leverage to be accretive again, sooner than in the direct market.

Conclusion

Our analysis shows enhanced returns when including an allocation to global REITs alongside a traditional direct UK property portfolio. However, investors should note this comes at the expense of additional volatility, which keeps risk-adjusted returns more subdued over a 10 to 15-year horizon.

Separate liquidity and regulatory benefits are also seen, but not modelled (i.e. regarding the current FCA consultation, open-ended funds with a certain allocation to REITs will not be subject to mandatory notice periods).⁴ An enhanced liquidity profile is particularly important, in our view. This may allow investors more immediate access to capital and improved risk management - seeking to mitigate potential opportunity costs should market conditions change, while potentially retaining diversification benefits within multi-asset portfolios.

Sources

1. Moss & Farrelly (2015); cited that over the 15 years to 2015 a 20% listed real estate allocation provided a total return enhancement of 19% (c. 1% p.a. annualised).

2. Addressing adjustments for global indirect holdings for sterling-based investors.

3. The modelled portfolio’s best rolling three-month return was higher at 4.1% versus 2.1% for MSCI UK Property, whereas the extent of the downside was similar (worst rolling three-month return was -5.8% versus -6.3% for MSCI UK Property).

4. Financial Conduct Authority – CP20/15: consultation on liquidity mismatch in authorised open-ended property funds