Recent research details stronger returns through indirect real estate investment

By Allen Kenney

The results detailed in a September 2007 paper prepared at the Massachusetts Institute of Technology Center for Real Estate show that REITs have consistently beaten the returns on direct real estate investment—and done so by a wide margin—even after controlling for leverage. The analysis, conducted by Jengbin Patrick Tsai, finds that REITs still outperformed when other distinguishing factors, such as property-sector mix, are eliminated as well.

TAKE AWAY PRIVATE VERSUS PUBLIC REAL ESTATE INVESTMENT Results MIT study found that returns on REITs consistently best direct real estate investment. SNAPSHOT Between 1987 and 2006, REITs averaged a 15.35 percent return, compared to direct real estate investment’s average return of 10.13 percent. When controlling for fees, leverage and property-sector mix, REITs generated an average return that was still 2.66 percentage points higher than direct real estate investment. UPSHOT Institutional investors should consider placing greater weight on REITs in their real estate portfolios.

The Nitty-Gritty

The object of the research conducted at MIT was to devise a better way to effectively measure the difference between the performance of public and private real estate direct investment. To do so, Tsai compared the historical returns of the FTSE NAREIT Equity REIT Index and the National Council of Real Estate Investment Fiduciaries (NCREIF) Property Index. Tsai attempted to control for the factors that analysts claim negate useful comparisons between the two indexes, including leverage, property-sector mix and management fees. The study also updates pre-existing research by extending the time period to include market performance through 2005.

The results are clear and should send a message to the country's largest investors, according to NAREIT Vice President of Research and Industry Information Brad Case. While smaller individual investors tend to put their money in REITs, institutional investors typically have gravitated toward separate accounts and commingled funds for most of their real estate investment because of the stability of reported returns. Based on Tsai's findings, Case says, institutions may need to reevaluate the weight that they place on different investment structures for their core real estate portfolios.

"REITs outperform direct investment by more than 2.5 percentage points per year," Case says. "That amounts to somewhere between 24 percent and 38 percent of the average returns on direct investment. The question that pension funds and other institutional investors now have to wrestle with is, 'Why would I do all of my core real estate investing directly, through separate accounts or through core funds, when I can put half of it in REITs where the returns are a quarter to a third higher?'"

Glenn Mueller, a real estate professor at the University of Denver and investment strategist for Dividend Capital Group, concurs with Case's assessment.

"One conclusion that can be drawn from this study is that investing in real estate via publicly traded REITs provides similar benefits to direct investment, along with a consistently higher average return," Mueller says. "If institutional investors are going to be long-term holders of real estate, why wouldn't they want to get that extra return?"

Mike Kirby, director of research and co-founder of the REIT consulting firm Green Street Advisors, goes a step further.

"This study should be required reading for both the chief investment officers and real estate staffs at every pension fund in this country," Kirby says. "This study demonstrates clearly that REITs should comprise a major portion of the real estate allocation for any institutional investor."

Market Capitalizations of the REIT Index and NPI
	Market Capitalization ($millions)¹
Year Ended	NAREIT Equity REIT Index	NCREIF Property Index
1987	4,759	22,185
1988	6,142	28,471
1989	6,770	32,656
1990	5,552	37,971
1991	8,786	37,010
1992	11,171	39,499
1993	26,082	40,950
1994	38,812	41,031
1995	49,913	48,279
1996	78,302	54,424
1997	127,825	66,135
1998	126,905	67,353
1999	118,233	81,989
2000	134,431	97,635
2001	147,092	113,709
2002	151,272	122,621
2003	204,800	133,291
2004	275,291	146,604
2005	301,491	189,800
2006	400,741	247,102

Apples-to-Apples?

Between 1977 and 2006, the FTSE NAREIT Equity REIT Index averaged returns of 15.4 percent, while the NCREIF Index generated returns more than 5 percentage points lower at 10.13 percent. Industry analysts have long maintained, however, that the structural differences in measurement between the two indexes prevent any meaningful comparison.

For instance, the FTSE NAREIT Equity REIT Index reports total returns by REITs that reflect the use of leveraging, while the NCREIF Index unleveraged returns. Also, core properties, including office, apartment, retail and industrial, dominate the NCREIF index, but the FTSE NAREIT Equity REIT Index includes REITs that invest in a broader range of property types, including hotels and self-storage facilities.

Furthermore, the direct investment returns do not account for fees charged by asset managers, while the equity REIT index factors the overhead for expenses associated wih managing the REIT.

According to Tsai, accounting for fees actually widens the return spread of REITs by 76 basis points, yet many observers have attributed public investment's superior performance to the leverage and property-mix factors. As a result, some researchers say that they are unable to draw legitimate conclusions as to whether one approach is superior to another. After controlling for the leverage and property portfolio differences, however, REITs still maintained an edge of 1.9 percentage points over direct investment—which widened to 2.66 percentage points after accounting for fees—in average annual returns between 1987 and 2005, according to Tsai.

"Taking the results at face value, if you believe that the adjustments get you to a risk-equivalent basis, there's something about holding real estate assets in the public forum that generates better risk-adjusted returns," says Tim Riddiough, a professor with the University of Wisconsin-Madison School of Business who specializes in real estate.

Riddiough points out that Tsai's findings parallel the results of a widely circulated analysis of earlier data that he co-authored in 2005. That study also found a private-public performance gap of about three percentage points per year.

Not surprisingly, academics like Riddiough caution against jumping to dramatic conclusions based on the new research. David Geltner, head of MIT's real estate development program and an advisor on the study, notes that the research explains most, but not all, of the differences underlying the returns from the different investments. This enables a "Macintosh apples-to-Granny Smith apples" look at public and private investment, he contends.

"The study and methodology is not meant to provide a complete or definitive picture of whether either REITs or private direct investment are 'superior' to the other," Geltner warns.

Geltner also asserts that the performance differences could largely be due to what he calls "an artifact of the way private returns have been measured." While the NCREIF index is based on appraisals, the FTSE NAREIT Equity REIT Index reflects transaction-based returns. When a transactions-based version of the NCREIF index developed by MIT is used instead, the gap between its returns and those of the de-levered FTSE NAREIT Equity REIT Index shrinks.

REITs Rise Up

Observers offer a variety of theories as to why REITs might offer superior returns to investment by separate accounts.

"To those of us who work in the industry it is hardly surprising that REITs deliver superior risk-adjusted returns, especially considering that they offer access to the most talented managers in the real estate industry, executives who have their interests well aligned with investors, very high quality real estate, and the lowest-cost investment vehicle," Kirby says.

Riddiough speculates that the regulatory requirements placed on REITs—quarterly reporting, stronger governance, fewer conflicts of interest among managers—may force them to operate their assets more efficiently than private investors. Similarly, Riddiough notes that, because most REITs have some public debt in their capital structure, rating agencies may provide another level of informal oversight.

"All of that monitoring does help keep your eye on the ball," he says. "It's not always clear that is the case in the institutional world."

REIT Index and NPI Cumulative Return Comparison Source: NAREIT, NCREIF

Case suggests that talented real estate professionals may be more attracted to the "nimble" investment environment of a REIT, when compared to that of a large institutional investor. As a result, REIT property managers may be more aggressive in attracting high-quality tenants. He notes, for example, that REIT-owned properties have lower vacancy rates on average than other properties.

Geltner adds that, if REITs actually do offer higher long-run average returns, it could be because the REIT approach enables the company to attract investors by engaging in "value-added" activities, such as property management and project development.

Good News on the Horizon?

Mueller argues that the new research also portends well for the near-term future of REIT stocks, which are behind this year after a seven-year streak of beating non-REIT stocks. By controlling for the characteristics that distinguish REITs from private real estate investment, the study shows that REITs "essentially are commercial real estate," according to Mueller.

"That's good news," he says, "because we can analyze REITs based on the fundamentals of the real estate industry and forecast accordingly."

The new research should bolster the confidence of investors who foresee continued positive fundamentals in REITs, Mueller says.

"We know that the fundamentals of commercial real estate are good right now," he says. "So, the current—and incorrect—negative emotion of the market means that REITs' share prices should eventually come back."