5 Ways a Factor Alpha Approach
Can Boost REIT Portfolios
Here’s what we found:
- The public real estate market is uniquely inefficient and a fertile ground for active, factor-based investing.
- Real estate is a diversifying asset class with many benefits, but most investors are under-allocated.
- Public REITs offer complementary exposure while avoiding the drawbacks and barriers to entry of private real estate, but with lower fees and no loss of performance.
While factor investing is primarily applied to common stocks, we’ve found a set of factors unique to REITs that has historically delivered strong absolute, risk-adjusted, and consistency of return. Critical to accessing the opportunity presented by these factors is the liquidity found in public REITs, which is unavailable in private real estate — REITs have the liquidity to exploit mispricing. We believe a strong approach for both absolute and excess returns in real estate isn’t much different from public equities: conviction-weighted, and factor-based.
Further, most REIT strategies are very index-like, with active share in the 60% range on average, and heavily concentrated in the largest REITs. This suggests more attractive investments are getting overlooked. As with public equities, using hybrids of multi-factor selection themes (Value, Quality, and Momentum) to build unique portfolios can reward investors.
As studies have shown, most institutions are below their real estate allocation targets — especially smaller plans. An active portfolio in public REITs can help to fill that allocation gap while avoiding drawbacks and barriers to entry typically associated with real estate.
The Factor Investing Opportunity in REITs
For more than 2 decades, we’ve built portfolios in other niche markets, such as Canada, and we’ve seen how markets ripe for alpha tend to have top-heavy benchmarks and low active share strategy coverage (“closet indexers”). Though ubiquitous in public equity markets, factor investing has largely been overlooked in REITs! This neglect is likely because REITs require a different set of underlying factors. For example, a conventional ratio such as price-to-earnings is ineffective! Our research and track record show that customized factor investing works extremely well in the REIT universe and, better yet, few investors are currently taking advantage of this opportunity.
The inefficiency of the REIT market is appealing to factor investors.
The REIT market is very top heavy: the top 25 names make up over half of the market and the top 3 sectors are just under half. Any index that is market cap-weighted will be heavily concentrated in these names and sectors. This is also true for closet indexers and strategies with asset bloat. Closet indexing is prevalent in “active” REIT strategies. The largest active funds all have a very low active share (i.e., high overlap with the benchmark). Active managers with an active share less than 60% are typically considered “closet indexers” (none of the top 10 REIT funds in the eVestment database have an active share over 60%).i
Because most REIT strategies are closet indexers, the largest 25 REITs tend to get the overwhelming majority of analyst attention, which suggests that many of the smaller REITs get overlooked. Nearly half of the smaller cap REITs are covered by two or fewer analysts, and they have 75% less institutional ownership than their large cap peers. The smaller cap REITs have sparse analyst coverage levels, similar to the microcap public equities market:
Analyst Coverage — REITs
1. Use Factors & Themes to capitalize on mispriced REITs.
High-quality REITs with cheap valuations and good recent price trends can offer better risk and return profiles than the broader REIT market. Below, we show 5 key investment themes1 that have successful track records of separating public REIT winners and losers. The chart shows the historical return spread between the highest- and lowest-ranking 20% of the REIT universe by each theme. Market cap is shown in a similar format to illustrate that any portfolio that uses, or closely resembles, a market cap-weighted approach is likely sacrificing returns. Over 60% of the index is in the largest 20% of names.
Quntile Spreads: Highest- (solid black) & Lowest-Ranking (checkered)
2. Build a REIT strategy for alpha, not scale.
Instead of building portfolios via market cap-weighting, investors are better served using these key themes to build a more concentrated portfolio of stocks with favorable characteristics. Factor AlphaSM is our term for this type of approach.
Portfolios that mimic the market cap-weighted index offer more scale than they do alpha. Focusing instead on Factor Alpha allows for better returns and creates significantly more advantageous factor profiles,ii giving investors an “edge” over market cap-weighted portfolios.2 Portfolios that make small tilts toward better characteristics typically have high overlap with a passive index, offering only minor advantages via the factors they favor. Our philosophy is that factors drive returns and building conviction-oriented portfolios with the highest possible factor profile and purest factor signals can help investors achieve consistent alpha.3
3. Increase your real estate allocation.
A real estate allocation can improve a portfolio in several ways: it can provide diversification, serve as a hedge against inflation, provide current income, and deliver attractive returns. Given the benefits of real estate to a portfolio, it is no surprise that some of the most sophisticated investors have been increasing their exposure to real estate; pensions,iii endowments,iv and sovereign wealth fundsv have all reported increasing allocations to the asset class. That trend is likely to continue, as indicated by the numerous institutions reporting they are currently missing their target for real estate allocations (see chart below). Interestingly, plans under $1 billion in assets tend to be even more under-allocated to real estate. These smaller institutions have less than half the exposure as their larger peers.vi
Institutional Investors are Under-Allocated to Real Estate
(Average allocation to real estate, as a % of AUM)
Smaller plans often don’t have the capital to build a diversified portfolio of direct investment in property or the head count to manage them. Also, they do not have the same access to private equity real estate funds that their larger peers do.
4. Choose public REITs to get lower fees and cash drag with comparable returns and volatility.
Public REITs’ returns have historically been similar to private real estate, but with lower fees and other favorable characteristics. Also, the opportunity set spans 12 sectors and 16 sub sectors, providing diversification. Exposure to public REITs can complement a concentrated private real estate portfolio.
When choosing between public and private real estate, returns are often a top consideration, but studies have shown both offer similar exposure to the underlying real estate. Although lower volatility and lower correlation to equities and bonds are often cited as key advantages to private investment, when accounting for items that artificially smooth the private index returns these advantages go away. The NCREIF private real estate indices are appraisal-based and do not adjust for leverage, both of which artificially disguise the true volatility in private real estate returns.viii–xii Some studies even show private equity to be more volatile and risky after these adjustments.vii
Adjusting returns for fees and cash drag will further favor an investment in public REITs. Institutional investors typically pay around 50bps for a domestic REIT strategy while private investors could pay two and twenty; the range of fees of the funds in NCREIF indices range from 106bps to 303bps.viii–ix The NCREIF indices also assume 100% investment and don’t account for any dry powder — which can be as high as 27% on average.x This cash will not participate in market returns and will create a cash drag, REITs will not have this cash drag.xi Higher fees and cash drag erode the returns of private real estate and the private indices are inflated to show a gross return the average private real estate investor does not attain.
5. Seek liquidity, transparency, and diversification.
In addition to favorable returns, REITs offer better liquidity, more transparency, and a wider range of property types.
REITs are traded just like stocks allowing investors to allocate capital quickly to capitalize on mispricings. There is no lockout period, no minimum investment or high entry/exit cost; all typical of a private investment.
In private real estate there is no standardized reporting and transparency will vary widely by fund. As publicly-traded companies, REITs disclose a lot more information — therefore investors don’t bear the burden of all the due diligence themselves. The transparency into fees, property valuations, and financials will all be better with REITs.
Private real estate tends to focus on core corporate property sectors which include office, apartments, retail, industrial, and hotels. REITs offer a much more diverse exposure to real estate that includes self-storage, health care, infrastructure, timber, data centers, among other specialized real estate companies. Over half of these noncore sectors outperformed the NAREIT index in 2016 and two were among the highest-performing real estate sectors for the year, with specialty REITs returning 20.2% on average and Data Centers returning 24.8% (versus the 8.9% return of the benchmark).
REITs offer similar returns to a private real estate investment and have many favorable aspects in comparison to the latter.
We feel the better option for real estate investors looking for improved returns is a concentrated, all cap REIT portfolio with the highest-ranking valuations, quality, and momentum. An active, factor-based REIT strategy can benefit any allocation; whether used to increase liquidity, increase access, or broaden the list of real estate opportunities across the risk-return spectrum.
i. Cremers, Martijn and Petajisto, Antti, “How Active is Your Fund Manager? A New Measure that Predicts Performance” (March 31, 2009). AFA 2007 Chicago Meetings Paper; EFA 2007 Ljubljana Meetings Paper; Yale ICF Working Paper No. 06-14.
ii. See osamlibrary.com “Alpha or Assets — Factor Alpha Versus Smart Beta” (April 2016)
vii. Brad Case, Ph.D., CFA, CAIA “Is Private Real Estate Actually Less Volatile Than Public Real Estate?”
ix. The average fees and expenses in funds in the NCREIF indices reported fees ranging from 106bps (average of Core Funds ODCE) to 303bps (Average of Opportunistic Funds). (Source: REIT.com)
xi. The weighted average cash relative to market cap is 2.9% for the NAREIT All Equity REIT Index (as of 12/31/2016). Also, REITs are required to return 90% of net income back to shareholders in the form of dividends.
Much more REITs research to come.
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- Descriptions of Key Factor Themes:
As can be intuitively expected, REITs with the largest valuation discounts have historically outperformed peers, however, REITs require their own definition of value. Two of the more popular measures in common equities, (price-to-earnings and price-to-book) can result in very misleading results when evaluating the relative attractiveness of REITs.
Traditional value metrics don’t work because historical cost accounting does not recognize one of the key elements of value creation — the appreciation of underlying real estate assets. Cost accounting assumes real estate assets diminish predictably over time even when these values actually appreciate. Taking a depreciation expense on an asset increasing in value causes distortions in key financial items. When asset values appreciate, book value and earnings are both understated because they are reduced by an historical expense while the economic gain of asset appreciation is unrecognized.
To compensate, we use funds from operations (FFO) and net asset value (NAV) for REIT valuations. FFO adjusts for distortions caused by depreciation and for non-recurring events like property sales, which makes price-to-FFO a better choice over price-to-earnings. NAV is the estimated market value of all the real estate assets and therefore makes price-to-NAV a more accurate measure of discounts to intrinsic value than price-to-book.
Momentum would be impossible to take advantage of in private real estate. We are only able to capture the alpha provided by this signal because of the liquid nature of REITs. REITs with good recent trends in their prices have tended to go on to outperform over the next 1-year period. Momentum can be used to favor stocks with good relative trends and avoid stocks with very poor recent trends. Momentum works very well when combined with value as the excess returns of the two tend to have a negative correlation.
We favor real estate companies exhibiting above average growth trends and that also demonstrate good growth potential for the future. We look at the trend of key metrics like FFO and a measure of current profitability. We also include the REITs recent growth trends and any recent surprises in that trend.
We avoid real estate companies that are highly levered or that have poor balance sheet strength relative to peers. We look at leverage ratios, how they are financed, if they are adding debt or paying it down, and how easily they can service their current level of debt with the cash they are generating.
We avoid REITs that are the most aggressive in their accounting choices. One focus is reported FFO numbers. As a non-GAAP item, this number is not as scrutinized by auditors and therefore has the most potential for dubious assumptions. Any large difference in reported FFO versus audited GAAP results are a red flag. Assumptions in non-cash accrual accounts can also boost a REITs operating profit. We want to avoid the REITs with large accrual increases.
- Market cap-weighted portfolios offer broad exposure to REITs but they also have middle of the road value and quality.
- The advantage of Factor Alpha is not just theoretical. The live time performance of our multi-factor theme REIT strategy (incepted 1/1/2012) has achieved alpha by (a) taking advantage of the liquidity that only the public REIT market provides, (b) rotating sectors and names to always invest in the most attractive investments, and (c) building a very nimble strategy that systematically maintains high conviction overweights to areas with a strong factor profile, rather than simply piling up stocks that have the largest market cap.