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Wednesday, July 13, 2011 2:45 PM ET
To reap real estate's full benefits, investors need more than REITs, academic says
By Tom Yeatts
If you're looking to capture the full benefits of real estate investment, you'd be wise to venture beyond REITs. That's the finding, at least, of Andrey Pavlov, associate professor at Simon Fraser University's Beedie School of Business, whose recent research has led him to the conclusion that the asset class alone does not fully reap the advantages of diversification, real estate's real draw.
"It was my hope, and many other people's hope, that now that we have REITs and they're well-developed, all you need to do is invest in REITs and that gives you exposure to real estate," Pavlov told SNL. "Regrettably, the data so far is showing that that's not as true as we hoped."
Pavlov, with Susan Wachter, a professor at The Wharton School at the University of Pennsylvania, recently conducted research to broadly determine the relationship between REIT valuation and the underlying real estate. To what extent are REITs' stocks driven by their holdings, and to what extent by other factors?
Utilizing the Moody's/REAL Commercial Property Price indexes, Pavlov and Wachter created a "shadow" portfolio that matches the property type and regional exposure of the REITs. Over time, they determined that, for each of the property sectors except office, there was no "statistically significant" relationship between the return of the REIT and that of the underlying real estate. And the other sectors — retail, multifamily and industrial — offer only "very weak and insignificant" correlation.
"This finding suggests that direct real estate investment or investment through the property price index derivatives cannot be replicated using REITs," Pavlov and Wachter said in a paper, published by at the end of June, titled "REITs and Underlying Real Estate Markets: Is There a Link?"
Notably, they found that when market conditions were favorable — low interest rates, rising property values, increasing industrial production — REITs across the board performed well. But in a down market, there was real separation and, accounting for all the variables, the management component made the difference.
"In economic stagnation … only the best managers do well, thus the value of management increases," they said in the report. "This increase dampens the negative effect of the economic downturn and weakens the relationship between the REITs and the real estate properties they hold."
So why the relatively strong correlation between the performance of office properties and the REITs that hold them? Pavlov offered the effect of agglomeration, or homogenization, as a possible cause. He noted that many of the office markets where REITs have exposure, particularly the central business districts, are densely packed, and property values move together.
For retail centers, which are spread far and wide, the situation is precisely the opposite. "You don't want any agglomeration, because to you, agglomeration is competition," Pavlov told SNL.
So there are two possible explanations for the relatively strong correlation between office REIT stock performance and the return on the underlying real estate, Pavlov said: "Either REIT management matters a lot for retail and less for office. Or, it matters the same, but we are better able to capture the returns to real estate in the office space that we can't really do all that well in retail."
Either way, Pavlov is firmly convinced that REITs, though they represent a solid, maybe even an essential, component of real estate investment, do not alone fully capture the diversification benefit.
"REITs alone don't do it. They're still better than nothing; if you're only going to do stock market-type investments, REITs do offer diversification. … But if you want to go even more into real estate, you have to buy direct assets or the indices."
