Swedroe: Real Estate Isn’t Special

April 30, 2018

Many investors think of real estate investment trusts (REITs) as a distinct asset class because, in aggregate, they historically have had relatively low correlation with stocks and bonds. In addition, their returns were not well-explained by the single-factor CAPM.

For example, during the period January 1978 through December 2017, the monthly correlation of the Dow Jones U.S. Select REIT Index with the S&P 500 Index was 0.58, and with five-year Treasuries it was just 0.07.

Real Estate Return/Risk Behaviors

Peter Mladina contributes to the literature on REITs as an asset class with the study “Real Estate Betas and the Implications for Asset Allocation,” which appears in the Spring 2018 issue of The Journal of Investing. In it, he sought to answer the question: Does the real estate asset class offer different return and risk behaviors than conventional stocks and bonds?

Mladina used a modified version of the Fama-French five-factor model to evaluate how well the returns and risks of publicly traded equity REITs and private real estate investments are explained by common stock and bond factors.

The five factors Mladina used in his model are the Fama-French market beta, size and value factors plus the term (the return of the Barclays U.S. Treasury Index minus the return of one-month Treasury bills) and default (the return of the Barclays U.S. Corporate High Yield Index minus the return of the Barclays U.S. Treasury Index) factors.

He modified the original Fama-French five-factor model to account for research finding that, because there is no real-time market price for illiquid private assets, returns are appraisal-based and subject to manager judgment. The result is that public REIT returns lead private real estate returns, with the lag of private real estate returns being statistically significant for up to four quarters.

Mladina’s database included:

  • The FTSE NAREIT Equity REITs Index, which contains 157 publicly traded REITs (as of 2016) that span commercial real estate in the United States, excluding timber and infrastructure REITs.
  • The NCREIF Property Index (NPI), the industry-standard, private-market index for core real estate. NPI returns are appraisal-based, unleveraged and gross of fees. The index is constructed from data collected from 79 contributors (as of 2015).
  • The NCREIF Open-End Diversified Core Equity Index (ODCE), constructed from data provided by 33 open-end commingled funds (as of 2015) pursuing a core strategy.
  • The Cambridge Real Estate Index, compiled from about 860 value-added and opportunistic private real estate funds formed between 1986 and 2015 that report net of fees.

His data covered the period January 1986 to December 2015. Following is a summary of Mladina’s findings:

 

  • All five factors have economically large and statistically significant (at the 1% confidence level) factor betas. The betas were: market beta: 0.58; size: 0.38; value: 0.72; term: 1.04; default: 0.45.
  • The alpha was -2.15%. However, it was not statistically significant (with a t-stat of -0.95), indicating that common factors explain the returns of public and private REITs.
  • The r-squared value was 0.67.
  • These betas are analogous to a balanced portfolio allocated approximately 60% to small value stocks and the remainder to long-term, high-yield bonds. Real estate is a hybrid asset class, showing return and risk behaviors common to both stocks and bonds.
  • The largest contributor to excess REIT returns is the market beta factor (which accounts for more than 50%), followed by the term (about 35%), value (about 20%) and default (about 10%) factors. The total sums to more than 100% because the alpha is subtracted from returns.
  • The largest contributor to excess REIT risk is idiosyncratic real estate sector risk (accounting for about one-third), followed by market risk (approaching 30%) and default risk (more than 20%). Two-thirds of excess REIT risk is explained by compensated factor risk and one-third by uncompensated sector risk (alpha).
  • All five risk factors contribute positive return to REITs. However, real estate sector risk does not contribute a positive return while still contributing risk.

Additional Conclusions On Real Estate

Mladina also conducted a horserace to determine which of the four proxies he used for real estate—REITs, NPI, Cambridge Real Estate Index or his factor benchmark—dominates the real estate allocation along the efficient frontier. He found that the factor benchmark dominated the other real estate indexes along the efficient frontier. He writes: “REITs, NPI, and Cambridge Real Estate achieve no material allocation in the presence of the factor benchmark for real estate.”

Finally, Mladina used his five-factor model to test the alphas of all live and dead active real estate mutual funds in the Morningstar database from 1986 to 2015. He found that the average alpha was negative, with fewer active real estate funds showing statistically significant positive alphas than would have been predicted by chance.

This finding is consistent with the latest SPIVA results, which demonstrated that over the prior 5-year and 10-year periods, 85% of active REIT managers underperformed ther benchmark. At 15 years, 82% underperformed. On an equal-weighted (asset-weighted) basis, over the prior 15-year period, the average active REIT fund underperformed by 0.86 percentage points (0.81 percentage points).

Mladina concluded: “We find that current and lagged REIT betas and factor benchmark betas explain the entire return premium of private real estate, suggesting that private real estate does not offer a unique source of compensated return that differs from its exposure to systematic risk factors.” What’s more, Mladina writes, the “residual risk is idiosyncratic and uncompensated real estate sector risk.”

He added: “These results suggest that REITs are no different from any other industry sector, with the notable exception of their hybrid (stock-bond-like) nature and rich factor mix.” Finally, Mladina also concluded that if one were taking a factor-based approach to asset allocation, then “real estate would not be considered a separate source of return.”

 

Defining An Asset Class

Mladina’s findings are consistent with those of my colleague, Jared Kizer, chief investment officer for Buckingham Strategic Wealth and The BAM Alliance, and Sean Grover in their May 2017 paper, “Are REITs a Distinct Asset Class?

Their research was motivated by the observation that many studies treat REITs as a distinct asset class based on correlation alone, and that many investors overweight REITs in their portfolios on a market capitalization basis. Their data sample covered the period January 1978 through September 2016.

In their analysis, Kizer and Grover employed a six-factor model comprising the market, size, value and momentum equity factors as well as the term and credit fixed-income factors. The credit factor (referred to as IGDEF) subtracts the return of a duration-matched portfolio of Treasuries from the corporate bond index total return.

Following is a summary of their findings:

  • The annual alpha estimate for REITs was -0.89% with a t-stat near zero (-0.3).
  • REITs showed statistically significant exposure to market beta (0.61 with a t-stat of 10.2), size (0.44 with a t-stat of 6.1) and value (0.77 with a t-stat of 9.9), as well as a small negative (-0.08) and statistically insignificant (t-stat of -1.7) exposure to the momentum factor, a large (0.70) and statistically significant (t-stat of 3.8) exposure to the term premium, and a large (0.92) and statistically significant (t-stat of 3.9) exposure to the credit (default) premium.
  • While the r-squared value was relatively low for REITs (0.51), this was also true for other industries they examined, including energy, utilities and health care.

These findings led Kizer and Grover to conclude: “While the relatively low correlation with the S&P 500 Index and 5YT was encouraging, the four- and six-factor regression models indicate that REITs are likely not a distinct asset class, especially when compared to the results of other industries.”

Kizer and Grover next tested whether REITs could be easily replicated by a long-only portfolio of established asset classes. Given the factor exposures they found, and using returns for U.S. small-cap value stocks (SV) from Ken French’s data library and the Barclays long-term corporate bond index (CORP), they attempted to replicate REIT returns with these two returns series.

 

The following table shows results from a portfolio allocating about 67% to SV and 33% to CORP. This optimal replicating portfolio has a monthly correlation with REITs of 0.72. The table also presents other data points that compare the optimal replicating portfolio to REITs over the period January 1978 through September 2016

 

 

The replicating portfolio dominates REITs in almost every way—it earns higher compound returns, has lower volatility, achieves a higher Sharpe ratio, has lower kurtosis and wins on most historical risk characteristics. A skeptic might note the replicating portfolio has a 33% allocation to long-term corporate bonds during a period in which interest rates have declined significantly. However, the regression results show the term factor loading for the replicating portfolio is lower than the term factor loading for REITs. Thus, interest rate risk exposure can’t account for the results.

Summary

The findings from the two papers I reviewed demonstrate that returns to real estate are well-explained by exposure to common, systematic factors. These factors—market beta, size, value, term and default—comprise an uncorrelated set with compensated return premiums. In contrast, idiosyncratic real estate sector risk and misappraisals contribute to risk but not return. In other words, investors using factor exposures to determine their portfolio allocation do not need to consider adding real estate as a separate asset class.

For investors using asset classes to determine their allocation, the findings suggest that REITs should receive no more than a market-cap weighting. Data from Morningstar show REITs represent approximately 3.5% of the iShares Russell 3000 ETF (IWV) on a market-capitalization basis, which is a valid starting point for a REIT allocation.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.

 

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