Why REITs Return More Than Directly Owned Properties

Pension funds hold a big chunk of their assets in commercial real estate, some in directly owned properties, some in real estate investment trusts. But which performs best? The answer, according to research firm CEM Benchmarking, which did a study of its data on 350 U.S. institutional investors, is REITs.

This latest finding, which echoes other studies in the past, comes after REITs have weathered a rough spell due to the Federal Reserve’s interest rate increases and post-pandemic weaknesses in commercial properties, particularly in office buildings. While the S&P 500 was up 15.7% this year as of Tuesday’s close, the Nareit index was down 5.9%.

U.S. public pension funds have 10.5% of their assets in real estate, although there is no breakdown between REITs and directly owned property (at times in partnerships with other investors), according to Public Plan Data at the Center for Retirement Research at Boston College. There are other iterations of property ownership, but these two are the most prominent.

The CEM study is more granular than other research on the REIT-versus-direct-owned-buildings question. It parses out how both investment vehicles have performed in terms of net return on investment (income after expenses divided by purchase price). The study focused on return groupings—listing the bottom segment of growth increases up to the top.

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According to CEM, from 1998 through 2021, REITS came out the best in every return grouping: 4.6% for REITs versus 0.6% for direct-owned real estate at the 10th percentile, and 17.9% versus 16% at the 90th percentile.

The usual reason for this disparity between REITs and direct-owned buildings is that the latter are more labor- and capital-intensive than just owning REIT shares, which are easily bought on stock exchanges. Unlike landlords, REIT investors do not need to worry about fixing the conked-out boiler (any such costly repairs will be spread over dozens, if not hundreds, of properties in a REIT portfolio).

One big appeal of real estate, no matter how it is owned, has long been its “low correlation to equities,” says John Worth, executive vice president of research at the National Association of Real Estate Investment Trusts. Nareit commissioned the CEM study, but Worth insists that its findings were independently arrived at.

Indeed, his assertion is borne out by the fact that other studies have concluded that REITs perform better.

As a Morningstar analysis put it, REITs provide “the diversification benefits of real estate without the commitment and responsibilities of directly owning property.” What direct ownership does provide, according to the Morningstar report, is a steady stream of rental income and, assuming a continuous improvement in market values, a big cash lump sum.

Per a 2021 article in the journal Portfolio Management Research, by three professors at the Warrington College of Business at the University of Florida, REITs “typically take on less development and operational risk and deliver a significant portion of investors’ total returns through quarterly dividend distributions.” Direct-owned property, on the other hand, incurs “moderate-to-high risk/return opportunities with short-to-medium-term horizons” and higher debt loads.

One plus, the PMR piece noted, is that directly owned real estate is good for pension funds and other investors that need to pay out beneficiaries regularly. It offers “a high level of liquidity” that allows such investors to raise a lot of capital at once.

True, building sales can take months, while REIT shares can be offloaded with a mouse click. But a large REIT share sale might lower the security’s valuation, whereas a building divestment has less effect on the slow-moving field of property values.