Pension funds show heightened interest in REITs.

As pension funds increasingly raise their overall real estate investment allocation largely due to the continued securitization of real estate in the U.S. - real estate investment trusts (REITS) likely will become the investment vehicle of choice over the next three to five years.

That forecast, part of a forum titled, "REIT Roundtable: Pension Fund Investment," is found in the fall issue of The Real Estate Report, a newsletter published by the National Real Estate Practice of KPMG Peat Marwick LLP. The quarterly publication is distributed to more than 20,000 real estate and investment professionals nationwide.

According to roundtable participants, which included executives from KPMG Peat Marwick, the Public Employees Retirement System of Ohio, Realty Income Corporation and Heitman/PRA Securities, several factors are behind the growing popularity of REITs with institutional investors.

Liquidity is Key

"A majority of pension funds are expressing interest in REIT investments, in part because they see greater liquidity in owning a security instead of actual real estate," said Ray Milnes, partner and national director of KPMG's Pension Fund Real Estate Services. "As a result, I think we'll continue to see larger percentages of pension funds' real estate allocations go to REIT investments."

Pension funds are turning to REITs because of the relative ease of buying, owning, selling and valuing securities compared to real estate properties, observed KPMG. Whereas REIT securities can be managed by a general staff or portfolio manager, physical properties often must be managed and maintained by specialist staffs or third-parties. At the same time, investors are recognizing that REITs are healthy companies with focused strategies and an emphasis on seasoned, professional management of real estate assets. This has led to institutional investors reducing their direct real estate holdings.

"Institutions are more confident holding paper than real assets - it's so much more efficient. I think REITs will be the vehicle of choice for pension funds," said Mary Beth Shanahan, assistant investment officer of the Public Employees Retirement System of Ohio pension fund.

Outperforming the S&P 500

KPMG also reports that heightened interest in REITs is due to the impressive track record of the industry. According to the National Association of Real Estate Investment Trusts (NAREIT), the 199 REITs listed in its NAREIT Index delivered a year-to-date total return of 12.45 percent, compared to 7.45 percent for the S&P 500, for the period ending August 30, 1996. Furthermore, during 1996's turbulent stock market, REITs proved to be "all-weather investments" with lower volatility than other equities.

In an accompanying interview in The Real Estate Report, NAREIT President and CEO Mark Decker discussed the REIT industry's positive track record. "Over much of the past two decades, REITs have outperformed the S&P 500, government and corporate bonds and direct real estate ownership. This year, we've seen REITs consistently outperforming the broader market. Whatever the market environment, REITs historically have proven their ability to perform," he said.

Roundtable participant Dean Sotter, president and director of Heitman/PRA Securities, said "Initially, pensions were skeptical about the amount of time REITs were public. Now there's a track record, an attractive track record, that will only bring about additional interest. Investors are recognizing that the REIT is a concept that's here to stay."

Increased Market Capitalization 

The continued growth and maturation of the market in light of attractive returns is still another factor for REITs' growing acceptance by institutional investors. Since 1991, the total capitalization of publicly traded REITs has increased 170 percent to reach nearly $112 billion, largely due to healthy initial and secondary public offering activity, growth through mergers and other creative financing options and strong operating results industry-wide.

"There is little room to argue that REITs have moved from their infancy to their adolescence," said John Davis, partner and national director of KPMG's REIT Services and chair of the National REIT Leadership Team. "Growth will result in increased REIT market capitalization, which should increase the liquidity of the stock and therefore the attractiveness to investors and institutional investors in particular."

Larger market capitalization also will allow REITs to benefit from expanded capital funding options, greater operating efficiencies and enhanced acquisition opportunities - REITs currently own only eight percent of the $1.22 trillion of institutionally-owned commercial real estate market. Davis also believes that the economies of scale that brought about corporate mergers will bring similar activity to the REIT marketplace over the next several years. "We expect the pace of merger activity to accelerate," said Davis.

Tom Lewis, vice-chairman of the board of directors at Realty Income Corporation, observed that although the REIT market still is small, the infrastructure is now there for dramatic growth. "That's important to pensions," said Lewis, noting that maturation of the market has much to do with its growth and that we are still in the early stages.

Timing of Increased Investments in REITs

According to Milnes, a majority of pension funds will jump on the REIT bandwagon in the very near future. "Pension funds appear to be working at obtaining a more in-depth understanding of the REIT industry, so it will probably take three to five years for that to trickle down before a significant number of pension funds have made sizeable REIT investments," observes Milnes.

What are sizeable REIT investments? According to Shanahan, it depends on the pension fund. It could be 100 percent of its real estate investment. Currently, the Public Employees Retirement System of Ohio investment in REITs equals between 10 and 11 percent of its total real estate investment, she said. In the long-term, Lewis predicts REIT allocations at the five to 10 percent mark of total investments.

When asked by The Real Estate Report what form these increased investments most likely will take, Milnes said "I see pension funds focusing on equity REITs for the foreseeable future, since they're viewed as having the greatest potential to generate solid returns. I think some pension funds will enter the REIT market through smaller purchases in the open market, and as they become more knowledgeable and comfortable with companies in the industry, they'll make larger commitments through private placements." Lewis agreed with Milnes that direct purchases will dominate, and added that there will be some property exchanges for shares of REITS.

Outlook

According to KPMG, there exists enormous room for REITs to grow in today's improving real estate market. Supply and demand fundamentals are drifting back toward equilibrium, and there remains a generally favorable outlook for improvements in rents and property revenues for the remainder of 1996 and beyond.

"REITs are a particularly attractive investment in such a marketplace. As share prices rise, REITs are well-positioned to increase market share by raising capital for acquisition, renovation, build-to-suits or development. Over the next three decades, the industry could easily hold 30 to 50 percent or more - of the $3 to $4 trillion total commercial real estate market. This strong growth will continue reshaping real estate investment and development internationally," Decker said.

And how will institutional investors, in turn, affect the overall REIT industry going forward? Milnes says "Pension funds can and will significantly expand the market, and institutional money is a great way to create liquidity."

Lewis agreed, adding, "As REITs grow, liquidity will become a self-fulfilling prophecy. By pension plans getting in, REITs' liquidity expands and allows others to get in, too. It's like a freight train."