The debate between active management supporters and those who champion a passive investing style has become more animated since the global financial crisis. Passive investing is the consensus trade in several areas of the equity markets, and strategies investing in listed real estate investment trusts (REITs) are not immune from the trend. Undoubtedly, a passive investment approach—one that mirrors a market-capitalization- weighted index, for example—can provide low-cost market beta, but sacrifices the potential for alpha1 or a portfolio that actively manages risk. We think investors are overlooking the fact that many global REIT fund managers have consistently generated alpha over the short- and long- term. We believe that investing in public REITs is ideally suited for active management. Sector specialists, such as dedicated active REIT managers, often have the necessary knowledge and REIT-centric investment approach to potentially exploit the market’s inefficiencies. But much like picking a winning stock, due diligence by investors to find winning REIT managers is crucial. We believe an experienced and stable team, large breadth and depth of real estate resources, and a diversified approach to alpha generation is a successful combination for prolonged alpha generation in the market.
When it comes to choosing active versus passive management in REITs, the proof of “why active” is in the results.
Why choose active management for your REIT allocation
A quick study of Exhibit 1 shows that more than 65% of all U.S. and global REIT funds have outperformed their benchmarks net of fees over the past five years. And over a ten-year period, 55% or more of U.S. and global REIT funds have outperformed their benchmarks. That level of success is remarkable when compared to the 44% success rate over five years and 34% success rate over 10 years of active general equity funds. Interestingly, Exhibit 1 shows we are seeing overall an up-tick in the success of actively managed funds for the trailing five-year period. But the gap between REIT funds and general equity funds remains quite wide.
When it comes to choosing active versus passive management in REITs, the proof of “why active” is in the results. We believe the surge in popularity of passive REIT funds is a misguided attempt to lower costs in an effort to improve outcomes in client portfolios instead of focusing on enhancing returns. It’s our belief that you get what you pay for; the value of hiring an active manager for REITs is arguably one of the best choices an investor can make.
EXHIBIT 1: Where active matters most
Source: Morningstar as of 03/31/2023. Percent of active managers that outperform benchmark was calculated as the number of mutual funds with positive net excess returns divided by the total number of mutual funds in the category. Only actively managed funds using the oldest share class type were included. Broader equities include U.S. small-cap, U.S. mid-cap, U.S. large-cap, world large-cap stock, world small/ mid cap stock, and emerging markets categories. Funds that were benchmarked to non-REIT indexes were removed from the US and global REIT categories. For more details please see disclosures on page 8.
Active U.S. and global REIT funds have demonstrated consistent alpha generation over both short- and long-term periods, with the majority of these funds outperforming their benchmarks. Allocating to an active U.S. and global REIT fund in a portfolio can be a good opportunity for investors to potentially enhance portfolio returns.
EXHIBIT 2: Achieve potential alpha with an active REIT manager2
Source: Morningstar as of 03/31/2023. Top quartile fund is the 25th percentile fund and median is the 50th percentile fund by net excess return in the respective Morningstar category. Morningstar categories used are U.S. OE Real Estate and U.S. OE Global Real Estate.
As Exhibit 2 illustrates, choosing the right active manager can potentially enhance returns. On a net of fee basis, the top quartile of actively managed U.S. and Global REIT funds delivered results that were ahead of their benchmarks and significantly better than the median fund. This highlights the importance of investors utilizing a top-tier manager that has demonstrated the skill and other attributes necessary to consistently exploit mispricing opportunities available in public REIT markets.
Inefficient markets create opportunities
Beating the market requires mispriced investment opportunities and manager skill. Market mispricings require inefficiencies in market behavior. Outperforming the market is difficult, of course, as we believe that equity markets and public REIT markets are inherently efficient to a certain degree. Broadly, the costs and barriers to information have decreased, thanks to a maturing investment industry and technological advances. However, the modern public REIT market is relatively young (it started in the mid-90s) and the nuances of investing in REITs are not well understood by all market participants. We believe there are several informational inefficiencies that create opportunities for skilled active REIT managers to exploit. Some of these inefficiencies aren’t unique to REITs, but can create ample opportunities when combined with the unique factors impacting REITs.
The thirst for yield
Historically, many investors buy REITs for income. REITs must distribute the majority of their taxable income to shareholders. As such, they often provide higher dividend yields than other equity sectors. However, a specialized active REIT manager often invests seeking to produce attractive total returns with the largest contribution sourced from capital appreciation, not income. Avoiding richly priced REITs, for which investors are overpaying for yield or overestimating the durability of that yield, can be a winning strategy for active REIT managers, under certain market conditions. Our research reveals that the total return of lower-yielding stocks has outperformed higher-yielding stocks on a more frequent basis, as they tend to generate higher capital appreciation.3
Accounting distortion
Depreciation is a factor with an outsized impact that is unique to real estate—and other asset-heavy businesses— that can distort certain financial ratios and metrics in a unique way compared to companies in most other industries. The U.S. GAAP accounting rules require property owners to record depreciation (a non-cash expense). If assets are in real estate, a high level of depreciation expense is shown on the income statement and assets recorded on the balance sheet are recorded at a “depreciated” book value, not market value. This can misrepresent or heavily skew valuation and earnings metrics, like price-to-book value, for example, since book value is “depreciated down” when market value actually may have increased. Similarly, price-to-funds from operations (P/FFO), which adds back non-cash depreciation expense to earnings, is the REIT equivalent of an ordinary stock’s P/E ratio.
Without adjusting for real estate’s unique accounting treatment, an investor is likely to reach the wrong conclusion about a stock’s value. Investors’ quantitative screens that seek to use consistent metrics across all equities can easily fail for REITs. We believe it is essential to focus on metrics unique to real estate that consider these accounting distortions. The REIT investing lexicon is full of terminology unique to REITs (FFO, NAV, implied cap rate, etc.) that is well-understood by active REIT managers, but may be overlooked by general equity investors.
Other key reasons why active management should be favored for REITs
- Active managers can invest beyond the index to seek alpha from a broader investment universe.
- Passive index funds are typically comprised of the largest companies in an asset class—not necessarily the ones positioned for growth in shareholder value. Active managers will buy more of companies they believe offer the most promising returns in the future, not always chasing past winners. Passive market-cap based funds will indiscriminately buy more of stocks whose market caps have grown the most.
- The size, complexity, and local nature of the asset class demands a high level of expertise to navigate.
- Active managers can potentially construct portfolios with better risk-adjusted outcomes— taking into consideration risk management, style tilts, and long-term structural changes impacting real estate.
Underestimating capital needs
REIT stock mispricings can also originate from underestimating a property’s capital expenditures (capex) —that is, the investment needed to ensure the property remains competitive or is maintained properly. Capital might be needed to improve a hotel lobby, add amenities to a high-end residential tower, or invest in the best IT infrastructure for an office building. Estimating the future capex needs of a property is not easy and is often underestimated by many real estate investors. Capex is a burden on company cash flows; consequently, REIT buildings with more modest capex needs typically generate higher returns. Research by Green Street Advisors, LLC. has demonstrated that the lowest capex REIT sectors have consistently outperformed over rolling five-year periods, while the highest capex sectors have nearly always trailed (see exhibits 3 & 4).
Essentially, low capex stocks tend to be undervalued because investors underestimate the cash flow growth of the properties and, therefore, the potential shareholder value increase. If markets were priced more efficiently, a company with a lower capex burden would be priced higher and the persistent return differentials noted in the charts wouldn’t exist. On the other hand, high capex sectors, like hotels, frequently tend to be overvalued and disappoint in terms of their total returns.
These capex differentials can exist in a large way when comparing sectors but also amongst REITs within a sector. When choosing a stock, it is necessary to adjust capex appropriately when performing valuations in order to ascertain the intrinsic value of a particular REIT. This adjustment of capex can be quite complex and requires a deep understanding of real estate markets, the specific subsectors of the industry, and qualitative attributes of the real estate portfolio.
A glaring inefficiency
There is one key differentiator of sector returns that has long been underappreciated by many market participants, and, as a result, appears to have been the source of consistent and predictable mispricing. Though we have been banging the “capex is important” drum for over two decades, property-market participants continue to understate the long-term magnitude of the expense... The phenomenon has translated into large and persistent return differentials across REIT sectors.
Yes, the broad market may indeed be too efficient for most active managers to add much value, but there is good reason to believe that the REIT sector is an exception.
Source: Heard on the Beach, “The Most Important Thing,” June 10, 2019, Green Street Advisors, LLC.
EXHIBIT 3: Annualized outperformance vs. REIT Index: 5-year rolling
EXHIBIT 4: Capex and 5-year public market total return
Real estate investors have long understated the high costs of keeping commercial properties competitive. High capex real estate properties, like hotels and office properties, have been overpriced relative to those with small capital requirements such as storage and net lease properties.
Source: Green Street Advisors, LLC, 12/31/2022. Reproduced with permission. Utilizes FTSE NAREIT All REIT index and property sector index- es available to facilitate more narrowly focused exposure to commercial real estate.
Does not reflect the performance of any investment product.
Adjusting for capex: Imagine analyzing a company that owns a beautiful mid-century modern 80-story office building in New York City. Over the years, the wear and tear has required constant maintenance and upgrades to the building’s façade, HVAC system, elevators, and interior finishes. While it’s beautiful, the 60-year-old building now has to compete for tenants with a new office building next door that features all the latest in technology, open-architecture design style, efficiency, and green space. As active managers, we believe there’s a way to add value in this example by digging deep to analyze the company financials and its specific properties. The key is to accurately adjust for those capex needs.
Lack of attention from Wall Street
Relative to broader equities, the availability and preponderance of research from Wall Street brokers/ research firms on REIT stocks is significantly lower. This research is a major contributor of information available in the public domain to institutional investors and other market participants. The more coverage a stock receives from these firms the barriers to information may be lower. These firms can provide access to management, property tours, and their reports can often provide in- depth analysis of key issues impacting companies, industry trends, valuation analysis, buy/sell recommendations, and many other pieces of information to help investors make informed investment decisions. We believe the limited information flow for REITs relative to equities results in a more inefficient investment landscape, and a consensus view that is perhaps less informed. These conditions make for an ideal situation for active managers to capitalize on informational inefficiencies and mispricing opportunities.
EXHIBIT 5: Broader equities have roughly twice as much Wall Street coverage
Source: FactSet as of 03/31/2023. Current fiscal year EPS and FFO estimates used where available. U.S. equities defined as S&P 500 constituents excluding stocks classified as Real Estate (per GICs). Global equities defined as MSCI World Index constituents excluding stocks classified as Real Estate (per GICs). U.S. real estate stocks represent MSCI U.S. REIT Index. Global real estate stocks represent FTSE EPRA/NAREIT Developed Index.
The nuances of REIT property sectors
On the surface many REIT companies may look alike, but they can behave quite differently. Each property sector has its own profile and responds distinctly to different economic and market factors. Lease duration, demand drivers, construction cycles, and submarket locations (urban vs. suburban) really matter. The following are some of the examples that illustrate how a dedicated REIT manager can actively adjust portfolio holdings to account for unique circumstances.
Economic factors
Specific economic measures can have varying effects on different types of real estate sectors. For example, exports and changes in e-commerce relate more to industrial properties than they do residential or healthcare-related properties. Job growth, on the other hand, has a greater impact on office and apartment real estate sectors. Hotel properties would likely be more affected by an economic downturn than a self-storage building, while shopping center and mall REITs are driven more by discretionary consumer spending.
Construction factors
The construction cycles for various types of real estate also differ. Building a warehouse or a self- storage facility is dramatically different than building a high-profile hotel in a large metropolitan market. The former can be completed within six months, while the latter may take two years or longer to complete.
Lease factors
How real estate properties are leased varies from sector to sector. Renting a hotel room for one or two days, for example, is the equivalent of a very short-term lease. In contrast, a lease for retail space in a shopping center might range from five to seven years. Other types of property command even longer leases. As a general rule, real estate is, on average, considered a long duration asset, but the duration of those fixed cash flows from leases can vary considerably from one sector to another.
Exploiting inefficient markets
Capitalizing on these inefficiencies, of course, is what generates alpha. An investor must have the skill and information necessary to position the portfolio accordingly before opportunities disappear. A dedicated, active REIT manager is a sector specialist. The manager has a narrow, but very deep focus on real estate markets and the public real estate stocks they invest in. Such a manager should have the resources to dig deeper, beyond what’s readily available, to scrutinize REIT companies both large and small. Dedicated REIT specialists should also be well-equipped to make appropriate adjustments to valuation metrics that are unique to the asset class, taking into account factors like depreciation and capital expenditures. These adjustments require expertise to derive intrinsic values that may differ from consensus views and market values.
Exploiting information inefficiencies can be enhanced further with access to private real estate expertise and first-hand insights of real estate market conditions. Successful REIT managers can identify and capitalize on small inefficiencies that arise on a frequent basis when the market overreacts to good or bad news about a stock, sector, or at the market level.
EXHIBIT 6: Growth of $10,000 (net of fees)
U.S. REIT
EXHIBIT 7: Growth of $10,000 (net of fees)
Global REIT
Active management works, but not all active managers deliver the same results. As illustrated above, performance of the Principal Real Estate Securities Fund and Principal Global Real Estate Securities Fund have outpaced the median active REIT manager (navy) and their benchmark (cyan) since their inception.
Source: Morningstar as of 03/31/2023. Past performance does not guarantee future results. Inception date for Principal Global Real Estate Securities Fund I (POSIX) is 10/01/07; performance start date is 11/01/07. Inception date for Principal Real Estate Securities Fund I (PIREX) is 03/01/01 (oldest share class inception 12/06/00); performance start date is 01/01/01. Median refers to the Morningstar peer category median return. The peer groups included Morningstar U.S. OE Real Estate and Morningstar U.S. OE Global Real Estate categories. For more details please see disclosures.
The Principal advantage
At Principal, we believe investors shouldn’t settle for REIT market-like performance from a passive approach. We also believe investors should invest with an active manager that has demonstrated consistent results to potentially maximize their returns. At Principal, our experience investing in public REITs started in 1998 under the continued leadership of portfolio manager and chief investment officer, Kelly Rush. Today, we are a top-5 largest manager of REIT securities.4 The global REIT portfolio management team represents a stable and experienced team that historically has delivered results to clients across market cycles. We have followed the same fundamental investment philosophy and bottom-up investment approach for over 25 years. Our sizeable team with a presence in all regions of the world provide important breadth and in-depth focus in an effort to identify mispriced stocks across the global real estate securities investment universe. We attribute the long-term results of our investment approach to our focus on fundamental investing, an emphasis on owning higher quality companies, and constructing portfolios where alpha generation is diversified across a relatively large set of opportunities.
A 360° view of global real estate
As REIT investors, we have the distinct advantage of being part of a larger, resource- and experience-rich organization. Principal Real Estate is the dedicated real estate investment group within Principal Global Investors. With over 325 real estate investment professionals across the globe,6 our goal is to deliver consistent, risk-adjusted performance and high-quality service. Our capabilities span all four quadrants of the real estate spectrum. Our REIT team is able to leverage the substantial in-house insights of private equity and debt real estate professionals, as well as a team of global economists and top-notch technology and systems.
The breadth of our capabilities—across all four quadrants of commercial real estate, including private debt and equity, as well as public debt and equity—provides a distinct perspective on real estate and capital markets, and enables us to deliver the investment solutions that our global client base expects. Principal Real Estate traces its real estate investment history over more than six decades.7 Over that time we have earned a reputation as a trusted advisor and built a top-tier investment platform.
Average annual total returns through 03/31/2023
Returns represent past performance and do not guarantee future results. Share price, principal value, and return will vary and you may have a gain or loss when shares are sold. Current performance may be lower or higher than quoted. For the most recent month-end performance, visit principalam.com. See below for more information.
1 Alpha is the excess return of a portfolio when compared to its benchmark.
2 For funds used in this analysis from the Morningstar universe, only actively managed funds using the oldest share class type were included. Funds that were benchmarked to non-REIT indexes were removed from the U.S. and Global REIT categories.
3 Source: As of 12/31/22. Principal Real Estate, MSCI, FactSet. Our analysis divided MSCI U.S. REIT Index constituents into quintiles (equal number of securities) based on dividend yield and measured the six month returns of each quintile on a quarterly frequency. Since 06/30/03, the lower yielding stocks (quintile 4 and 5) outperformed higher yield stocks (quintile 1 and 2) 78% of the time (61 out of 78 periods).
4 Managers ranked by worldwide REIT assets as of 30 June 2022. “The largest managers of REIT assets” Pensions & Investments, 3 October 2022.|
5 As of 03/31/2023. Includes assets managed by Principal Real Estate Europe Limited and its affiliates. Assets under management figure does not include assets that are managed by Principal International and Retirement and Income Solutions divisions of Principal. Due to rounding, figures shown may not add to the total.
6 Includes investment professionals of Principal Real Estate Europe Limited and its affiliates.
7 Principal Real Estate Investors became registered with the SEC in November 1999. Activities noted prior to this date were conducted beginning with the real estate investment management area of Principal Life Insurance Company and later Principal Capital Real Estate Investors, LLC, the predecessor firm to Principal Real Estate Investors.
Carefully consider a fund’s objectives, risks, charges, and expenses. Contact your financial professional or visit principalfunds.com for a prospectus, or summary prospectus if available, containing this and other information. Please read it carefully before investing.
Past performance is no guarantee of future results and should not be relied upon to make an investment decision. Investing involves risk, including possible loss of principal. All figures shown in this document are in U.S. dollars unless otherwise noted.
Potential investors should be aware of the many risks inherent to investing in real estate, including: value fluctuations, default risk, liquidity risks, leverage, credit risk, occupancy risk and legal risk. All these risks can lead to a decline in the value of the real estate, a decline in the income produced by the real estate and declines in the value or total loss in value of securities derived from investments in real estate. REIT securities are subject to risk factors associated with the real estate industry and tax factors of REIT registration.
International and global investing involves greater risks such as currency fluctuations, political/social instability and differing accounting standards.
This material covers general information only and does not take account of any investor’s investment objectives or financial situation and should not be construed as specific investment advice, a recommendation, or be relied on in any way as a guarantee, promise, forecast or prediction of future events regarding an investment or the markets in general. The opinions and predictions expressed are subject to change without prior notice. The information presented has been derived from sources believed to be accurate; however, we do not independently verify or guarantee its accuracy or validity. Any reference to a specific investment or security does not constitute a recommendation to buy, sell, or hold such investment or security, nor an indication that the investment manager or its affiliates has recommended a specific security for any client account. Subject to any contrary provisions of applicable law, the investment manager and its affiliates, and their officers, directors, employees, agents, disclaim any express or implied warranty of reliability or accuracy and any responsibility arising in any way (including by reason of negligence) for errors or omissions in the information or data provided.
Exhibit 1: The following Morningstar categories were used in our analysis: US Fund Small Blend, US Fund World Large Stock, US Fund Mid-Cap Blend, U.S. Fund Large Blend, U.S. Fund Diversified Emerging Mkts, U.S. Fund Real Estate, U.S. Fund Global Real Estate, U.S. Fund World Small/ Mid Stock. Only actively managed funds using the oldest share class type were included. Funds that were benchmarked to non-REIT indexes were removed from the U.S. and global REIT categories.
This paper includes investment options that contain information from a variety of sources. A primary source is Morningstar which provides holdings information, operations data, and rankings or statistics proprietary to Morningstar. Morningstar is generally the source of information on mutual funds unaffiliated with the Principal.
© 2023 Morningstar, Inc. All Rights Reserved. Part of the investment data contained herein includes Morningstar peer group comparisons, ratings, holdings and other data from its mutual fund and variable annuity databases and: (1) is proprietary to Morningstar and/or its content providers: (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete, or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information.
Exhibits 6 & 7: PIREX inception date for the I share class is 03/01/01. Its calculated returns reflect the historical performance of the oldest share class of the fund, adjusted to reflect a portion of the fees and expenses of this share class. For time periods prior to inception date of the fund, predecessor performance is reflected. Please see the fund’s prospectus for more information on specific expenses, and the fund’s most recent shareholder report for actual date of first sale. Expenses are deducted from income earned by the fund. As a result, dividends and investment results will differ for each share class.
For average annual returns table on page 8: The net expense ratio reflects contractual expense limits, if any, which may lower net expenses and cause the gross and net expense ratios to differ. In such cases a date is listed through which expense limits are expected to apply; however, Principal Funds and the investment adviser may mutually agree to terminate the expense limits prior to the end of the period. Returns displayed are based on net total investment expense.
Class I shares are available only to eligible investors, including various institutional investors and investors in certain mutual fund wrap or asset allocation programs. See the prospectus for eligibility requirements.
This document is issued in the United States by Principal Global Investors, LLC, which is regulated by the U.S. Securities and Exchange Commission.
Principal Funds are distributed by Principal Funds Distributor, Inc.
© 2023 Principal Financial Services, Inc. Principal®, Principal Financial Group®, Principal Asset Management, and Principal and the logomark design are registered trademarks and service marks of Principal Financial Services, Inc., a Principal Financial Group company, in various countries around the world and may be used only with the permission of Principal Financial Services, Inc. Principal Asset ManagementSM is a trade name of Principal Global Investors, LLC. Principal Real Estate is a trade name of Principal Real Estate Investors, LLC, an affiliate of Principal Global Investors.
MM10897A-15 | 05/2023 | 2864629-082023