Can Real Estate Exposure Enhance DC Plans?

In the last few years, real-estate exposure has been gaining traction in the DC space; however, its potential for key benefits also poses several challenges.

In order to weather potential storms like market downturns, plan sponsors are looking to diversify portfolios with alternative investments. These asset classes aim for returns less correlated to market swings than stocks, bonds and other traditional assets.

Among them is real estate. And even though defined benefit (DB) plans have been investing in real estate for decades, this asset class is relatively new to the defined contribution (DC) plan space. But it has been gaining traction in the past few years.

According to research by Callan Investments Institute, DC plans primarily get real-estate exposure through publically-traded real estate investment trusts (REITs) forming asset allocations within target-date funds (TDF)s. A 2014 Callan study found that about 70% of TDFs have some exposure to REITS, and 22% of DC plans offer REITs in their fund lineup. But this may change as TDFs evolve and aim to capture more of the strengths of REITS and protect against its flaws.

“The problem with REITS is that they tend to behave a lot like equities so they may have volatilities similar to that of equities,” explains James Veneruso, vice president and defined contribution consultant in Callan’s Fund Sponsor Consulting. “But what we’ve been seeing slowly over time is that through TDFs, participants are now able to access direct or private real estate. Private real estate gives you the advantage of a lot less volatility. So you’d have an asset class that over the long term could have a return similar to REITS but with a dampened volatility profile.”

Veneruso tells PLANSPONSOR the firm’s latest research shows about 9% of off-the-shelf providers are using direct real estate. “They’re taking REITs and going a step further.”

Research by consulting firm Casey Quirk, a practice of Deloitte Consulting, reflects this trend.

“Over the course of the last two or three years, we’ve seen a transition from REITs and other publically listed real estate exposures to direct real estate,” says Jonathan Doolan, principal with Casey Quirk. “I think there is a value to have direct real estate exposure because of interest rate protection, and diversification.”

These are some of the benefits that stake holders giving real estate exposure to DC plans point to.

A survey of large corporate 401(k) plan sponsors, TDF managers, and plan consultants conducted by the Defined Contribution Real Estate Council (DCREC) found that almost all respondents viewed real-estate as a fundamental asset class for diversification. Many also cited the potential for enhanced risk-adjusted returns, low volatility, and inflation protection as major attributes of real estate assets.

Some data suggests the addition of real-estate exposure to other income-focused assets could substantially benefit participants. Using nearly 40 years of investment return data and analytical portfolio optimization strategies, Wilshire Funds Management found that adding income-generating assets such as REITS to model retirement portfolios would have generated nearly 40% more income than retirement portfolios with more traditional investment allocations, while maintaining nearly equal total return and risk profiles. This study sponsored by the National Association of Real Estate Investment Trusts (NAREIT) also found that with risk and income constant, the addition of equity-listed REITS would have increased average annual total return by 9 bps. Including these assets along with Mortgage REITS would have boosted average annual total return by 15 bps—increasing the ending portfolio balance by 4.4% in a 30-year investment horizon.

But despite all the potential benefits of real estate exposure, they certainly don’t come without risks.

NEXT: Challenges of Real Estate Investing

The 2014 DEREC survey found that limited track records in varying real estate and economic cycles, capacity restraints, and fees were all impediments to further adoption of alternative investments.

Furthermore, private real-estate products can raise concerns regarding liquidity, valuation, and fees—all of which need to be analyzed closely to develop a successful investment strategy around such products.

“When it comes to direct real estate, plan sponsors need to understand the valuation process,” Veneruso says. “Understand how you’re taking something that inherently doesn’t have a daily valuation and using an appraisal process to get to a daily valuation. And understand the liquidity provisions.”

The DCREC survey noted, “While there is awareness of new daily priced products in the marketplace, many remain skeptical and have concerns with the reliability of daily pricing; an issue that may be aided by the development of consistent standards and practices within the industry.”

Doolan recommends looking at liquidity at the plan and participant levels. He offers an example of a plan sponsor looking to change TDF providers. “If you had a real estate exposure and you want to map all assets over, you need to acknowledge that there will be some drag on liquidity to get those assets outside the existing structure into the structure of the new provider.” He also points to how a similar situation could apply when a participant leaves the company and moves assets over to an individual retirement account (IRA) or to another employer’s plan.

Still, with a careful analysis of the real-estate investment products, plan sponsors and their participants can stand to maximize the benefits that come with real-estate exposure. And as platforms evolve, these products can also become easier to manage. “Operationally, it’s becoming more accepted for plan sponsors and consultants,” Veneruso explains.  

Callan concludes that rapid adoption of real-estate assets into the DC space heavily would rely on “the increased use of custom funds, greater acceptance of illiquid assets within plans, less focus on costs/fees, and appropriate staffing,” as well as evolving recordkeppers’ abilities to handle these complex products.

Doolan adds, “I think overall, there is significant opportunity for real estate exposure in DC plans. The challenge is going to be making sure you’re able to use the right vehicle to get the exposure that makes the right sense for the specific glide path that the portfolio manager is trying to build, and making sure that you’re managing liquidity appropriately.”