While real estate has long been a part of defined benefit pension plans’ asset allocations, its inclusion in investment portfolios has steadily climbed in recent years. But defined contribution plan sponsors and members also stand to benefit from the asset class’ inflation-hedging properties, as well as its ability to boost income and improve portfolio diversification.

Pension funds are increasingly diversifying their holdings and moving into real estate, said Joseph Shaw, managing partner and head of institutional sales for Hazelview Investments, during Benefits Canada’s 2022 DC Investment Forum in late September.

The institutional real estate market has reached an estimated $12.6 trillion and its target allocation within portfolios has continued to rise, from roughly eight per cent in 2013 to an expected 12 per cent in 2022, according to data from the Cornell University Baker Program in Real Estate. And Canadian pension funds represent the largest ownership segment of the country’s real estate market.

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Real estate has numerous benefits to investors, said Shaw, including both lower risk and higher-yield profile than fixed income. Since 1993, fixed income yields — represented by Canadian, Eurozone and U.S. government bonds — have steadily diminished from highs of between five and nine per cent to one per cent or less.

Meanwhile, a comparison of real estate investment trust, equity and 10-year government bond yields in Canada, the U.S. and four other countries revealed REITs consistently outperform. In Canada, the average REIT yield was close to four per cent, while equities were three per cent and bonds less than three per cent. However, Shaw noted a comparison between REITs and government bonds isn’t quite an apples-to-apples comparison as the former comes with credit risk.

REITs work well as an investment vehicle for DC plans that have historically stuck to the public markets. These vehicles offer immediate liquidity, better transparency than private assets and tax efficiency, though  Shaw cautioned they do come with equity market risk.

In the short-term, he said, REITs behave very similarly to public equities in terms of their volatility. But over the long-term, REITs behave much more like the underlying real estate asset class and outperform public equities. “So we have to find a way to absorb the volatility to achieve the return.” 

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He noted there’s very low correlation in the real estate asset class as countries experience different cycles and markets, which can create significant diversification benefits for pension plan sponsors. Other countries tend to have their own sector-specialized REITs, such as exposure to health care and data storage centres in the U.S.

Real estate has also historically performed very well in inflationary environments, said Shaw, referring to global research by the Bank of America, which found REITs have had annualized total returns of 13 per cent in inflationary times and real estate, specifically, had roughly eight per cent annualized total returns, far above cash, commodities, energy, equities and fixed income.

While real estate valuations should hypothetically be negatively impacted by interest rate increases driving future cash flows down, “that’s not the whole story,” he said.

“In an environment where labour costs, materials cost and land costs are going up — and frankly, in Canada, we are unfortunately, subject to some of the worst regulatory [development] time frames in the world — it takes longer and it’s harder to build here than anywhere else. In an inflationary environment, it’s harder to add new supply [and] we have increasing demand for a fixed supply so there’s more rooms for rents to increase.”

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There’s a strong case for long-term investment in Canadian residential real estate, particularly in multi-family housing, said Shaw. The country has set immigration targets of 1.3 million new Canadians between now and 2024, with 60 per cent of those being economic immigrants who are expected to settle in urban centres. Canada is also the fourth leading destination worldwide for international students, who play a major role in rental demand — as of 2021 620,000 foreign students were enrolled in Canadian schools and contributed $22 billion to the domestic economy.

Canada is also facing demographic shifts, including people remaining single for longer and living longer, which necessitate more homes. Meanwhile, the cost of home ownership has skyrocketed, driven by a dearth of new supply, particularly in Toronto, and historically low interest rates. By 2030, the province of Ontario alone is expected to be short by two million homes, noted Shaw.

Read more coverage of the 2022 DC Investment Forum.