The direct real estate allocation in TIAA’s Lifecycle series is through a fund managed by TH Real Estate, an investment affiliate of Nuveen, which became the investment management arm of TIAA after TIAA purchased Nuveen in 2014.

TH Real Estate is among the top three direct real estate investment managers in the world, overseeing about $99 billion in assets across roughly 80 different funds.

Cunniff said the fund now available in TIAA’s lifecycle funds will concentrate in commercial real estate holdings in “supply constrained” markets that are expected to have continued high demand and price appreciation relative to the country’s larger commercial real estate market.

The question that plan advisors and sponsors will have to weigh is what added advantage a direct real estate fund offers over the much more readily available REITs.

Some defined contribution plan sponsors already do invest in privately held commercial real estate through collective investment trusts, which are for the most part available to large plans, and do not have the pricing or liquidity requirements of mutual funds in standard 401(k) plans.

According to TIAA’s research, both REITs and direct real estate investments have outperformed U.S. equity, non-U.S. equity, and U.S. fixed income on an annualized basis for the twenty-year period ending at the end of 2016.

REITs beat direct real estate investments over that period by a slight margin—9.67 percent to 9.31 percent, respectively. By comparison, U.S. stocks averaged 7.86 annualized returns, and U.S. fixed-income returned 5.29 percent.

But on a risk-adjusted basis, direct real estate beat out REITs narrowly over the twenty-year period by 15 basis points.

Therein rests the primary argument for direct real estate, says Cunniff. Volatility in REITs has a considerably higher correlation to volatility in equity markets. Publicly traded REITs are subject to macro events and news cycles in ways that other equities are, while returns on direct real estate investments, which are more driven by lease income than by appreciation of real estate values, have proven more consistent over market cycles.

Both direct real estate investment and REITs also function as a hedge against inflation, as commercial rents and property values tend to increase with overall price inflation.

“Were inflation to rise unexpectedly, real estate is an excellent hedge,” said Cunniff.

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In-house capability

One option for TIAA was to increase its lifecycle funds’ exposure to REITs.

That would have been a less cumbersome option to rebalancing TDF investors’ risk as equity markets search for legs in a long-running bull market and the Federal Reserve considers more near and mid-term rate hikes.

In order to incorporate a direct real estate offering through a TIAA affiliate, the firm had to get an exemption from the Securities and Exchange Commission. As publicly traded stocks, REITs are a much more liquid option compared to direct real estate investment funds. That TH Real Estate has a proven track record managing direct real estate investments no doubt influenced the SEC’s decision to issue the exemption, explained Cunniff.

“We find direct real estate attractive for young investors, as well as for those near and through retirement,” said Cunniff. “Across glide paths, we expect the allocation to reach 2.5 percent this year, and closer to 5 percent by the end of next year.”

For younger investors, the fund will direct assets from existing fixed-income allocations. For those near or through retirement, the direct real estate allocation will be drawn from equity allocations.

While Cunniff doesn’t see real estate, or any asset class, matching the returns of the past twenty years in the foreseeable future, TIAA’s projections still expect real estate to perform competitively. Cunniff says the firm’s long-run view has real estate returning around 5.5 percent annually, while equity is projected to return closer to 6 percent, and fixed income around 3 percent.

Considerations for sponsors, plan advisors

According to Morningstar, the physical assets in direct real estate funds are valued quarterly, allowing the daily net asset value to remain stable compared to the potential day-by-day volatility in REITs.

Direct real estate’s primary risk “is the ability to sell exposure if faced with significant outflows,” according to Morningstar’s 2017 Target-Date Landscape report.

In the case TIAA’s lifecycle funds, the new real estate allocation will come from a new fund, not from an existing fund. “It could take a while for them to build a diversified portfolio of properties,” said Jeff Holt, an associate director for Morningstar Manager Research.

Another consideration is whether the ultimate allocation will be substantial enough to have a meaningful impact on the funds’ performance, noted Holt.

“That being said, TIAA has experience in direct real estate,” he said.

Over the past decade, when TDF managers have incorporated new strategies along glide paths, like emerging market or commodity exposure, other managers were quick to follow suit.

But Holt doesn’t expect that to be the case with direct real estate. “This leverages a capability TIAA already has. But the administrative hurdles in implementing this strategy will likely deter others from following. I don’t expect we’ll see widespread adoption of this strategy.”

Fees will stay the same

One thing sponsors and advisors won’t have to consider? Additional costs.

According to TIAA’s website, institutional class shares of the Lifecycle 2020 fund come with a net expense ratio of 40 basis points. The fund held $3.55 billion in retirement assets as of the end of May.

“We’ve held the fees on the lifecycle funds the same while investing in direct real estate,” said Cunniff. “There will be no change from the shareholder perspective.”

Overall, adoption of alternative assets in TDFs has been slow, given the high costs associated with alternative investments. Last year, only seven target-date series included alternative investments, according to Morningstar.

That TIAA is incorporating direct real estate without raising participants’ fees doesn’t surprise Morningstar’s Holt.

“With such heightened attention on fees, managers have to consider the implications on investors’ costs with any change in strategy,” said Holt.

So far, sponsors have shown a willingness to consider the latest iteration in the target-date universe.

“We are seeing a response that is overwhelmingly positive,” said Erin Donnelly, head of DCIO at Nuveen. “Whether sponsors are using the right TDFs is a top-of-mind question for them. As is the fee profile of the funds they use.”

That investors are able to access direct real estate without incurring additional costs has made conversations with sponsors more compelling, said Donnelly.