Real Estate

Q&A with IFA: Is Private Real Estate Superior to Publicly-Traded REITs?

Real Estate

Question: I have heard that private real estate offers higher yields or better returns than publicly-traded real estate investment trusts (REITs). Is it worth my time to seek out private real estate investments for that portion of my portfolio?

Answer: We begin by noting that there are essentially two ways to invest in private real estate--direct purchase of property (either for flipping or deriving rental income) or investing via a pooled fund that is professionally managed. An important distinction between them is that with the latter the investor is purely a supplier of capital, and with the former, the investor supplies not just his capital but his time and perhaps labor. The capital expenditure is by no means limited to the down payment and subsequent mortgage payments but includes many other expenditures such as taxes, insurance, utilities, repairs, upgrades, etc. All of this makes the calculation of the true return received from a property purchase very difficult, if not impossible. With direct property purchases, we have witnessed an extremely wide range of outcomes, from outright bankruptcy of house flippers in the 2007-2009 downturn to long-time investors who have managed to create a steady stream of rental income, similar to an annuity. However, it is difficult to argue that these landlord investors are better off compared to what they would have achieved with a simple market index fund that would have made no demands on their time. Since we are not aware of any reliable data revealing how direct real estate buyers have fared (and we would not expect to see any, given all the costs and other intangibles that go into it), the rest of this article will focus on the pooled investment approach.

It is our opinion that there are several problems with private real estate that make it a sub-optimal choice for most investors. The first problem is the lack of liquidity. Many deals are structured so that investors' cash is tied up for many years, and the managing partners can issue a call for more cash that investors are required to cough up or see their stake diminished. Only at the end, when the investors cash out, do they see what their return truly was by calculating an internal rate of return based on the timing of the cash flows.

This brings us to the second problem which is the lack of transparency in valuations and in risk undertaken. With a publicly traded REIT, the market opines everyday on its value, and everybody agrees that is the value that can be reported on financial statements. With private real estate, the managing partners have a tremendous amount of leeway as to how its value will be determined at any point in time. The appraisal-based methodologies employed for private real estate make their returns appear to be much smoother than exchange-listed real estate. An additional transparency issue with private real estate is that whenever the net rental income from the underlying real estate investment is insufficient to pay promised dividends to shareholders, the managers can increase the amount of borrowing, thus increasing the amount of leverage (i.e. risk) in the investment. Of course, publicly-traded REITs borrow too, but their market price will fully reflect their risk exposure. One instance of a non-traded REIT that ran into valuation and borrowing problems is the series of Apple REITs sold through David Lerner & Associates. Please note that these REITs have no connection to Apple Inc.

The third (and perhaps most obvious) problem is the lack of diversification in private real estate. A well-constructed exposure to public real estate would own office buildings, hotels, shopping malls, apartment buildings, warehouses, etc. all over the world. If one property type or geographic region becomes troubled, it is usually not a major problem. Such diversity is infeasible with private real estate.

Last year, Cohen & Steers published a white paper called "Revisiting the Truth about Real Estate Allocations" in which they evaluated the data on private vs. public real estate. Of course, they have a bias towards the latter since they actively manage exchange-listed REIT funds, but we found their arguments and conclusions to be compelling. Here is the introductory statement:

"While markets have changed significantly since we began the series, our findings have been consistent, year after year; listed real estate continues to outperform nearly all forms of institutional private real estate funds, regardless of the time periods in the study."

We have access to the same index data that they used, so we ran our own results shown in the table below:

1/1/1978 - 6/30/2014 (36.5 years)

  Annualized Return Annualized Standard Deviation
Publicly-Traded REITs 12.9% 17.3%
Private Real Estate Funds 8.5% 6.5%

Source: Morningstar. Publicly-Traded REITs are represented by the FTSE NAREIT Equity REIT Index and private real estate funds are represented by NCREIF Fund Index—Open-End Diversified Core Equity Index.

At first glance, it appears that while public REITs had a higher absolute return, private real estate had a higher risk-adjusted return. The authors of the white paper attribute this to the valuation distortion issue of private real estate discussed above. Given that cash invested in private real estate is required to be tied up for many years, the authors felt it reasonable to look at ten-year rolling periods based on calendar years in order to produce a fairer comparison. Below are the results we obtained from Morningstar:

1/1/1978 - 12/31/2013 (27 Ten-Year Rolling Periods Beginning 1/1)

  Lowest 25th Percentile Median 75th Percentile Highest
Publicly-Traded REITs 7.42% 10.56% 11.63% 14.12% 18.24%
Private Real Estate Funds 2.97% 5.11% 6.96% 10.46% 13.01%

Source: Morningstar. Publicly-Traded REITs are represented by the FTSE NAREIT Equity REIT Index and private real estate funds are represented by NCREIF Fund Index—Open-End Diversified Core Equity Index.

When put in terms of a ten-year holding period, public clearly dominates private, but the white paper authors perceive a deeper problem. When an investor purchases an illiquid asset, he usually expects a higher return as compensation for giving up easy access to his cash. As the authors state, "Our discussions with asset consultants and clients indicate that the expected annual returns from private real estate should be 300 basis points [3%] more per year than from public investments to compensate for the lockup period." This means that the private real estate shortfall is much worse than what is indicated by the numbers above.

Naturally, the authors ask why investors accept higher prices (or lower expected returns) for private real estate, and they opine that some investors (such as pension funds with liabilities that are relatively steady) have a strong incentive to minimize volatility, so they will pay up for assets that engender the appearance of low short-term volatility. If the gap between the value of the assets and the value of the liabilities becomes too wide, the pension fund manager is likely to lose his job. It could be considered a behavioral finance issue. The authors conclude:

"Despite the liquidity offered by listed REITs, and the near-death scare of the global financial crisis, private core real estate is priced at parity with the expected returns of listed REITs, without any adjustment for liquidity. To put this into perspective, core private real estate is currently priced to return about 7% (unleveraged) and about 6% after expenses. With 30% leverage, this net return potential would rise to about 8%—similar to our current expectations for listed REITs. Historically, REITs have returned more than these forecasts, while core private real estate funds have not achieved them. In our view, the current pricing parity between listed REITs and private real estate fails to justify the high allocations to direct property typically found in corporate and public pension plan portfolios."

One part of the white paper that we disagree with is the claim that active REIT funds have outperformed passive REIT funds. The active manager data they cited came from eVestment Alliance, which we have never seen used as such a source before. The most recent S&P Dow Jones Indices Index vs. Active Scorecard (as of 6/30/2014) states that out of 142 actively managed domestic REIT funds, 130 (or 91.55%) underperformed the S&P US REIT Index for the five-year period.

The average return of the active funds was 19.8% compared to 23.8% for the index. Over the same period, Dimensional Fund Advisors' US Real Estate Portfolio returned 23.5% which is essentially the index minus a small management fee. If we make the simple assumption that the returns of the actively-maged funds are distributed normally (a bell-shaped curve) then we can estimate that the DFA fund beat 90% of the active funds. If we look at the 15-year period ending 9/30/2014 using data from Morningstar.com, we see that the DFA fund returned 11.6% vs. 11.8% for its benchmark, and the Morningstar US Real Estate Category (which is dominated by active REIT funds) returned only 10.8%. The 10.8% may be considered overstated because it only utilizes the returns of funds that survived the whole period. Please note that IFA advises our clients to invest in DFA's Global REIT fund which includes both their US and international funds. Their Global REIT fund has only been around since June of 2008, and for the five year period ending 9/30/2014, it has returned 13.1% vs. 12.1% for its benchmark (the S&P Global REIT Index). The bar chart below shows 15-year returns for the DFA US REIT fund, the two Morningstar REIT categories, and the two S&P REIT Indexes.

Although we have recently leveled criticisms against white papers published by fund companies (see here and here), we are happy to acknowledge one that truly helps investors steer clear of a sub-optimal asset class. If you would like to learn more about IFA's approach to global real estate investing, please call us at 888-643-3133.