Why REITs Will Benefit From the Real Estate Crisis

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 |  Includes: FFR, VNQ
by: Brad Case

I posted an article on November 7 noting that a private real estate investment fund had lost essentially all of its investors’ money and predicting more such announcements over the next few years. Truly, we haven’t seen most of the bad news about commercial real estate defaults and distressed sales. Still, I emphasized, bad news for private real estate investors is good news for investors in publicly traded REITs. Today I thought it would be a good idea to expand on that theme.

Publicly traded REITs have one goal—to maximize share values—and three ways of accomplishing it: (1) maximizing operating income from the properties they own, (2) buying properties at favorable prices, and (3) selling properties at favorable prices. If you invest in a REIT, it doesn’t change their goal, their operating decisions, or their decisions on asset acquisition/disposition (buying and selling properties). In contrast, private real estate investment managers have multiple goals—and, because of this, publicly traded REITs can take advantage of them.

For example, when an investor commits new capital to a private real estate fund, the fund manager’s goal is to deploy that capital as quickly as possible. That means they have an incentive to buy buildings, even if it’s a bad time to buy, and even if they have to pay too high a price—which gives REITs an opening to dispose of properties at favorable prices.

Conversely, when an investor in a private fund wants to get out, the fund managers have to make sure that cash is available. That means they have an incentive NOT to buy buildings, even if it’s a good environment for buying; in fact, they have an incentive to sell buildings, even if they have to accept too low a price—which gives REITs an opening to acquire properties at favorable prices.

The graph below shows how that dynamic worked during the real estate bubble. Property values bubbled up in 2006 and hit their peak in 2007. Publicly traded REITs became huge net sellers of properties, while private funds became huge net buyers. This year, REITs have been the most active buyers, while private funds are net sellers—a situation that’s likely to last for some time as funds start having to pay back the tremendous debt they took on during the go-go years.

Click to enlarge

In short, publicly traded REITs buy low and sell high—the perfect formula for making superior investment returns. Of course, there has to be a losing investor on the other side of each of those winning transactions—which is where private real estate investment funds come in. The fact that there are so many of those buy-high, sell-low funds is why publicly traded REITs are going to continue benefiting from the trouble that private funds are reporting.

Disclosure: Author is long Vanguard REIT Index Fund and ING Real Estate Fund

Disclaimer: The opinions expressed in this post are my own and do not necessarily reflect those of the National Association of Real Estate Investment Trusts ((NAREIT)). Neither I nor NAREIT are acting as an investment advisor, investment fiduciary, broker, dealer or other market participant, nor is any offer or solicitation to buy or sell any security investment being made. This information is solely educational in nature and not intended to serve as the primary basis for any investment decision.