Another Close Look at Capital Appreciation in Real Estate Investment

by: Brad Case

I published an article back in October looking at the returns to investments in commercial real estate, separated into their income and capital appreciation components. Recently I took a closer look at it.

Pension funds and other institutional investors do their real estate investing mainly through private real estate investment funds, but it turns out that private funds have done a pretty terrible job of executing their real estate investment mandate.

Income isn't their problem, though. The problem is that investment managers - on behalf of institutional investors and their pension beneficiaries - basically haven't produced any increase in property values in 33 years.

From the end of 1977 through September of this year, the total return on investments in publicly traded equity REITs averaged 12.4% per year, with 7.9% of that coming from income and the other 4.5% from capital appreciation.

Over the same period, private real estate investment funds with a core strategy produced total returns averaging only 7.9% per year. Average income was nearly as good as for publicly traded REITs, 7.7% per year. But capital appreciation was spectacularly bad, averaging just 0.2% per year. (And that's in nominal terms - meaning that, controlling for inflation, private real estate fund managers basically have watched their assets deteriorate.)

That result is not a fluke, and there's no problem of endpoint bias. The graph here shows the difference in average annual capital appreciation between publicly traded REITs and private core funds over every available rolling period of 20, 25 or 30 years. During the 2008-2009 liquidity crisis, the outperformance by REITs dipped dramatically (mostly because funds use appraisals to measure their values, and appraisals didn't dip down until much later), but it was still positive. On average, publicly traded equity REITs have produced better capital appreciation by 4.34% per year, along with better income by 0.17% per year.

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What could possibly explain such a huge difference? In my opinion, it's the fact that private real estate investment managers tend to buy properties at their peak prices (like in 2007), and - to a lesser extent - sell them at their lowest prices (like now). Buy-high, sell-low is a pretty sure way of destroying your chances to benefit from capital appreciation, even if prices generally move upwards, and even if you can get your assets to throw off income while you own them.

What does this mean for most investors? Well, to me it means that investors in publicly traded REITs have benefited from decades of taking advantage of the lousy investment decisions of private real estate investment managers - and, more importantly, that REIT investors will likely continue benefiting from that dynamic for decades to come. (The only ones who lose, of course, are the pension beneficiaries.)

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional 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.