Private equity real estate investments are commonly sold on the premise that investors can achieve significantly higher returns than available to the public market. By investing in an illiquid market, investors are supposedly getting compensated for the higher risk of their investment. At least, you would hope so.
Yet, when we look at the data behind this claim, we find the opposite to be true. Private equity real estate has significantly underperformed public and liquid real estate companies (REITs) over the long run. The result is particularly interesting when you consider that:
- Private equity investors commonly follow riskier approaches (value-add, development…)
- They use much higher leverage on average.
- Their investments are more concentrated, and therefore the individual risk of properties is less mitigated.
- They are highly illiquid, difficult and costly to transact.
You would think that investors need compensation for these 4 factors, and yet, they have historically paid a big price for the higher risk of their illiquid real estate investments.
Private real estate investments have underperformed REITs by as much as 3.91% per year for the last 25 years according to Cambridge Associates.
Using other data points and a slightly different time period, EPRA comes to the same conclusion with REITs outperforming private real estate by up to 600 basis point per year depending on the underlying strategy (Core, Core+, Value-add, Opportunistic).
We are here talking about massive outperformance. To put it into perspective, if you invested $1 million 25 years ago into private equity funds, you would have $5.6 million today, but if you had put it into listed equity REITs instead, it would have grown to $13.8 million— nearly 2½ times as much.
Private equity real estate investors find this hard to believe, but really when you look at the underlying return drivers, it is not normal for REITs to outperform, it is in fact expected.
Three Main Reasons Why REITs Outperform Real Estate
We identify 3 main reasons why REITs generate higher total returns than private real estate investors in the long run:
- REITs grow cash flow faster
- REITs are more cost-efficient
- REITs are liquid – saving transaction cost to investors
1- REITs Grow Cash Flow Faster
An important advantage of the REIT structure as compared to private real estate investment is that REITs can create substantial value to investors by engaging in supplemental growth activities typically not available to private investors. REITs can generate external growth by accessing public equity markets and making accreditive property acquisition, developments, engaging in joint ventures or even initiating new real estate related businesses. As long as the REIT is able to access public capital at a lower cost than the achievable expected returns, there is an arbitrage profit for the existing REIT shareholders can profit from.
Example: REIT issues $50 million in new shares and adds $30 million in leverage for a blended average cost of capital of 6%. It then uses the capital to buy a property with an 8% cap rate. The result is a positive 200 basis point spread that results in immediate cash flow growth on a per share basis.
It boosts the growth rate of the REIT and its expected return potential, whereas private investors are generally limited to rent increases to grow cash flow. This is how REITs such as Realty income (O), National (NNN), STOR (STOR), EPR (EPR), Simon (SPG) and many other are commonly able to grow their cash flow by 5-10% per year. Since private investors have no access to public capital markets, their options to achieve growth are reduced.
2- REITs Are Cost-Efficient
REITs are able to save costs at many levels, including interest expenses, property management and brokerage. Scale brings cost-efficiency, and the superior relationships of REITs give them a significant competitive advantage.
REITs may often own 10s or 100s of properties in a same market, allowing them to manage assets at an exceptionally low cost with internalized property management.
Similarly, REITs have better access to cheaper capital than most private investors. Think of you walking into a bank to ask for a loan, versus a $10 billion REIT walking into the same bank. It is quite clear who is likely to get the best terms on their financing.
Some studies find that REITs have up to 4% head start per year from cost savings compared to other direct property investments. From my experience working in private equity real estate, it is in most cases very difficult for private market investors to ever catch up to this advantage – causing them to underperform in the long run when accounting for all additional expenses and fees.
3- REITs Are Liquid Investments
REITs also greatly reduce the cost of illiquidity as they can be freely traded on liquid markets at minimal transaction cost. In comparison, buying and selling private real estate is very costly and time-consuming. It is common to pay somewhere between 5-10 percent of the purchase price in different fees and transaction costs when buying and/or selling a property.
It dilutes returns considerably for the investors who are essentially losing up to 10% on day one in fees alone when making an investment. In comparison, REITs have already paid transaction costs and own a portfolio in which you can invest by buying shares, saving the real underlying cost of real estate transactions.
The Future Will Be No Different
Most importantly, all of the above factors remain highly relevant today – implying that the outperformance should continue into the future.
This is especially true when you consider that REITs are today priced at historically cheap valuations. On a cash flow multiple basis, Lazard notes that REIT valuations have now fallen 20% below the long-term average of 16.5x FFO.
Source: Lazard Real Estate
Moreover, the current P/NAV also suggests that REITs are substantially undervalued at a 4-7% average discount compared to a 2-3% long-term average premium.
Source: Lazard Real Estate
Priced at a discount to the underlying value of the properties, REIT investors are essentially getting all the benefits of the REIT structure for free. In fact, private investors appear to be today paying a premium for their illiquid investments which really makes no sense from a risk-to-reward standpoint.
Our REIT portfolio holds today many positions trading at their lowest valuations in years. We consider these to be significantly undervalued by the market and expect significant upside to materialize in the next years, in addition to the average ~8% dividend yield of our portfolio. With a well-diversified high yielding portfolio of undervalued REITs, we are convinced that we are set to outperform the great majority of private real estate investors.
- REITs outperform private real estate by a large margin and for very good reasons.
- There is no reason to believe that the past results would be any different in the future when it comes to REIT’s outperformance over private peers.
- Since REITs are historically cheap, the outperformance over private real estate could be even greater in the future.
- Our high yielding REIT portfolio appears to be particularly well positioned with an average ~8% dividend yield and capital appreciation potential.
Private real estate has not been able to keep up with REITs in the past, and we do not expect it to do so in the future either.
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Disclosure: I am/we are long EPR; IRM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.