REITs Vs. Private Equity Funds: What's The Best Way To Invest In Real Estate?

Summary

• Everybody knows that they should invest in real estate; but most investors do not know what is the best approach.
• Put simply, the best approach should provide the highest level of return for each unit of risk.
• Numbers don’t lie: REITs provide higher rates of return and are less risky than Private Equity Funds.
• We present how we put the favorable math of REIT investing "on steroids" by following a Value strategy.
• Looking for a portfolio of ideas like this one? Members of High Yield Landlord get exclusive access to our model portfolio. Start your free trial today »

Most investors understand that they should invest in real estate whether it is for:

• High current income.
• Long-term appreciation.
• Inflation protection.
• Diversification.

Income-producing real estate has historically generated high rates of return with lesser risk than most stocks and provided valuable diversification benefits. It is often recommended to invest up to 25-30% of one's portfolio into real estate, and this is well-justified, in our opinion.

Over the past 20 years, real estate outperformed literally every other investment asset class:

The more difficult question to answer is HOW to invest in real estate?

Most investors are not experts in real estate investing and do not have the time or interest to do all the work themselves. Therefore, the most common options are the following:

Option 1: Invest in publicly-traded REITs.

Option 2: Invest in a private equity real estate fund.

We think that this article can help you decide which one is the better option. For us, there's no doubt: REITs are far superior.

And, we do not say this lightly. I have myself a background in private equity real estate and once thought that there was no better way. The truth is that I was investing in private real estate because I did not know better and suffered from many misconceptions on REIT investing. Today, I have turned my back to private equity, and my real estate portfolio is (almost) fully invested in REITs.

Here are the three main reasons why:

Reason #1: REITs Produce Higher Total Returns

Private equity real estate funds are commonly sold on the premise that investors can achieve higher returns than available in 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 funds have significantly underperformed public REITs over the long run.

According to an extensive study conducted by Cambridge Associates, REITs have outperformed private equity funds by nearly 4% per year for the last 25 years:

Source

Using other data source and a slightly different time period, EPRA comes to the same conclusion, with REITs outperforming private real estate by up to 6% per year depending on the underlying strategy (Core, Core+, Value-add, Opportunistic).

Source: EPRA

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 (according to the Cambridge study).

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:

1. Faster Growth: REITs have access to public capital markets to raise capital and seek external growth. 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. As a result, while private funds may grow cash flow by 2-3% per year; REITs will commonly achieve double of that.
2. Cost Efficiency and Aligned Interests: Private equity funds are initially created by a sponsor with one objective in mind: generate fees. They may tell you a fancier story, but no one goes into this business with anything else in mind than fees. REITs, on the other hand, own their management who work for them as employees. It reduces conflicts of interest and reduces the cost of management.

Certain analysts argue that REITs provide a 4% per annum head start over private equity funds on the cost front alone! Add to that the growth advantage and it is no wonder that REITs outperform by a large margin in the long run.

Reason #2: REITs Are Significantly Less Risky

The higher returns may lead you to think that REITs must be much riskier to earn these higher returns. In reality, it is the opposite. Historically, private equity funds have taken much greater risks to achieve these disappointing results:

REITs are the clear winner here. The underlying asset is the same: Real estate. However, structured as a public REIT, investors enjoy wide diversification, only moderate leverage and liquidity. By holding a well-diversified portfolio of REITs, investors have never lost money in the long run, but many private equity investors file for bankruptcy each year.

Reason #3: No Liquidity, No Control, No Problems?

The most commonly mentioned argument in favor of REITs is the higher liquidity; and the main argument in favor of private real estate is greater control.

In the case of private equity funds, you get to combine the worse of both worlds with no liquidity and no control in most cases.

Just try to exit your private fund. Is it complicated? Is it costly? Well, yes it is, and this is a huge problem. On day 1 of your investment, you are likely to lose up to 5-10% in transaction cost because transacting in an illiquid market is costly. This is just the cost of buying/selling the underlying property, and there may be additional costs charged by the fund itself.

In comparison, with REITs, you invest in a diversified portfolio of assets, and the transactions costs of buying the underlying properties are already paid off - avoiding large dilution on day 1 of your investment. Therefore, you start at a 5-10% disadvantage with private funds, on top of having no control and no liquidity.

Conclusion:

In our book, REITs handily beat Private Equity Funds because:

• They generate higher total returns over time.
• They are significantly less risky.
• You enjoy liquidity and control over your investment.

Higher returns combined with lower risk should be the conclusion for most investors.

Our Approach to Real Estate - Value REIT Investing

I used to work in private equity real estate myself. I have owned properties, earned good cash flow doing it; but once I learnt more about REITs, I quickly came to the conclusion that they were better investments for the reasons explained in this article.

I know that many private real estate investors are very skeptical about REITs, but please have an open mind to consider the following benefits:

1. Professional and cost-effective management: All the unpleasant work is managed by professionals in a highly cost-efficient way, thanks to economies of scale. These are people who do this full time and have great resources.
2. Liquidity and low transaction cost: Unlike private investments that are highly illiquid and involve up to 10% in transaction costs on day 1, REITs are publicly listed, and shares can be traded in one click of mouse at a minimal cost.
3. Diversification: When you invest in a REIT, you own an interest in a portfolio of 100s of properties. As such, your risks are well mitigated as compared to owning a few rentals or investing in a private fund.
4. Passive Income: REITs must, by law, pay out 90% of their net income in dividends to shareholders. In this sense, you have control over the cash flow and without putting any work, you will earn a very consistent income from a passive investment.
5. Better long-term returns: As already shown, REITs (VNQ; IYR) outperform private real estate by up to ~4% per year in the long run:

If I'm able to achieve similar (or better) results with REITs, why would I venture into investing in an illiquid, concentrated, and highly leveraged private equity fund?

Even better, with REITs, if you know what are doing, you may often find very good deals with individual opportunities selling at materially less than the underlying value of the real estate.

As an example: Back in January, we identified a REIT (Front Yard Residential (RESI)) that owns a portfolio of more than 16,000 single-family houses on sale at a 50% discount to the private market value of the real estate. It's just common sense that buying real estate at less than fair value is a strategy for outsized cash flow and appreciation in the long run.

Since making our investment, our investors have earned over 22% on this investment:

Data by YCharts

Obviously, it does not always work out this well. We occasionally also suffer losses (e.g. Washington Prime Group (WPG), Uniti Group (UNIT)), but when you build a diversified portfolio of deeply undervalued REITs, you may greatly improve your returns. The best value REIT investors have managed to reach up to 22% annual returns over the past decades by following such strategies:

Source

In our real-money portfolio at High Yield Landlord, we aim to do just that by putting the favorable math of REIT investing on steroids.

Our secret? We spend hundreds of hours and thousands of dollars researching for solid REITs that trade at large discounts to NAV and high dividend yields. As a result, we are able to achieve superior dividend yields (7.71% weighted average in our portfolio) at sustainable dividend payout ratios (73% weighted average in our portfolio), thereby giving us generous and sustainable income. Moreover, our holdings trade at an estimated 20% discount to NAV - providing us a strong margin of safety and superior appreciation potential as compared to private equity funds.

If my options were to hold a portfolio of REITs like this one, or invest in a Private Equity Fund, I would pick the REIT portfolio any day of the week; and this is why I decided to switch careers... away from private equity into REIT investing.

Source: High Yield Landlord Real Money Portfolio

Ending Remarks

We believe that most investors invest in private equity funds (instead of REITs) because they do not know enough about REITs to recognize that they are better investments in most cases. With our "REIT vs. Private Equity" comparison, we aim to educate investors on the power of REIT investing.

Today, I have become a professional REIT investor and I aim to buy REITs at less than what they are worth in order to achieve high income and capital appreciation. It's just common sense that such strategy, when implemented correctly, can lead to fantastic investment results.

Disclosure: I am/we are long RESI. 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.