Seeking Alpha

Why REITs Beat Private Equity Real Estate Funds

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Includes: O
by: Jussi Askola
Jussi Askola
REITs, real estate, research analyst
Summary

Real estate generates the best risk-adjusted returns of all asset classes in our opinion.

Most investors favor private equity funds to invest in real estate.

We believe that REITs are superior vehicles. We explain why.

Real estate is the epitome of Graham’s definition of an investment. It's quite simply a piece of planet earth that combines land with a man-made structural improvement. As a result, it's a tangible asset that provides clear value to its occupier. Additionally, the nature of its value is limited, necessary, and flexible - giving it remarkable durability and stability in value.

Real estate has a phenomenal long-term track record of generating the best risk-adjusted returns of all asset classes, making the decision to buy today and hold for the long haul even easier to make.

Therefore, most investors understand that they should invest in real estate whether it's for:

  • High current income.
  • Long-term appreciation.
  • Inflation protection.
  • or diversification.

The more difficult part is to determine HOW to invest in real estate? When looking at all the different possibilities, most investors consider two main options:

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. I used to work in private equity so I know that there is a lot of misinformation out there.

Private sponsors earn high fees for managing real estate funds. Their lifeline relies heavily on them spreading misinformation on the REIT industry. They are always quick to dismiss REITs as highly volatile paper assets with diluted returns.

What they conveniently fail to mention is that REITs have historically produced significantly higher returns than private equity funds:

source

From 1992 until 2017, REITs returned more than 11% per year. In comparison, private equity real estate investments returned just 7% on average, or a ~4% annual underperformance. In other words, if you had a million dollars 25 years ago and invested it in REITs rather than in private equity real estate, you would have nearly two and half times more today.

This result directly implies that private real estate funds have significant flaws in their structure as compared to REITs. Despite owning similar underlying assets (property investments), private funds earn diluted returns to their investors. We identify 3 reasons to that:

  1. Private funds have poorer access to capital and slower growth.
  2. They have higher fees and lower economies of scale.
  3. Finally, they also suffer from greater conflicts of interest.

1. Private Funds Have Poorer Access to Capital and Slower Growth

Private equity funds have no access to public capital markets and are therefore limited to raising rents and occupancy to grow cash flow.

REITs on the other hand have access to public capital – which gives them much greater opportunities to boost growth beyond rent increases.

The most common way for REITs to increase growth rates is by issuing new shares, raising new debt, and investing these proceeds in new acquisitions. As long as the average cost of capital is lower than the expected return of the property, there's a positive spread to be earned for the existing REIT shareholders. We call this “external” growth – or “spread” investing.

Consider the following example:

REIT “X” issues 1,000,000 additional shares at $30 each for $30,000,000 and adds another $20,000,000 of debt. The total $50,000,000 capital stack costs the company 6% per year, but it's able to invest the proceeds in a property yielding 8% annually. There's an immediate 200 basis point of profit to be added to the bottom line of existing shareholders. Even as the share count goes up, the cash flow per share increases – creating value to all shareholders.

This is not possible to private real estate investors who are not able to issue new shares on a public exchange to raise additional capital and boost growth rate.

While private funds may be happy with a 2% annual growth rate, REITs can grow by 5%-10% per year by doing spread investing in addition to raising rents. Realty Income (O) is a great example here. It has grown cash flow at an average of 5.2% per share over the last 20 years:

Source: Realty Income

The Net Lease REIT returned ~16% per year from a lower-risk approach with quality properties and little leverage. This is simply not possible for private funds because their cash flow growth rate would have been 2x smaller over the same time horizon.

If REITs can consistently achieve stronger growth rates than private peers, it's not surprising that they also produce higher total returns over time.

2. Private Funds Have Higher Fees and Lower Economies of Scale

Private funds are generally managed by an external management team according to a management agreement that includes a fee structure.

Most REITs on the other hand are managed internally by a management team that is hired as employees of the corporation.

This difference in management structure is very important and can lead to substantially higher cost with the average private fund charging up to 1.5-3% per year in fees; whereas REITs are much more efficiently managed with just 0.5-1.5% in overhead cost:

Source: EPRA

REITs enjoy significant economies of scale because their managers receive salaries rather than a fee that automatically goes up based on assets under management. This large scale also allows to save on property management, brokerage, interest, and many other fronts.

Again, taking the example of Realty Income – it has a 0.4% Overhead cost as a percentage of its portfolio value:

Source

Private funds are generally 2-3x more expensive than that and then still enjoy lower economies of scale on other fronts. Certain studies argue that cost advantages puts REITs ahead by up to 4% per year as compared to private funds.

3. Private Funds Suffer From Greater Conflicts of Interest

There is a common saying in private equity that: "At the beginning, the limited partners/investors have all the money and the general partner/sponsors have all the knowledge. At the end, the general partners/sponsors have all the money and the limited partners/investors have all the knowledge!"

You get the point: Fees are high and so are conflicts of interest. Private real estate fund managers earn a fee on all “assets under management”. They are incentivized to maximize the size of the portfolio and this often comes at the expense of the performance. The manager might also earn a fee on all new acquisitions and dispositions which may lead to more frequent trading and higher transaction cost. Finally, it is very common for external managers to earn incentive fees above a certain hurdle rate. This leads to greater risk taking and excessive leverage.

At the end of the day, the external manager is running an asset management business and his interest is to maximize the volume of investments. Buy, buy, buy! This conflict of interest is well reflected in the below graph:

Source: EPRA

REIT management teams became net sellers of real estate in 2006 and 2007 when prices were at bubble levels. On the other hand, private equity funds were incentivized to increase their assets and therefore kept on buying until the crash. Conflicts of interests are real and can significantly affect investment results as seen with this historic event.

REIT management teams are better-aligned because managers are hired by the shareholders as employees of the company. They earn a salary to maximize performance and can be fired at anytime if results are disappointing. This is not so simple with private funds because the manager will generally be tied by a long term contractual agreement for the management.

Bottom Line:

When you invest in Private Funds, you are setting yourself for lower returns in most cases. Additionally, you have no liquidity, you have no control, and you are taking greater risks.

People lie… Numbers don’t… REITs outperform Private Funds:

Source

From 1977 until 2010, REITs have returned more than 12% per year, according to EPRA. In comparison, private real estate investors returned between 6.4% and 8.7% per year on average depending on their underlying strategy. (Core, Core+, Value-add, Opportunistic)

Finally, many REIT investors have done even better than that by picking winners and avoiding losers. This is what we aim to do at High Yield Landlord by specializing in active REIT investing. We believe that the best way for investors to earn high returns from real estate is to buy undervalued REITs as if you would buy rental properties. In other words, invest in REITs, but think like a landlord.

The best active REIT investors have earned up to 22% annual returns over the past decades:

source

A Note about REIT Investing: To succeed as a REIT investor and earn high consistent income, we recommend to:

  • Closely monitor your REITs, including quarterly NOI and FFO performance.
  • Diversify your REIT portfolio with at least ten companies (there are over 200 publicly traded REITs so please be selective).
  • Identify REITs with strong long-term fundamentals but affected by temporary challenges causing their valuation to decline and yields to rise.
  • Be ready to take advantage of market volatility and look for opportunistic buying points.

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