- A lot of investors appear to think that private real estate investments are more rewarding than REITs.
- Yet, studies show the opposite. REITs have outperformed by ~4% per year on average.
- There are three main reasons why REITs are more rewarding investments. We discuss these in greater detail in today's article.
- Looking for a portfolio of ideas like this one? Members of High Yield Landlord get exclusive access to our model portfolio. Get started today »
Lately, I have been publishing a lot of articles on the topic of REITs vs. private real estate investments. It's a topic that interests me a lot because I used to work in private equity and once thought that there was no better way to invest in real estate.
I was mentored by other private equity real estate investors, and not surprisingly, they taught me that REITs were riskier and less rewarding than private real estate.
In reality, the opposite is true.
I was taught this way because private equity sponsors earn fees for managing real estate investments and so the last thing they want is investors to buy REITs. There's an army of people whose businesses depend on pushing the idea that "REITs are poor investments."
But as we will show in today's article: REITs are actually much better investments in most cases.
REITs are not only safer, but they are also more rewarding than private real estate.
They are safer because they are well diversified, conservatively financed, liquid, professionally managed, and offer limited liability. We discuss this topic in great detail in a separate article entitled "Why REITs Are Much Safer Than Rental Properties."
In today's follow-up article, we will focus on what makes REITs more rewarding than private real estate. Let's start by reviewing the results of a few studies on this topic.
The Results of Extensive Studies
You often hear anecdotal evidence from private real estate investors.
But you rarely hear them mention real studies.
That's because the real studies show that REITs crush the results of private equity funds.
According to a study conducted by EPRA, REITs generated 3.7% to 6% higher annual total returns depending on the strategy:
And another study by Cambridge finds that REITs generated 4% higher total returns on average:
We are not talking here about slight outperformance: 4% per year is enormous.
How is it possible that REITs are so much more rewarding?
There's actually a simple explanation.
Below we review the three main reasons why REITs generate higher total returns than private real estate investments.
Reason #1: Access to Public Capital Boosts Growth Rates
This is perhaps the main contributor to REIT's higher total returns.
They are able to raise equity capital on public markets.
You would think that expanding the share count leads to dilution and lower returns, but it's actually the opposite.
As long as a REIT is able to raise capital at a cost that is lower than the expected returns on their investments, then raising capital is accretive and leads to cash flow "per share" growth, even despite the rising share count.
Let's look at an example:
Realty Income (O) commonly issues new equity and blends it with cheap debt for an average cost of capital of roughly 4.5%. It then uses this capital to buy new properties at a 6% cap rate - resulting in a 150 basis point spread.
That's how Realty Income is able to grow its cash flow per share at ~5% per year even as its properties only grow rents by ~1% per year. The rest comes from raising capital and reinvesting it at a positive spread:
As such, public REITs don't rely only on organic growth. They can boost their growth rate beyond what is achievable in the private market by conducting spread investing.
It's simply not possible for private real estate investors to grow cash flow at 5% per year with this level of consistency, and over time, this faster growth leads to higher total returns.
And to be clear, there's nothing exceptional about Realty Income.
Many other REITs such as American Tower (AMT) have managed to do the same thing with closer to 10% annual growth.
In comparison, private real estate investors are happy with just 1%-2% annual growth. They don't have access to public equity markets and it limits their total returns.
Reason #2: Significant Economies of Scale and Synergies in Operations
Secondly, REITs are extremely efficient vehicles. They often manage billions worth of real estate, and that comes with many advantages that you wouldn't have if you only own a few properties.
REITs are able to attract the best talent, pay them well, have them work hard for you, and even then, the management cost as a percentage of assets is very small.
As an example, in the case of STORE Capital (STOR), the management cost is just 0.45% of assets:
For this small cost, you get Christopher Volk, a veteran of the net lease industry, and his entire team working for you.
Moreover, the large scale also leads to economies on other levels.
If you are Essex Property Trust (ESS) and own billions worth of apartment communities, you can be sure that your contractor will give you a better deal on regular property maintenance than if you only own one or a few properties.
You also can internalize property management and brokerage. Instead of paying brokers to rent your apartments, you can now hire your own brokers, which leads to significant cost reduction. The same applies to property managers.
All these costs add up over time, and because REITs are more efficient, there's more money left for shareholders.
Reason #3: Ability to Create More Value in the Investment Process
Finally, because REITs enjoy large scale and have access to better access to resources, they're also able to create more value for shareholders.
STORE Capital is a great example.
It creates a lot of value by originating its own deals. Instead of going through the brokerage market to find new deals, STORE has its own origination team that calls companies directly to offer sale-and-leaseback solutions.
It leads to higher returns because STORE skips the brokerage market and it is able to get higher cap rates and better lease terms than you could.
Another great example would be AvalonBay Communities (AVB).
It creates a lot of value for shareholders by actually building its own properties.
In the private market, cap rates are today very low for high-quality apartment communities. But AVB is able to earn higher returns by buying vacant sites, getting building permits, and developing new properties.
Most private real estate investors wouldn't be able to do that. It requires $10s of millions of capital, good relationships, and expertise.
By investing in REITs, you benefit from value creation that goes beyond just buying stabilized assets and holding them for income. Not surprisingly, it leads to higher returns over time.
You often hear investors say that private real estate investments are more rewarding than REITs.
But once you dive into real studies, you find that the opposite is true, and there's a good explanation as to why that is.
REITs can do spread investing to grow faster, they enjoy economies of scale on many fronts, and they add more value to the investment process by developing their own properties and/or originating their own deals.
All of this combined together has historically led to higher returns than what was achievable in the private market.
And we think that today could be a particularly good time to enter the REIT market because most of them are still undervalued due to COVID-related fears.
You could just pick a diversified REIT ETF such as the Vanguard Real Estate ETF (VNQ) and be done with it. Or alternatively, if you want to target superior results, you could build your own portfolio.
We specialize in active REIT investing and have managed to consistently earn higher returns by focusing on smaller and lesser-known REITs that are undervalued:
Either way, we think that passive and active REIT investors are set for more outperformance in the coming years.
REIT valuations are historically low and it's a question of time before they recover as we put this crisis behind.
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This article was written by
Jussi Askola is the President of Leonberg Capital, a value-oriented investment boutique that consults hedge funds, family offices, and private equity firms on REIT investing. He has authored award-winning academic papers on REIT investing, has passed all three CFA exams, and has built relationships with many top REIT executives.He is the leader of the investing group High Yield Landlord, where he shares his real-money REIT portfolio and transactions in real-time. Features of the group include: three portfolios (core, retirement, international), buy/sell alerts, and a chat room with direct access to Jussi and his team of analysts to ask questions. Learn more.
Analyst’s Disclosure: I am/we are long STOR; O; AVB. 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.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.