Why REITs Earn Higher Returns Than Private Real Estate Investments

Summary

• 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:

source

And another study by Cambridge finds that REITs generated 4% higher total returns on average:

source

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:

source

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:

source

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.

source

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.

source

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.

Bottom Line

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.

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.

Comments

[Nroberts04]

@Jussi Askola , Is your article taking into consideration private equity real estate deals for accredited investors? I have access to a variety of individual deals that I can pick and choose from that return better than most reits. Every deal I own pays 8-15% monthly cash on cash plus back end equity when properties are flipped. I have acces to development deals , data warehouses , medical buildings , etc paying up to 15-30% irr depending on the deal. Dividends on development deals obviously don’t kick it for the first year or two but returns after are substantial.

Yes, some capital is tied up for several years but if you have the capital to play around with , why choose reits over private “hands off” deals with potentially much higher returns?

[Jussi Askola]

@Nroberts04 Yes, it is. These research studies specifically compare REITs against these private equity real estate vehicles. I have been in the PE field. Remember that the IRR that they show you (pro-forma) is almost never what you really get in the end. The actual results have been much worse. Pro-forma numbers are to sell you on the idea.

[Jussi Askola]

We just published our Top 5 Picks of the moment for members of High Yield Landlord. You can read a portion of it for free here: seekingalpha.com/...

Have a great day!
Jussi

[VolNightLong]

@Jussi Askola I think you're analysis avoids a few key factors. The first being that all private commercial property indexes (NCREIF and RCA) are based mostly on surveys. There really is no truly accurate measure of private commercial property values (although many great sources like WSJ and Bloomberg frequently refer to these flawed indexes too). Secondly, the privately investing in CRE offers the tax advantages of investing through an LLC. In most cases now with 39 yr depreciation and 27.5 on multifamily, there is 0 income tax burden for at least the first few years of the hold. This is not the case with REITs as the dividends are taxed. Additionally, the 90% requirement for paying returning cash to shareholders is a major problem for REITs. For ex., anyone who privately owned a hotel or retail property in March likely would've used their discretion in limiting distributions. The REITs just distribute to meet the requirement and then issue more stock which fundamentally is just a silly exercise. Also, you would never privately invest in real estate that is being managed externally, so why would anyone buy any of the many externally managed REITs? Furthermore, buying REITs limits you to only buying portfolios of real estate vs. targeting single assets... this means generally less transparency on a property-by-property basis.

Also, I think your O and AVB examples are really bad. These companies are still transacting in the private market so none of what you're saying makes sense about somehow O being able to find 5% NOI growth but PE investors can't. Similarly with AVB, there is no logic in saying AVB is better than buying multifamily privately because AVB can boost returns by developing and buying assets that aren't stabilized. Of course PE investors can do the same thing.

Bottom line is that the clear advantage to investing in REITs vs. private real estate investing is the liquidity. Otherwise it's all downside.

[Jussi Askola]

@cregod You don't understand REITs. Nearly all points you make are wrong.

These are based on transactions and real-returns, not appraisals. You can get accurate information through performance reviews of private equity funds and smaller L.Ps.

I pay less taxes with REITs. No corporate tax and tax-deferred accounts.

Issuing shares is a positive, not a negative thing. When your cost of capital is lower than your expected returns, it leads to accretive growth and value creation for all shareholders. That's impossible to achieve for private investors and it is the main reason why REITs outperform.

[Jussi Askola]

Hi,

Thanks for reading!

We just published our monthly portfolio review for members of High Yield Landlord. You can read a portion of it for free here: seekingalpha.com/...

Have a great day!

Jussi

[trader 71]

Great analysis as usual Jussi.

Here's an article from none other than Forbes that confirms what you say.

www.forbes.com/...

REITS over physical real estate is a no brainer for the average person.
However, if you have the skill to maintain properties, then the latter is the better option.
Managing properties is an actual job, and not for people who already have a full time job.

[Jussi Askola]

@Seeker of truth Canada Thank you for sharing your thoughts. I used to do it full-time, working in private equity, and even then, I think that REITs deliver better results.

[goadamgo]

Duh. Leverage. But a dividend or return of capital cannot be compared with an income stream on a property

[Jussi Askola]

@goadamgo REITs are also leveraged. That is a common misconception.

When you invest in them, you are providing the equity, and REITs then add debt to it. You enjoy the benefits of leverage with no personal liability.
To give you an example: if a REIT has a 50% LTV, and you invest $1,000 in it, you effectively control $2,000 worth of real estate.

REITs have earned 15% per year on average over the past 20 years. You can only earn these returns if you add leverage, which REITs do.
Have a great day!

[vitullijoe]

My private real estate investments sell to the Reits at very high prices

[Jussi Askola]

@vitullijoe That's what private sponsors want you to believe to earn high fees. I used to work in this industry. In reality, they get worse deals than REITs and create less value. They have historically earned much lower returns.

[vitullijoe]

@Jussi Askola Maybe generally but not my stuff, thx

[Dr8802]

Would someone please enlighten me about the benefits of depreciation in a REIT? When I own private real estate I get really great depreciation protection against income. How does that translate in the REIT arena? In other words, how does the benefit of depreciation, or asset segregation get realized if I buy into a REIT?

[goadamgo]

@Dr8802 you don’t

[Jussi Askola]

@Dr8802 REITs don't pay any corporate tax and they can be held in tax-deferred accounts.

[Greg Graham Here]

Jussi...I am sorry but I have to disagree with you big time. I was going to comment on your first article on this subject but didn't have the time to do so. If a person starts when they are young and full of energy, and acquires distressed residential houses that only require cosmetic fix ups (paint, carpet, etc), buys them with minimum down payments, uses as they say "other peoples money" 15 year mortgage leverage, holds the property until the mortgage is paid off, lets their renter buy the house for them over time, ends up with a property they own outright that they basically obtained for free and can increase the rent to offset inflation at any time, etc, etc. Once they get started, they can easily leverage their current properties to buy another property and so on. In the end, they can end up holding a raft of properties that produce a serious income. The returns totally crush what investing the same amount of money (ie, the down payments) in equity REITS would produce.

Of course, this outcome totally depends on starting early, being willing and able to take care of the properties yourself until you can afford a property manager, and doggedly sticking with it for the long term.

It is a cash poor business in the early years and a cash rich business in the latter years.

I have two friends that took this route and they are both gazillionaires now. One of them ended up selling all his residential properties and started buying mid sized apartment complexes on his own. Neither would ever be as stinking rich as they are now if they had instead invested what ever money they had in equity REITS.

If you don't start early, as you get later in life, this scenario vaporizes. Once you get past say 50 years old (with 15 years left before retiring), it is probably too late to start. That is my case and has been for some time...lol.

If I want to generate income from rental property, I basically have to pay cash for the house and receive the rent as return on the investment. With no leverage being employed, the ROI is greatly reduced. Not to mention having to manage the property and all the hassle.

So for an old guy like me, you are correct. It is a whole lot easier simply to buy REITS and my return will be more than paying cash for a house to obtain a stream of rental income.

I look back now and sure do wish I had taken the same route as my two friends.

[Jussi Askola]

@Greg Graham Here Note that we discuss averages here. I have no doubt that a young, entrepreneurial, hard-working individual can earn great results by directly investing in real estate.

We think however that on average, REITs will deliver better results for the great majority of investors. That's the point of this article. REITs enjoy many advantages that boost their performance beyond what is achievable in the private market.

[proteus244]

@Greg Graham Here You're right, but the risk factor is outsized when using leverage to develop the type of business model and RE portfolio you outline. I personally know a number of people who pursued that path and are still recovering from filing BK in the early 2010s when the whole RE house of cards collapsed. For me, no thanks. I'll take my 8% annual and use my time to generate additional income in different ways and sleep more soundly at night knowing I'm not going to get a call from my property manager at 2 AM that the AC is out and it's 110 F.

[Darwens123]

Timing & target are everything. I wouldnt be rushing into an office REIT after Covid... Highly leveraged REITs will suffer as treasury yields and debt financing rates rise, causing performance & liquidity problems like we've seen in the past. It will also put pressure on new deal acquisition and refinancing, requiring higher rents to attain the same returns. Better to wait and see how the rate environment settles out, and who has the strength to navigate it. I know that as a private owner, over the past 15 years Ive been able to put 3 - 10% down, have a positive cash flow, and see both property equity and values increase annually during this extremely strong property cycle, resulting in residential portfolio growth of 17% per annum. I've been in some good REITs through cycles of debt rate increases... the impact on stock price more than offset the dividends paid out to me over a priod of many years...

[Chancer]

@Darwens123:

IMO, REITs are like any other sector: sometimes good and sometimes not so good. Right now I own none.

[Jussi Askola]

@Darwens123 Office REITs represent about 5% of the REIT market. Most REITs invest in more defensive property sectors.

I would add that the time to invest is when there is blood on the street. Today, REIT valuations are historically low. Many REITs have more doubled in value over the past 6 months. Similar opportunities remain. In comparison, the private market is more expensive than ever before. I know where I will inest. Feel free to join us for a 2-week free trial to access all our Top Picks: seekingalpha.com/...

Have a great day!

[longdeath51]

I've owned both rental properties and REITs for the past 20+ years. I can say that without a doubt, your assertion that REITs perform better than rental properties has not been borne out by my experience. The difference, in my experience, is massive--my rental properties have returned more than double what my REITs have.

[Jussi Askola]

@longdeath51 Thank you for your comment. For me, it is the opposite. REITs have done far better.

[Upyourassets]

All I know is my private real estate investments have returned far beyond anything I have made in the stock or REIT market, especially when I consider the tax advantages.

[Jussi Askola]

@Upyourassets For me, it is the opposite. REITs have done far better. In this article, we discuss averages. On average, REITs have done better than private real estate investments

[tgallagher72]

@Upyourassets That's my experience as well. Good for you.

[Upyourassets]

@Jussi Askola ,
I appreciate your opinion and like the way you professionally and politely engage with your readers. Here is why I think the comparison is worthless. There is no good way, that I am aware of, to track private real estate investments. My buys and sells and tax records and rent receipts are all not part of some public database that can be easily compared to a REIT. I will give you one of my most recent examples. I bought a foreclosure for 176,000. I put ~20k down, with closing costs. I have put another 60k into repairs and maintenance. My mortgage, with insurance and taxes, has totaled ~134k over the last 9 years. My rent receipts have totaled 162K. On the surface, it looks like I may have lost money with only 28k in rents over my payment and 60k in costs plus 20k down. This ignores the capital appreciation. I just closed on the sale of this home for 480k, netting 332k, after paying off my current mortgage. I was able to sell without commission and the buyer covered closing costs, two things that may not happen in other real estate environments. Regardless, I put, out of pocket, 52k (after netting out the 28k in rents over the mortgage, insurance, and tax expenses) into this investment and got 332k in gains, at sale. That's over 5 times my money in 9 years. This investment is middle of the road, at best. I could have made more in rent, but I kept back a couple of bedrooms and a kitchen for personal use and it required more work than many of the properties I acquire. This analysis does not include all the tax savings I reaped along the way with depreciation and other deductions. If you can find me a REIT with a similar track record, I will be the first in line to invest.
Now, I recognize that not everyone is skilled or has a desire to manage properties and that the risks are much greater in a concentrated portfolio of individual properties. The rewards, for me, have been more than just compensation for the added risk and work.

[RPearl]

And yet all your sites examples are significantly lower y/y

[Jussi Askola]

@RPearl Our Portfolio is up significantly y/y: seekingalpha.com/...

[Jussi Askola]

Hi,

Thanks for reading!

We just published our monthly portfolio review for members of High Yield Landlord. You can read a portion of it for free here: seekingalpha.com/...

Have a great day!

Jussi

[Chancer]

I care more about my personal experience than studies which are averages across the US.

We own a rented condo with paid off mortgage (because we purchased cheap in a down condo market). Our net income is 13.37% of the purchase price. The cash flow (adding back non-cash depreciation) returns 17.3%.

[Jussi Askola]

@Chancer Sure, but that is just one deal among many others. I could point you to some of our REIT investments that have doubled or tripled over the past year. That's not reflective of the average.

Average still matter because they show you which pond presents better opportunities.

[Whiskey for me, water for my horse]

The one big advantage owning residential real estate is leverage. You can control 100% of a property with only 20% or less of your own money. So if I put 20k down on a 100k house and it goes up 10% in value, I have a 50% gain on my investment. (10k gain vs 20k investment) Not to mention any positive cash flow you have, paying down the mortgage with each payment (which becomes significant as the years go by) and the tax advantages. The safest investment is in lower to moderate priced and sized homes in good areas. Regardless of the economy, people will always need a place to live. Regardless of all of this, you have to make sure your investment is cash flow positive. This philosophy worked well for me during the 2008 housing crisis as I was able keep my properties paying for themselves even with a decline in rental rates. But rental demand never waned. Just my experience.

[Jussi Askola]

@Whiskey for me, water for my horse REITs are also leveraged. That is a common misconception. When you invest in them, you are providing the equity, and REITs then add debt to it. You enjoy the benefits of leverage with no personal liability.
To give you an example: if a REIT has a 50% LTV, and you invest $1,000 in it, you effectively control $2,000 worth of real estate.
REITs have earned 15% per year on average over the past 20 years. You can only earn these returns if you add leverage, which REITs do.
Have a great day!

[Whiskey for me, water for my horse]

@Jussi Askola didn't know that. Thanks for the information.

[thebpr]

It's all in the buy. In general returns are higher by a few % points by owning rentals, however at great time an effort.. Had I purchased a large number of superior reits last March the cash flow would be similar or better and there would be no headaches, not including massive capital gains. I will take care to be more ready, the next go round.

[Jussi Askola]

@thebpr The research studies show the evidence. Rentals have lower returns.

[Jamjack]

In my opinion too, unless you have the time and are professional at real estate management as well as have lots of capital, go with a REIT. If you have talent knowledge and skill sets in this area of investing use that to pick good REITS. I do.

Good article!

[Jussi Askola]

@Jamjack Well said! Thank you for your comment. Feel free to join us for a 2-week free trial to access all our Top Picks: seekingalpha.com/...

Have a great day!

[Clarity_Fund]

In 2009 I started buying rental properties. I ended up with a 5M portfolio of homes, and I only invested 150k of my own money. After I put 20% down on the first 4 I understood I had to learn how to fund the down payments not using my personal funds to scale my rental home company. I learned to leverage the downs payments and rehabs with private lenders, seller financing, subject too's, lease options, and I became "financially free" in about 4 years. Now I am selling the properties and funding my Dividend portfolio, that is 70% REIT's and has a starting yield of ~7%, (holding steady during current decline) and also Bitcoin. The superior method would be to buy a rental property and then take the free cash flow to fund the DGI/Crypto. Now I have millions in equity and I am using HELOCS(relocs) to access that, along with all free cash flow, and it is all going into DGI/BTC. if I could do it all over again, I would have just started the DGI fund and not bought the houses. Owning the doors will create faster quicker wealth if you are an above average investor, but the equities add a lot of value with your time/risk/hassle factors of the property mgmt aspect, and I own a prop mgmt company. So, I think it is ok to own a few doors, as you can refi them over the years and dump that cash into that next new thing that will 10x your money. Strive for 3-5 different revenue streams that each one will fund your monthly expenses, ex; rentals, DGI, crypto in an interest bearing account like BlockFi, your day job, etc.

[Jussi Askola]

Sounds like it worked out very well for you. Congrats! Unfortunately, most rental investors don't ever reach this level of success. Buying in 2009 was great timing on your end.

[pete crayton]

I am not a "savvy" RE investor. 18 months ago I bought an $85K rundown single family house from a property wholesaler. I spent $40k on rehab and it rented immediately for $1400/mo. Taxes are $1300 and maintenance, given the scope of the renovation, is nil. My realtor estimates current market value @ $185K. Simultaneously I invested $100K in a diverse portfolio of SA recommended REITs. Currently they are not valued at what I paid and the dividend income does not come close to the rental income. What am I missing?

[monsterd]

@pete crayton you're one renter away that decides not to pay and you can't evict from it being a temporary horrible investment You get the strength in diversity + if you wanted to leverage a million dollars, would you be 8/8 all good deals? How long to get those 8 cashflowing? How much of your time does it take? If you see RE opportunities in other countries or outside of your cash ability , how would you invest? Pros and cons.

[Jussi Askola]

@pete crayton My experience and that of most investors is the opposite. My REITs have done far better than my private real estate investments.

I don't which REITs you picked, but your selection may be the reason why you did worse. Our Portfolio is trading higher than before the pandemic. Feel free to join us for a 2-week free trial to access all our Top Picks: seekingalpha.com/...

[pete crayton]

@monsterd Thanks for the consideration. I used one home as an example, but I own a total of 10 acquired in the past five years. The renovation does take time and significant physical effort (that's a good thing for a retiree) and I have had the nightmare tenant you envision. Overall I am experiencing an 8% ROI and best estimate the properties have appreciated, on average, 4% annually. All that said, I am not bullish on the concept but can not find an alternative. I started investing in REITs two years ago and blindly followed the suggestions found here on SA, a thousand dollars at a clip. I am not achieving anywhere near 8% and of course there has been no appreciation thanks to the Covid Crash. I want to quit being a landlord but I am loath to take the "pay cut". Thanks again for your thoughts.