Commercial real estate is a big draw for investors for two main reasons – cash flow and appreciation.
When it comes to cash flow, in the public sector, income is distributed in the form of dividends with commercial real estate REITs representing the vast majority of dividend-paying stocks.
In the private sector where the majority of private commercial real estate funds are organized as limited partnerships (LPs) or limited liability companies (LLCs), income flows to the investors in the form of partner or member distributions.
When it comes to appreciation, investors in public REITs are entirely dependent on the rise in the stock price of the REIT, which oftentimes has nothing to do with the value of the underlying assets.
In the private sector, investors benefit from the appreciation of the underlying asset from profit distributions resulting from the sale of such assets.
Unlike in the public sector where a stock’s price can be batted about by broader market volatility and external factors such as the news, social media, and herd mentality, appreciation in the private sector relies almost entirely on the market value of the real asset and is largely shielded from market volatility.
To say 2020 has been tumultuous from a financial and social standpoint would be a huge understatement.
With the stock market in bear territory and the economy officially in recession, 2020 has exposed the market for the volatile beast that it is. Market volatility has also exposed the significant risk of public REITs and the difference between private and public commercial real estate investing.
Investors are drawn to REITs because of the 90% rule. The 90% rule says that by law, REITs are required to distribute 90% of annual taxable income.
But here’s the dirty laundry that the volatile 2020 market has aired about REITs:
If there’s no income, there are no dividends and because most REITs are invested in commercial real estate sectors that are highly correlated to the broader market like retail and office, not only does income suffer but REIT stock prices are even more vulnerable to market downturns than the average stock. The proof is in the data.
On the dividend front, some of the largest retail REITs including Retail Properties of America, Acadia Realty and Kimco have all announced they’re suspending dividend payments.
As for stock price, during the Great Recession, REITs underperformed the Dow by a wide margin.
In 2007, for example, the iShares Dow Jones US Real Estate ETF (IYR) dropped 20.35% followed by another 40.03% the following year. The total drop of more than 60% far exceeded the 50% drop in the Dow.
In 2020, REIT performance has mirrored that of the Great Recession. Over the first four months of the year, the average REIT has dropped a staggering 27.61% vs. 16% for the Dow.
In a downturn, not only does it not pay to be invested in the stock market, but it’s even worse to be invested in REITs where income is suspended and appreciation takes a nosedive.
Even in good times, REITs are nothing to write home about.
According to an article on MarketWatch last year, which reviewed the past 12-month returns of 32 real estate dividend stocks – all but one being REITs – the average dividend yield among all the 32 companies was 2.99%. 2.99% barely outpaces inflation in a good year. There are ways to achieve better yields without Wall Street volatility.
The ultra-wealthy and institutions like university endowments have long preferred the private sector compared to the public sector for investing in commercial real estate. They gravitate towards private equity and private real estate syndications for higher risk-adjusted returns over REITs.
Private equity and private syndications are peas in the same pod. The only difference is a private equity fund is an open real estate fund that can invest in a variety of properties; whereas syndications are typically formed to invest in one particular property.
The ultra-wealthy routinely allocate 25% or more to real estate because private real estate offers high risk-adjusted returns with capital appreciation uncorrelated to Wall Street.
So while investors in public REITs see their portfolios vanish in a puff of smoke as stock prices tank with herd-induced selloffs, the underlying value of the private real estate investor’s portfolio stands firm with income continuing to flow.
The numbers back up private real estate’s advantages:
Based on the NCREIF (National Council of Real Estate Fiduciaries) Property Index, a reliable measure of private commercial real estate performance and the NAREIT (National Association of REITs) All Equity REITs Index, a reliable measure of public REIT performance, private real estate delivered an average annual inflation-adjusted return of 6.6% vs. 5.5% for public REITs over the past 20 years.
A deeper dive into the numbers will reveal something amazing:
Public REITs are all large public companies with billions in assets on the books, so the 5.5% figure is a fair representation of all REITs.
On the other hand, the 6.6% figure is not a fair representation of all private real estate funds as that number is highly diluted by big hitters like Blackstone, Lone Star Funds, and Brookfield Asset Management with tens of billions in assets under management each. Blackstone had $115.3 billion in real estate assets under management in 2017.
Here’s a little known secret: These private real estate giants aren’t providing the highest returns to investors among all private real estate funds.
That’s because these large companies only deal in Class A core properties in the coastal markets where cap rates are driven down by competition – domestic and foreign. With so much capital under management, these companies have no choice but to stick to big deals in big markets.
Smaller private funds are providing higher returns for their investors. That’s because they tend to focus on value-add and opportunistic properties that allow them to leverage management expertise and personal market knowledge to minimize risk and generate outsized returns. The numbers back this up.
Based on Prequin ROI data for private equity real estate funds between 2005 and 2015, the average net internal rate of return for funds with at least $1 billion in assets was 5.7%. For real estate equity funds at $200 million or less, net IRR was 11.2%.
The average annual return of 6.6% for private funds vs. 5.5% for REITs make private funds a no-brainer – especially considering private real estate is less volatile.
For measuring volatility, the Sharpe ratio is a reliable measure and when comparing risk-adjusted returns as measured by the Sharpe ratio, private funds blew away public REITs by an almost 2.2:1 margin scoring a Sharpe ratio of .87 vs. .33 for REITs.
Looking at 6.6% vs. 5.5% is great. In the current year, 6.6% vs. -27.61% looks even better. But compared to reality where most private real estate investors look to smaller private funds with $200 million assets or less, the gap is even wider. That’s because the small to midsize funds focus on value-add and opportunistic properties that nearly double the annual returns for their investors vs. larger funds.
How does 11.2% compare to -27.61% now?
Even giving REITs the benefit of the doubt in a good year, how does 11.2% compare to 5.5%?
No wonder when it comes to investing, the private sector is a no-brainer compared to the public options.