An ongoing debate in the world of real estate is whether to invest in public or private real estate. We have written on this topic before, but it is time for an updated thesis because of the sharp contrast in opportunity between the modes of investment. Specifically, one is about 20% cheaper than the other right now.
We shall begin by looking at the mechanical differences in function between the investment vehicles, and follow by looking at where each stands today.
Definition of public versus private
For clarity, when I say public or exchange-traded REITs, I mean the ones that trade on the NASDAQ or NYSE that can be bought for free through a custodian. Something like a Prologis. When I refer to a private REIT or private equity real estate, I mean funds or other vehicles that are not traded on a major stock exchange.
Similarities and differences in property acquisitions
Both public and private essentially invest in the same pool of assets. They look at the overall universe of commercial real estate and select individual properties or portfolios of properties to buy. Any property that is available to be bought by a private equity vehicle is also available to be bought by public vehicles and vice versa.
Both public and private real estate investments will often try to sell investors on the exclusivity of their pipelines. For the most part, this is just salesmanship. Just about any property is available to whomever has the capital, and properties will overwhelmingly go to the entity willing to pay the most.
Differentiation in purchase comes from the selection process. Both public and private vehicles run the gambit from highly sophisticated selection criteria to buying whatever deals are marketed to them. Neither has a clear advantage over the other, so it comes down to case by case analysis of the skills of the team in charge of acquisitions.
One difference that does show up statistically is that publicly traded REITs tend to select higher quality assets by choosing almost exclusively from the top quartile of quality. This results in publicly traded REITs having higher occupancy across property types.
NAREIT
Publicly traded REITs are shown in dark blue above, while private real estate is estimated by the large asset base CoStar tracks in light blue.
The higher occupancy for public REITs holds true for all major property types, whether the asset in question is strong (industrial and retail) or weak (office).
I believe there are 2 reasons behind publicly traded REITs picking stronger assets than private equity real estate:
- Acquisitions among public REITs are announced, which results in increased scrutiny
- Public REITs generally have access to more capital, which allows them to buy more trophy level assets.
Private vehicles such as Blackstone’s (BX) BREIT, which have access to very large amounts of capital, likely look more like public REITs in terms of occupancy.
Overall, while there are slight differences in asset selection between public and private vehicles, it is more a case by case rather than being tied to the method of investment.
At the end of the day, both are investing in real estate and the results are going to be related to how well real estate performs.
Similarities and differences in performance
Performance of either type of vehicle will be the returns of its properties minus the costs. Since the properties are largely the same as discussed in the previous section, the main differences will be in the cost structures. There are multiple key costs to note:
- Property operating expense
- Interest expense
- Fees
- Listing and regulatory
Operating expense is largely going to be related to the type of property. Office and retail are a bit higher on capex, while industrial and self storage are lower capex. This would be true whether they are public or private. Capex as a percentage of revenues should decrease with size, as there are cost synergies in scale.
Interest expense varies company to company. Public REITs, in general, have lower cost of debt presently because they termed out their debt during the low interest rate environment of the past 5 years. Note on the chart below how as interest rates were lower, public REITs extended the weighted average duration of their debt to about 7.5 years, which has since fallen to 6.3 years.
NAREIT
At a 4.1% weighted average cost of debt, the interest expense of publicly traded REITs is actually well below that of Treasuries.
Debt signed today would be higher than treasuries of course as it conveys more risk than a U.S. treasury, but since the majority of REITs opportunistically termed out their balance sheets during the zero interest rate environment, they can still enjoy low interest expense for a while.
Private real estate cost of debt will vary greatly depending on the vintage of when the vehicle raised its capital. Funds that began in 2021 were likely able to lock in low-cost mortgages for the long term, while those raising capital today are probably looking at interest expense closer to 7%. This has clear implications for expected return, as spreads on funds raising capital today appear to be significantly lower.
Another aspect to consider regarding debt is whether it is fixed or floating. Exchange traded REITs overwhelmingly use fixed rate debt. The percentage of fixed has increased over time to approximately 91% today.
NAREIT
It is harder to find a similar statistic for private equity real estate, but it varies from entity to entity. It would be wise to check before investing. Given the interest rate environment, it is quite preferable to have a fixed rate that was locked in prior to the rise.
Real estate overall is performing okay. FFO is flat in 2024 compared to 2023 with significant variance by property type.
S&P Global Market Intelligence
FFO, of course, is inclusive of interest expense. Looking at EBITDA, the growth is stronger, with the average REIT coming in at 3.7% year over year.
S&P Global Market Intelligence
Thus, it would appear growth in revenue generation of the underlying properties is being offset by growth in interest expense.
The main difference in expenses between exchange traded REITs and private REITs is going to be in fees and listing expenses.
Fees and listing expenses
Private vehicles each have different fee structures, but there are 3 main fees:
- Flat percentage of invested capital
- Upfront cost/commission
- Backend performance fee
These can be quite substantial.
Exchange traded REITs have G&A expense along with regulatory expenses to keep up with compliance reporting of running a public company. These tend to be an absolute number of dollars, which means they are very burdensome for small companies but less relevant for large companies.
Which type of vehicle is more cost-effective depends on size.
Listing expenses are cost prohibitive for any company under $250 million. Canada’s regulatory burden is lower, so it can be viable to list on the Toronto exchange at closer to $100 million USD.
All else equal, for really small companies a private vehicle might be more cost-effective while for medium to larger companies exchange traded has lower overall fee/overhead burden.
Overall, large cap ($20B plus) exchange traded REITs offer the most cost-effective structure.
So with both public and private real estate offering similar assets, long-term returns are going to come down to cost structure differences discussed above and entry pricing.
Entry price
When investing in a private equity real estate vehicle, one is essentially buying properties at net asset value (NAV) plus upfront fees. As an example, if there is a 5% up front commission, one would be investing in real estate at 105% of NAV.
That is going to remain consistent over time with private vehicles. The price of the fund fluctuates with NAV, so when NAV goes down, new shares are cheaper and when NAV goes up, new shares are more expensive such that new investors consistently buy at NAV plus fees.
Exchange traded REITs are different in that one is not investing at NAV, but rather at market price.
As such, the relative opportunity in exchange traded versus private depends on whether market prices are above or below NAV.
Market prices are subject to the bull and bear forces of the market and consequently swing around much more erratically than asset values of hard properties.
Historically, there have been times when market prices were substantially above NAV. When REITs are hot in the market and trading at 115% of NAV, buying shares of the REIT would functionally be buying real estate at 115% of NAV.
At those times, the private vehicle is probably the better deal because you can still get at the same 105% of NAV.
Conversely, when the market sentiment is low on public REITs, it is possible to buy at significant discounts to NAV. This happens to be the case right now and is why I am writing this article.
Here is the P/NAV of the Dow Jones Equity REIT index over the past 3 years
S&P Global Market Intelligence
Back in 2021, the market prices of REITs were at about 110% of NAV. At that time, it may have been better to buy private so as to get in at just over NAV.
Today, the REIT index is at 89% of NAV. It makes absolutely no sense to buy private equity real estate today.
Why buy at 105% of NAV when the exchange traded REIT index is at 89% of NAV?
One can get an even greater discount by selecting individual publicly traded REITs. The index is overweight the more expensive valuation REITs. As of 4/22/24, the median exchange traded REIT is trading at 79.2% of asset value. Specific REITs can be bought at 50%-65% of NAV.
Simplicity obscured by marketing
The time to invest in public versus private REITs is quite simple.
- Public (exchange traded) is probably better than private when public REITs are trading below 105% of NAV
- private is likely better when public is above 105% of NAV.
Right now, public REITs are anywhere from 50% to 95% of NAV, depending on which ones you buy. It is simply leaving money on the table to invest in private equity real estate, with market prices where they are.
Unfortunately, the simplicity of this concept gets obscured by marketing. Exchange traded REITs are cheap right now because market prices are down while asset values are up.
The private REITs use this to demonstrate outperformance. They show prospective investors that public REITs are down and contrast it with their NAV being up a bit. They use this to claim outperformance and lure investors in.
Be warned that this is not real outperformance. It is comparing apples to oranges. It is comparing the whims of an erratic market price against the stability of real estate asset value.
If instead of using market price as a barometer, one looks at the asset value of the publicly traded REITs, it is clear that asset values have gone up moderately for both public and private.
The big difference here is that exchange traded REITs are on sale, while private equity still costs about 105% of NAV.
