Public REITs or Private Equity Real Estate? Strong Portfolios Need Both

Topic:  • By Michael Episcope • January 23, 2018 967 Views

REITs or Private Equity Real Estate? Strong Portfolios Need Both

Which is the better investment: publicly-traded real estate investment trusts (REITs) or private equity real estate? We get this question all the time, and it’s not an either-or decision. Real estate provides one of the best ways to build wealth long-term. A strong portfolio will have REITs for diversification and liquidity, and private equity real estate to counter stock market fluctuations and long-term appreciation.

REITs were an early innovation in this asset class — enabled by Congress in 1960 — and many more breakthroughs have joined them. Unlike C corporations, the legal structure that most companies choose to organize themselves to limit their owner’s legal and financial liabilities, REIT’s are exempt from taxation at the corporate level so long as they distribute 90% of their income to shareholders. The fact REITs turn rental income into “powerfully consistent and reliable dividends,” notes Forbes, and its unique taxation rate, helps explain why real estate became an important institutional investment.

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REIT ETFs Offer Even Broader Exposure

With the innovation of exchange-traded funds (ETFs) in the 90s came REIT ETFs, which offer broad exposure to commercial real estate’s stable, higher-yield returns. Recently, the JOBS Act of 2012  has made private equity real estate equity affordable at a lower minimum investment, giving individual investors an alternative to privately traded REITs and their high upfront fees. Now there are options to fit everyone’s needs, and it’s wrong to think any one investment vehicle is perfect for everyone.

Yet that’s an argument advanced by some supporters of REIT ETFs. One statement that caught my attention recently was from the robo-adviser Wealthfront. CEO Andy Rachleff argued that Vanguard’s REIT Index Fund outperformed the 5- and 10-year average of actively-managed real estate funds. Passive investors, he concluded, should buy index-tracking REIT ETFs and stay out of the private markets entirely.

That may be true on average. But the results of some private equity real estate funds make a good argument for choosing this investment if you find a better-than-average manager. Yale’s endowment, which produced a 12.1% return over the last 20 years and grew from $5.8 billion to $27.2 billion, followed this strategy. It couldn’t have reached those heights investing only in public securities. Yale’s Endowment CIO David Swensen advocates going to the lowest cost provider for public securities, and finding the best manager possible in the private sector.

Private Equity Real Estate Funds Can Deliver Better Alpha

A good manager can consistently deliver alpha. In some ways, the sheer size and scale of the Yale endowment makes it easier for Swensen to find and vet high-performing managers. But smaller managers can and do outperform larger managers. Data analysis shows that private equity fund returns tend to diminish with scale.

Why? Size alone explains a large portion of return performance because large managers are too big to buy direct. As a result, multiple layers of fees destroy returns. The top quartile $1 billion-plus manager will generally underperform the average $300 million fund manager. Blackstone is simply the best among the biggest. The good news is that individual investors now can access many of the smaller, higher-performing real estate fund managers.

Ultimately the size and efficiency of a crowdfunder like Fundrise — which also took exception to Rachleff’s argument — will win the performance game with a Goliath like Blackstone. Yet, most likely, neither option is the best in the market today for investors. Fundrise is not a fund manager, but rather a tech company that operates an online investment platform. Blackstone’s business model relies on scale and gathering assets rather than managing those assets themselves, which makes them more of a “manager of managers.” This is an inefficient investing strategy. A top-tier smaller real estate manager will be more nimble in finding opportunities and more focused on generating returns.

Private Real Estate is More Like A Hybrid Between Stocks & Bonds

In truth, multifamily and commercial real estate act more like a hybrid between stocks and bonds because the leases behave like stable bonds and the physical real estate appreciates over time as the property’s cash flow increases. For this reason, private equity real estate belongs in every portfolio because it has very little correlation to other asset classes. Having both public equities, including REITs, and private real estate will improve any portfolio, but only if investors do the research to identify a top-tier manager. Just look at Swensen’s latest returns again. Private real estate has been a big driver of his performance.

Posted By

Michael Episcope
Principal

Michael is principal of Origin, co-chairs the Investment Committee and oversees investor relations, marketing and company operations. Michael brings 25 years of investment and risk management experience to the company and believes that calculated risk-taking in inefficient markets is the key to building wealth.