Mind the Gap

Mind the GapThe question is a common one for many institutions – For the real estate allocation, should we use publicly traded REITs or private real estate?  The usual answer is to mix them.  Yet recent research highlighted by Institutional Investor magazine notes that public “REITs have beaten private funds by almost 5 percent a year over the past three decades.”  For the 30 years ended December 31, 2011, listed REITs returned 11.95 percent annually while private funds returned 6.97 percent. 

That’s a huge performance gap. Reality CheckPlenty of other research supports this conclusion (see here, here and here, for example).  These findings may not be entirely dispositive, but it’s pretty powerful stuff.  Yet institutional investors don’t seem to be swayed in that they “still keep about 80 percent of their real estate allocations in illiquid private real estate funds.” Why they do so is a fascinating question.

These investors are giving up a lot to invest privately.  They are not getting any illiquidity premium whatsoever (typically thought to be about 3 percent annually) and they are giving up roughly 5 percent in annual return (which, on a risk-adjusted basis ought perhaps to be reduced by about 100 basis points due to additional leverage employed by listed REITs).  What are these investors getting in exchange for this huge annual performance gap? 

Primarily, they are getting less volatility, or at least less perceived volatility.Real Estate returns2  Public REITs are constantly being repriced by the markets.  But because private funds price far less often (typically quarterly), they feel significantly less volatile.  “It’s short-termism, but this group of investors should be thinking solely about the long-term,” argues Michael Kirby, Chairman of the REIT research firm Green Street Advisors. Yet some consultants still argue that public REITs should not be part of a portfolio’s real estate allocation, but instead part of the equity allocation because of their correlation to equities, especially in times of crisis.  The basic argument is that institutional investors should own real estate both publicly and privately, with publicly owned real estate providing liquidity and privately owned real estate providing return stability and diversification.  As summarized by TIAA-CREF, “REITs are essentially real estate. But, for investors, the differences should not be ignored because they have a real impact on returns and risk.”

But this perception cannot be entirely correct.  Buildings don’t care whether their ownership is public or private and their value is not dependent upon who owns them.  Moreover, there is no evidence that there is any significant difference in management quality among private and public ownership.Real estate correlations  Thus the only ugliness taken on by moving away from private real estate to listed REITs is short-term volatility (the research is clear “that public ownership provides the same long-term return patterns as private ownership, with the enhanced advantages of exploiting temporary mispricings and liquidity”). 

Thus “[p]rivate core real estate ownership for many institutions is a narcotic that creates the ‘comfortably numb’ illusion of non-volatility in a harsh and demanding mark-to-market world. It is one of the few remaining assets where you can pretend that your assets have not changed in price, even when they have.”  The bottom line seems to be that institutions are locking in a very significant annual performance gap because they don’t like the feeling they get when there is a market downturn.  That might make sense if we were looking at individual investors who are particularly loss averse (because losses make cowards of us all, personally).  But for institutions?  Mind the gap indeed.

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