By LASRRY SWEDROE
As chief research officer for Buckingham Wealth Partners, I am often asked about the merits of investing in private (non-traded) real estate as an alternative to publicly available Real Estate Investment Trusts (REITs). Non-traded REITs are registered investment companies formed for the purpose of investing in real estate. Unlike traded REITs, non-traded REITs do not trade on an exchange.
To answer the question on the performance of non-traded REITS, as always, we look to the historical evidence. We begin our review with the study An Empirical Analysis of Non-Traded REITs, by Brian Henderson, Joshua Mallett and Craig McCann, published in the Summer 2016 issue of The Journal of Wealth Management.
The researchers began by noting: “Non-traded REITs have severely limited share redemption programs (SRPs) allowing investors to sell shares back to the trust. Non-traded REITs redeem shares for less than investors paid for them and limit repurchases to the amounts reinvested through DRPs . Non-traded REITs frequently change the rules to reduce the size of SRPs over time, generally reducing the fraction of DRP proceeds that may be used to redeem shares. These rules effectively prohibit investors from selling their shares prior to a listing or acquisition.”
They added: “The non-traded REITs’ prospectuses disclose additional conflicts of interest between shareholders and sponsor-affiliated advisors, including affiliated-party transactions in which the sponsors have direct financial interests and the possibility that advisors may have limited time to allocate to their role since they are permitted to pursue arrangements with competing REITs. In each of these conflicts, the financial interests of the sponsor and REIT management are the opposite of their shareholders’ interests.”
Their data sample covered 89 non-traded REITS and the period 2000-2015. Given their illiquidity, non-traded REITs should have higher returns than public REITS, which offer daily liquidity. Were investors rewarded for accepting illiquidity? Following is a summary of their findings:
Among the 89 sample non-traded REITs, 77 (86.5 percent) suffered shortfalls relative to the traded REIT benchmark (Vanguard’s REIT).
Non-traded REITs provided average annual returns of 4.0 percent versus 11.3 percent for Vanguard’s publicly traded REIT. The economic magnitude of the underperformance exceeded $44 billion.
A significant portion of non-traded REITs’ underperformance resulted from high upfront fees and expenses, which averaged 13.2 percent (range of 5.0-24.6 percent), that largely served to compensate brokers. Sales commissions averaged 6.7 percent of the investor’s capital and ranged from 1.5 percent to 8.0 percent. The balance was allocated among other fees (4.1 percent), such as property acquisition fees (2.2 percent) and reserve fees (0.2 percent). The fees accounted for approximately 58 percent of the return shortfalls.
The remainder of the underperformance was due to conflicts of interest that permeate the issuance and management of non-traded REITs. These conflicts include transactions with affiliated parties, such as the high fees paid to external advisors and property managers affiliated with the sponsor.
After non-traded REITS listed their shares, they significantly reduced expense ratios.
Mallett and McCann updated their analysis through 2019 (sample period 2000-19) in their study Further on the Returns to Non-Traded REITs, published in the Winter 2021 issue of
The Journal of Wealth Management. Their findings showed no improvement in performance:
The 140 non-traded REITs underperformed traded REITs by approximately 8 percentage points annually (5-6 percentage points annually before taking into account the 24.6 percent discount to net asset value observed in non-traded REIT auctions).
The aggregate underperformance was $75 billion as of December 31, 2019.
The underperformance did not decrease over time — non-traded REITs that broke escrow in 2015-2019 underperformed traded REITs to the same degree as earlier non-traded REITs.
Non-traded REITs’ aggregate underperformance was observed for capital raised in calendar quarter.
The best-performing non-traded REITs are merged into other REITs.
Their findings led Mallett and McCann to conclude: “Despite real estate risk and illiquidity,
aggregate non-traded REITs returns approximately equal returns to short term Treasury securities.”
Further evidence was provided by Cambridge Associates in their 2017 study. Cambridge Associates’ private investments database is an extensive collection of institutional-quality private fund performance. It contained historical performance records for more than 2,000 fund managers and more than 7,300 funds. In addition, it captured the gross performance information of more than 79,000 investments underlying venture capital, growth equity, buyout, subordinated capital and private equity energy funds.
Cambridge Associates’ database allows us to compare the performance of these institutional private real estate funds with the performance of publicly available REITs. For the 25-year period ending 2017, private funds in the database returned 7.6 percent, while the FTSE Nareit REIT All Equity Index returned 10.9 percent. For the privilege of investing with the greatest institutional managers, many of whom are not available to the general public, and in return for sacrificing the daily liquidity available with public REITs, the private, illiquid institutional investments underperformed by 3.3 percentage points a year for 25 years.
As bad as that sounds, the reality was actually far worse. The reason is that the private real estate investments used much higher amounts of leverage.
In a 2017 article, Comparing Listed REITs with Private Equity Real Estate: What the Cambridge Associates Data Have to Say, Brad Case, senior vice president at Nareit, showed that while private real estate investments were producing lower returns, they also were taking on much greater risk in the form of higher leverage.
Quoting Case: “The now-defunct NCREIF/Townsend Fund Indices reported that average leverage for the funds in its sample during the available period 2007Q4-2013 Q3 was usually between 51 percent and 56 percent for value-add funds and between 53 percent and 64 percent for opportunistic funds—but over the same period it was usually between only 36 percent and 47 percent for equity REITs. doesn’t report average leverage for the funds in their benchmark, but they do report that ‘in terms of limited partners’ total paid-in capital, the Real Estate benchmark is 70 percent Opportunistic and 30 percent Value-Added.’”
Thus, based on the information in the database, we can conclude not only that private real estate investments earned much lower returns but also that they did so while taking on much greater risk. Case offered the following analysis of the incremental risk taken by the private real estate investors:
41 percent leverage — the median value for the equity REIT industry during the 2007Q4-2013Q3 period—increased volatility by 69 percent.
54 percent leverage — the median reported by Townsend/NCREIF for value-added funds over the same period—increased volatility by 117 percent.
60 percent leverage — the median for opportunistic funds—increased volatility by 150 percent.
While institutional investors obviously believe they are able to identify managers who will deliver outperformance, the evidence is clear that they have not done so. Like many other investors, it appears they are guilty of overconfidence.
Case added: “There have been more than a dozen academic studies comparing the performance of listed and private equity real estate using different data sources, time periods, and methodologies, and all of them—every single one—has reached the same conclusion as Cambridge Associates: they all found better average performance on the REIT side, even after controlling for differences in the use of leverage, the mix of property types, and the geographic distribution of properties.”
Not only do publicly available REITs have the advantage of providing daily liquidity, but today investors can access the asset class at exceptionally low costs. For example, the Schwab U.S. REIT ETF (SCHH) has an expense ratio of just seven basis points.
A case for private real estate
While the evidence seems overwhelming against investing in private real estate in general, hope is provided by the small percentage of private REITs that have outperformed. A good example is the relatively new Blackstone Real Estate Income Trust (BREIT). From inception in January 2017 through October 2021, it outperformed Vanguard by 3 percentage points per annum (13.0 percent versus 10.0 percent) despite having a higher expense ratio (1.25 percent for the institutional I share class plus an incentive fee of 12.5 percent of the annual total return, subject to a 5 percent annual hurdle amount and a high-water mark). In addition, for taxable investors the structure of BREIT provides a significant improvement in tax efficiency, as most of the return is in the form of long-term capital gains instead of ordinary income, as is the case for public REITs. Explanations for the outperformance include:
There is a significant illiquidity premium for private vehicles.
While there is strong evidence of diseconomies of scale in equity investing, scale can be an advantage in real estate because there are economies of scale in management expenses, and most importantly, there is far less competition when bidding on multibillion dollar offerings than on multimillion dollar ones. In addition, as one of the largest owners, buyers, sellers and financiers of real estate, BREIT is able to execute with speed through complex situations where timeliness can be critical to the seller — BREIT is able to buy at lower prices.
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