“Public REITs VS Private Real Estate Investing”
/By Brett P Holmes, Managing Partner
We sometimes get questions comparing our development projects to publicly traded Real Estate Investment Trusts (REITs): Why would I invest in private real estate if I already own REITs in my 401k? Is the REIT market a leading indicator for private real estate values? What should I consider when balancing my real estate exposure?
We wanted to weigh in on these questions and hopefully shed some light on what a REIT is and how it relates to and impacts private real estate investments. [Full disclosure: We manage and develop private real estate projects. We also own REITs.] This article is by no means intended as guidance or advice on neither what you should invest in nor how. Ultimately, we intend to offer some thoughts that may enable you to make more informed real estate portfolio decisions.
First of all, a REIT is a publicly traded real estate company that you can buy and sell like a stock. Most REITs specialize in a specific sector of real estate like industrial, apartments, office, hotels, single-family rentals, and even mortgages, cell towers, or data centers. REITs are subject to specific rules regarding reporting, asset ownership, and profit distributions, but broadly speaking they are real estate stocks. You probably even already own some in your 401k or brokerage accounts.
Investors love REITs because they enable diversification and targeted exposure to specific subsectors in the real estate industry. Plus, REITs are extremely liquid. If you want to invest in real estate, it’s definitely the easiest way to do it. With that being said, you should also know that REITs are enormous companies with hefty overhead and compliance considerations. REITs must provide quarterly earnings guidance and reports, just like stocks. Investors get “institutional-grade” returns (sounds great, right) which effectively means lower risk and more stabilized properties. Along with the more diversified exposure that you attain in a publicly traded REIT, you typically own “core” assets that generate lower returns for shareholders.
In contrast, private real estate investing allows accredited investors to invest directly in real estate on a very specific deal or fund strategy. Direct investments are actually partnerships with real estate sponsors to execute an investment plan. It’s like going into business together as a silent, or “limited”, partner. You provide the capital and the sponsor provides the skill, time, and effort to deliver financial outcomes. This type of investing usually entails greater risks and the prospects of higher returns. Investors are mostly “accredited” and must place scrutiny on every facet of a project -- from a developer’s pro forma assumptions to his/her integrity, track record, transparency, and strategy.
Many developers build to create value in order to sell to a REIT, known as “merchant building”. This is similar to how VC starts a company that is scaled by PE and finally sold to the public through an IPO. In real estate, there are land developers that prepare the site, then developers that build the asset, and finally public REITs (or private investors) that purchase the income stream. Needless to say, each link in the chain involves a different risk-return profile. REITs are frequently the really the big institutional investor that gobbles up the asset at the end of the line. For that reason, the highest returns are usually not with REITs. In other words, there is significant value creation taking place before REITs get involved that astute investors may consider investing in.
Another thing to consider between public and private investments is how each is priced and the relationship between them. REITs are traded publicly so the market decides the stock price based on supply and demand. Typically, a REIT’s value is compared to its Net Asset Value (NAV). Prices often trade at a discount, or less than the NAV. There are several factors influencing this disparity including control rights inherent in private real estate as well as fund flows toward riskier assets like the stock market. Sometimes the discount to NAV in REITs indicates that private assets are overpriced and there is a softening in the future while other times it’s an indication that REITs are underpriced relative to private real estate.
In a rapidly moving market like we have today, REITs are expected to overreact relative to private investments in real estate. The reason is simply related to the instantaneous pricing of publicly traded securities compared to the slower adjustments in the private market. Private investments take months or even years for changes in the investment’s value or broader market to be fully reflected.
Therefore, some people theorize that REITs are a leading indicator for private real estate because prices change daily to update the information that the market is pricing into real estate assets. Others believe that REITs trade too closely alongside the stock market and are influenced by market sentiment (or “noise”) that does not account for property fundamentals like NOI, cash flow, and cap rates.
There is truth to all of these vantage points. Overall, we think that REITs should be an important part of everyone’s investment portfolio. We like REITs because it’s a crucial stepping stone into more direct real estate investing. Understanding private investments in real estate is helpful toward better understanding of public investing, and vice versa. We hope that this article gives you something to consider when making your next real estate related investment. In the coming months, we’ll post another article highlighting specific single family rental REITs and how they relate to our development projects. Thanks for reading!
Brett P Holmes, Steel City Management LLC