Isn’t it all just real estate?
Yes, REITs own commercial real estate. Yes, private real estate owns commercial real estate. But from there, their respective roles in a portfolio depart.
Do public and private REITs offer different return profiles?
Since their shared inception in 1978, the public REIT market index has outperformed core private real estate. However, over the last 35 calendar years, private real estate delivered a more consistent return, of between 5% and 20%, more than 80% of the time. While there were negative years, the dispersion of returns was narrow and skewed positive.1
Public REITs may outperform, but they are more apt to present a portfolio drag, particularly when equities are declining. Public REITs can be a useful leading indicator for private real estate, with a positive correlation to private real estate price movements on approximately a two-quarter lag. The key difference is that corresponding price changes in private real estate are typically a fraction of that of public REITs. For example, between 2007 and 2010, public REITs fell approximately 50% vs private real estate at 25%.2
What drives the volatility of public REITs?
Public REIT share prices may fluctuate significantly from the appraised net asset values (NAVs) of their properties. This is partially because prices of public REITs move based on investor perception of value. This trend is less prevalent with private real estate pricing because the market is less liquid.
The direction of movement is important for portfolio construction. Public REITs have a higher beta to the S&P 500 Index, meaning these REITs and equities move closely together. This is less helpful if one is looking to hedge equity risk. Public REITs have 3x the volatility of their private counterparts.3
Many portfolios require this level of volatility and return potential. In fact, public REITs can serve a meaningful role when portfolios are shifted into risk-on mode or when their share prices trade at significant discounts to NAV. But this volatility could be unwelcome for those looking to preserve and grow capital while generating income. The tradeoff for shielding portfolios from market volatility is liquidity.
Private real estate price changes are typically a fraction of that of public REITs.
How can upside/ downside capture aid portfolio construction?
Public REITs have had strong upside capture of the S&P 500 Index over the past 15 years. For example, if the S&P 500 Index rose 10%, public REITs increased 9.4%. On the flip side, when the S&P 500 Index fell 10%, public REITs fell 11%.4
Private real estate upside capture of 30% is muted in comparison, but it has a negative downside capture. That means that when the S&P 500 Index has posted negative returns, private real estate has been the bulwark, posting positive returns on average. An asymmetric upside/downside capture is desirable because it has more upside and even less downside.
Are valuations causing the difference?
The two biggest differences between public REITs and private real estate are the valuation and therefore the pricing mechanism. Private real estate values are informed solely by actual real estate transactions, rather than the noise of exchange activity. Public REITs are also valued through observed transactions, but they are traded on stock exchanges where prices fluctuate significantly and often. Public REITs offer meaningful transparency through required reporting. When selecting a private manager, it is important to note how regimented and regular its valuation process is (ideally 100% of its portfolio over a quarter).
What about taxes and income?
Both public REITs and private real estate pay out a large portion of their income in the form of dividends. Dividend distributions are allocated as ordinary income, capital gains and return of capital, each of which may be taxed at a different rate. The tax rate may be lower when there is a capital gains distribution or a return of capital distribution. When a lower ordinary income tax rate is combined with the lower tax on a return of capital distribution, the effective federal tax rate may be reduced considerably. These are important elements to assess since the tax benefits of public REITs and private real estate can deviate depending on the source of the dividend distribution.
What about the investment strategies underlying the vehicles?
Other differences can be attributed to strategic positioning. For example, private real estate strategies typically include leverage (commonly measured through loan-to-value). Given the tighter interest rate environment, the extent to which borrowings are fixed versus floating rate matters.
Additionally, one must consider property sector differences. Public REIT strategies tend to be more heavily weighted to alternative sectors such as cell towers, data centers and self-storage. Additionally, there are regional allocation differences, whereby traditional office public REITs are heavily weighted toward gateway cities vs. private real estate that has shifted exposures to Sun Belt markets in the U.S.
Is it one or the other — or both?
Real estate is indeed real estate, and the various ways to access it have portfolio implications. We contend diversified portfolios should contain strategic allocations to both public REITs and private real estate. Public REITs may diversify equity returns and provide a source of incremental return within one’s equity allocation. And private real estate may deliver a dependable source of income with less fluctuation in price movement and serve more of a fixed income role. The sacrifice is the liquidity, but in our portfolio consulting efforts we find clients overestimate the level of liquidity truly needed.
1 Data source: Morningstar, calendar year returns from 1996 to 2021. Representative indexes: REITs: FTSE NAREIT All Equity REITs Index; U.S. equities: S&P 500 Index; private real estate: NCREIF Fund ODCE Index.
2 Data source: Morningstar, 01 Jan 2007 to 31 Dec 2010. Representative indexes: REITs: FTSE NAREIT All Equity REITs Index; private real estate: NCREIF Fund ODCE Index.
3 Data source: Bloomberg, L.P., 1995 to 2022. Representative indexes: REITs: FTSE NAREIT All Equity REITs Index; private real estate: NCREIF Fund ODCE Index.
4 Data source: Bloomberg, L.P., 30 Sept 2022. Representative indexes: U.S. REITs: FTSE NAREIT All Equity REITS Total Return Index; private real estate: NCREIF Fund Index Open End Diversified Core (ODCE).
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