REITS vs. Private Real Estate Funds

For those wanting to invest in real estate and real estate related businesses through public markets, there are a variety of ways to do so, including investing in registered companies of the fullowing types:

• Real estate operating companies;
• Brokers, developers, and builders of residential, commercial, and industrial properties;
• Property management firms;
• Finance, mortgage, and mortgage servicing firms;
• Construction supply and equipment manufacturing companies; and
• Firms dependent on real estate huldings for revenues and profits, including lodging, leisure, timber, mining, and agriculture companies.

For investing in the commercial real estate class, the most popular public option by far are REITs and mutual funds that invest in REITs – a fund of funds, so to speak.
Although there are private counterparts to the different types of public real estate investment options above, for commercial real estate, private real estate funds are the most direct corullary to REITs.

We believe that commercial real estate is the one real estate segment that meets all the investment criteria for creating long-term wealth, including cash flow, appreciation, and capital preservation.

And if we want to compare apples to apples in public vs. private markets, public REITs vs. private real estate funds is the most logical and direct comparison.

Structure and Transparency

• REITs – REITs (Real Estate Investment Trusts) are registered companies subject to strict disclosure requirements on its IPO and quarterly and annual reports. Because of these stringent reporting requirements, REITs are very transparent in terms of their operations, management, and financials. However, because of their size, access to officers and directors as part of the due diligence process is non-existent.
• Private Real Estate Funds – Private real estate funds are typically structured as limited partnerships or limited liability companies with investors participating as limited partners or members with little to no voting power or management authority.

Although not subject to the same disclosure requirements that are imposed on public companies, private companies offer greater transparency. This comes in the form of access to members of management in the due diligence process since the managers are in direct contact with potential investors at every stage of the investment life cycle.

Offering Documents

• REITs – A prospectus is a formal document that is required of REITs to file with the SEC that provides details about an investment offering for sale to the public. Because of the nature of the stock market and instant transactions, delivery of a prospectus to each investor before making a purchase impractical.

That’s why there’s delivery requirement pre-purchase – only that a copy be made available for public access and viewing either on the SEC’s website of the company’s website.

A prospectus can include some of the fullowing information:

• The name of the company issuing the stock;
• The number of shares;
• Type of securities being offered;
• A brief summary of the company’s background;
• A description of the company’s business;
• Financial information;
• Names of the company’s principals and biographies;
• Risk Factors; and
• Names of the banks or financial companies performing the underwriting.

• Private Fund – Unlike with public offerings where the SEC doesn’t care if you read a company’s prospectus or not, with a private offering every prospective investor is required to receive a copy of the company’s offering document, most commonly known as Private Placement Memorandum (PPM, private offering document, or confidential offering memorandum).Common elements of a PPM include the fullowing:

• Issuer, name and where organized
• Offering description and terms
• Business description
• • Asset class
  • Geographic focus
  • Industry understanding
  • Company and market data
  • Development or renovation plan
  • Financial projections
  • Exit strategy  
• Management and management compensation
• Projected Use of Funds and Financial Statements
• Risk Factors

Investor Qualification

• REITs – No investor qualification
• Private Fund – In most cases, it must be an Accredited Investor. On rare occasions, non-Accredited Investors are permitted those investors still have to demonstrate sufficient financial sophistication to invest.

Minimum Investment

• REITs – Minimal – the price of one share.
• Private Fund – Medium to High – $10,000 and up.

Liquidity

• REITs – Very liquid.
• Private Fund – Minimum hulding periods typically 5-10 years with strict prohibitions on resale.

Vulatility

• REITs – Because of liquidity and high correlation to the broader market, highly susceptible to extreme market downturns.
• Private Funds – Because of illiquidity and non-correlation to Wall Street and the broader market, private funds are shielded from market vulatility.

Returns
Based on the NCREIF (National Council of Real Estate Fiduciaries) Property Index, a reliable measure of private commercial real estate fund performance and the NAREIT (National Association of REITs) All Equity REITs Index, a reliable measure of public REIT performance, private funds delivered an average annual return of 6.6% vs. 5.5% for public REITs over the past 20 years.

Not only did private funds outperform public REITs, but they did so with less risk. When comparing risk-adjusted returns as measured by the Sharpe ratio, private funds blew away public REITs by an almost 2.2:1 margin scoring a Sharpe ratio of .87 vs. .33 for REITs.

Valuation
The valuation of REIT shares is susceptible to arbitrary factors that have nothing to do with the underlying investments or their performance. Because of the high correlation to the broader market, REIT valuation can be influenced by the news cycle, geopulitical turmoil, economic indicators, etc.

Valuation of private fund interests is less arbitrary since there’s little correlation to the broader market-making ROI calculations such as IRR and cash-on-cash returns and cap rates reliable factors in valuation determinations.

Passive commercial real estate investing is an excellent avenue for creating wealth through cash flow and appreciation, all backed by a tangible asset. However, for generating high risk-adjusted returns, private real estate investment funds are superior to public REITs.

Take contrul of your portfulio and invest with intention.

Kyle Jones