It has been quite a year for those of us in the investment world — mostly fascinating, frequently challenging, and occasionally frustrating. The COVID-19 pandemic, and subsequent effects on markets and global economies, has been directly or indirectly responsible for much of this, accelerating areas ripe for change, causing societal shifts with rippling impacts in many ways, including on the value of real estate.
During the first half of 2020, amid the worst of the height of unknowns, many public markets traded with extreme variability. This was certainly true for public REITs; however, what followed was an opportunity that few were able to properly capitalize on. What caught my attention during this period were the conversations advisers were having around investing client capital, specifically in REITs and private or nontraded real estate vehicles.
When considering the use of nontraded or illiquid investment vehicles, there are plenty of considerations: suitability, structure, terms, economics, illiquidity premium, viability, sector exposures, geographic positioning, etc. But perhaps the single most important one is whether or not the investment is the most attractive option available for the client’s portfolio. For the purposes of this discussion, let’s not debate the performance of public versus nontraded REITs. We have all seen a number of studies on the matter, many of which sadly showcase survivorship bias, or do not take into consideration listing events and post-listing performance that investors are innately required to weather. We can generalize out to a simple statement that the best managers and sponsors will consistently outperform the less talented ones regardless of structure. Additionally, every sponsor or manager will tell you their portfolio is more recession/downturn resistant than their peers, and have a story or quip ready to emphasize that. We’ll work on the assumption that you, as an investor, can identify or access as talented a management team on the public side as on the nontraded side. In fact, many private fund managers have some sort of publicly traded vehicles already regardless. In those instances, this example tradeoff between public and private may be even more relevant, with something closer to an apples-to-apples comparison.
Illiquid vehicles have a number of valuable attributes. Low correlation to public markets, decreased volatility or pricing variance, consistent yield generation and performance are all legitimate factors. What’s important to focus on is that, far too often, it seems that point-in-time comparisons of public versus illiquid real estate opportunities are overlooked. And 2020 provided a nearly perfect example of just how disadvantageous such an omission can be for resulting performance.
Public REITs generally trade with far more variance than their illiquid counterparts, and for good reason. Public REITs are subject to the daily whims of market participants. They represent not just the value of the underlying assets, but also what investors are willing to pay for that exposure. This has both a positive and a negative result: Public REIT pricing can quickly adjust to appropriately factor in immediate events or changes in the environment, but emotional sentiment can also cause share pricing to deviate dramatically from underlying value.
So, we can extrapolate these deviations to revolve around some combination of two primary factors: predictive pricing and market sentiment. While there is no good way to dissect the degree to which each influenced pricing, it may not actually matter.
To us, deviations between public and private market real estate values are largely a function of whether public market sentiment accurately reflects underlying real estate values. However, during more volatile times, sentiment can overreact and misrepresent long-term value. In any case, it may not matter.
- If it turns out that a decline in public REIT price was largely a result of a change in underlying long-term real estate value, then you would expect that to carry over to illiquid real estate in the future. In this case, you would want to avoid the “overpriced” illiquid real estate that, because of the appraisal process, takes longer to reprice. You should either avoid investing in real estate altogether, or use liquid REITs in the interim until the illiquid real estate has naturally declined to values more in line with public comps.
- If it turns out that the decline in price was largely emotional and ripe with overreaction, then you would expect public REITs to present an attractive buying opportunity, especially in the short-run. Why buy real estate at NAV via illiquid vehicles when you can buy publicly traded REITs at discounts to NAV, and capture the benefit of that subsequent appreciation and bolster your return?
Regardless of the relative contribution of factors, either public REITs will recover, or illiquid REITs will decline, or some combination of both. A period of such dislocation is the exact type of situation where a good investor should consider the benefits of public vehicles on at least an interim basis.
In every economic cycle, there are periods of unexpected chaos that cause nearly all investments to trade down in value temporarily, regardless of their intrinsic value. During these times, demand for liquidity trumps all, and investors sell at a much greater volume than buyers can step in. This may have never been more evident than 2020 in the case of public REITs. So, just how significant was that opportunity in 2020? While the COVID-19 pandemic was relatively unique, the effect of market chaos on REIT pricing was not necessarily unprecedented.
For context, and as a supportive historical backing to this movement, let us look at the historical premium/discount to NAV of public REITs. Based on how you want to slice and dice the REIT market (U.S. versus global, equity versus debt, market capitalization hurdle or agnostic of size, etc.), there are various measures at any given time for what the average current premium or discount to NAV is. Thankfully, what remains relatively constant amid these metrics is the general extent and time frame of the movements. For example, we can use the below chart from Green Street’s North American All Property REIT premium/discount data measure.
Now, also consider the chart on page 44, FactSet’s U.S. REIT premium/discount data and the FTSE NAREIT Equity REITs Index.
In both charts there is the same noticeable takeaway — there are infrequent periods of time when publicly traded REITs trade at significant discounts to NAV, and they are almost always temporary before a mean reversion occurs.
Further, a crisis only exacerbates them. They provide very compelling entry points whenever dipping well below average. Using the FTSE NAREIT Equity REITs Index as a generic representation of publicly traded REITs, since 1996, whenever that discount was greater than 10 percent, the FTSE NAREIT Equity REITs Index was positive 33 of the 38 following 12-month periods. The average 12-month return for those 38 examples was just over 21 percent, nearly double the since-inception annual average of 10.9 percent.
How did this stack up in 2020? According to the Green Street data, in March of 2020, REITs traded between an intra-month high of 20.9 percent premium to a low of –20.8 percent discount. By the second week of April that discount had evaporated, had increased to a 16.5 percent premium by the end of the second quarter, and touched as high as a 30 percent premium in mid-October before closing the month at a 20 percent premium. That means by investing any time between March 11 and April 30 and holding through any point in October, you would have captured an excess return of anywhere from 5.6 percent to 51.7 percent just from the premium-discount reversion. To note, these metrics now equate to a scenario where it would likely be far more beneficial to utilize illiquid REITs (where you are buying at NAV) over liquid ones (trading at significant premiums to NAV). Or, if you rather, now selling the public REITs you bought so successfully earlier in the year, banking that substantial profit, and then turning to illiquid REITs with a much larger starting balance than if you had just gone straight into the illiquid REIT early in the year.
What would the reason be then, in this environment, to ignore or minimize the categorically higher performance expectations for the public REITs in favor of an illiquid vehicle? It’s a difficult case to make that the low correlations (which, notably, often self-correct and realign during more significant historical economic changes) or volatility (again, notably, an absence of price movement is certainly not proof of a lack of change in value of underlying real estate) trump it. Recall back in the financial crisis of 2008, real estate values were coming off all-time highs in 2007. Public markets crumbled, real estate prices plummeted, foreclosures ran rampant. Yet, for at least several quarters after that, many nontraded REITs showed little price decline, and were strongly promoted on the basis of this “non-correlation” and low volatility. Unfortunately, what typically followed was a lagging and eventually disastrous NAV declines for investors, even while many public securities were recovering. From an adviser perspective, this could very well be just the type of situation that several years down the road, regulators could bring up in client versus adviser cases of unsuitable investment decisions.
Yes, some of the assumptions here are oversimplified, for the sake of brevity or focus. The goal is to boil this down to the most straightforward comparative decisions and ramifications. This is also not about trying to time markets — the ability to move quickly and act nimbly with liquid markets can be advantageous, and it can also be dangerous. This is about understanding the environment around you, and accepting that while history does not repeat itself, it often rhymes. About having the wisdom to utilize historical observations, and in periods of dislocation, to act accordingly. And about employing that knowledge to put you, or your client, in the best situation to succeed. Finally, if you’re just not comfortable assessing this comparison on your own, there is no shortage of actively managed funds in structures that allow the portfolio management team to access both public and private securities.
There are times for using illiquid real estate, and times to utilize public real estate securities. Knowing which is appropriate at any time is what can separate successful investors from the pack. Remember, be greedy when others are fearful, and fearful when others are greedy. I believe some small-time investor out of Nebraska once said that.
Aaron Rosen is a portfolio manager and managing director at Validus Investment Advisors and a member of the Real Assets Adviser editorial advisory board.