The illiquidity premium has failed in private real estate

The illiquidity premium has failed in private real estate

Investors allocate to private equity with the expectation of achieving superior returns relative to public market investments. This approach has generally paid off in corporate private equity, with return premiums having compensated investors for the risk of illiquidity. 

However, the same cannot be said for real estate private equity. In the modern REIT era, since the early 1990s, the average private real estate manager has not delivered an illiquidity premium over full market cycles. In fact, private has often fallen short of listed real estate market returns. 

Investors allocating to private real estate have had some opportunities to generate an illiquidity premium through the selection of managers, strategies and vintages. However, as the business cycle matures and the stockpile of dry powder held by private real estate funds grows, these choices are likely to become even more consequential. Accordingly, investors should consider the ways in which REITs can complement real estate portfolios. 

Below, we outline six compelling benefits of allocating to REITs.

Performance incentives

Both listed and private real estate vehicles generally seek to create alignment of interests between managers and investors through performance incentives. However, there are key differences in how incentives are structured. REIT management teams tend to have significant equity ownership stakes and receive performance-based incentive compensation tied to specific objectives - such as earnings growth, shareholder returns and management of the firm's risk profile. This aligns financial rewards with investor interests.

For private real estate funds, business models are generally focused on buying assets, creating a tug of war between performance incentives and management fees based on invested assets. Increasingly, private funds are structured such that fees do not accrue until capital is invested, which can create a sense of urgency to put capital to work, even if at a lower rate of return.

Accessing capital

REITs have access to both public and private sources of equity and debt capital. This capital can generally be raised faster and often at a lower cost than in the private market. During the financial crisis, REITs were able to raise significant capital through common stock issuance, corporate debt and convertible offerings. Although the capital was expensive, it allowed REITs to strengthen balance sheets, address debt maturities and reduce leverage. By contrast, many private real estate owners were unable to recapitalise, prompting some to issue capital calls in an unfavourable market.

Private real estate managers tend to deploy higher levels of leverage with shorter maturities in an attempt to enhance returns by driving down the cost of capital. For listed REITs, leverage is largely governed by what investors believe is an acceptable range for the company - usually 30-40% of total assets. While higher leverage has the potential to benefit investors in rising markets, it also increases downside risk by increasing the volatility of real estate values.

Diversification benefits 

Some allocators have favoured private markets for exposure to non-core real estate sectors. However, as the REIT market has evolved, a diverse set of sectors has emerged - including cell towers, data centres, manufactured housing and self-storage - often represented by companies with dominant market positions. About half of the FTSE Nareit All Equity REITs Index now consists of these non-traditional sectors, providing access to strong secular growth themes. 

Some of these sectors are positioned to deliver higher long-term growth than many core property types, while also helping diversify real estate allocation. Moreover, within a portfolio of 20-40 securities, investors have the ability to participate in the cash flows and equity values of thousands of underlying properties and leases owned by the REITs.

Cash flow predictability

By law, REITs are required to pay out close to the entirety of taxable net income in the form of dividends to shareholders - a large portion of which is typically considered return of capital due to depreciation. Historically, reinvested distributions have accounted for 56% of the total return profile of REITs over the long term. 

The cash flows driving these distributions tend to be more predictable than real estate appreciation, helping to mitigate risk associated with property cycles. By contrast, opportunistic and value-add real estate strategies may not pay out any distributions. Also, returns tend to be more back-end loaded when the assets are sold.

Manager selection risk

Although private real estate fund managers have not delivered an illiquidity premium consistently, the success of top performing managers seems to have given many institutional investors sufficient confidence of achieving excess returns. However, this assumes investors have access to a steady stream of top managers and that they will be able to select top performers over a full cycle. 

In certain vintage years, the spread between top and bottom performing value-add and opportunistic funds has been massive. Some have produced relatively consistent results across private real estate funds, while others have seen a return difference as wide as 1500bps between top and bottom quartile managers. Manager selection is also a factor when allocating to REITs. However, the return differences between REIT managers over time has historically been narrower than for private real estate.

Capital deployment

Record fundraising activity by private real estate managers in recent years has raised concerns about the ability to put cash to work. Even as managers cast a wider net in search of opportunities, increasing competition and lower return expectations in the private market have resulted in a bottleneck of capital. In some cases, private fund managers have had to ask clients for extensions, or use other means to deploy capital. The increase in REIT privatisations in recent years reflects an environment where more private investors are seeing relative value in the listed market.

While different institutions may have varying sensitivities to the J-curve, it may be a consideration for some, and potentially more relevant in an increasingly crowded private market. By comparison, even the largest listed real estate mandates can typically be invested in a matter of days, with no material impact on market prices.

Jon Cheigh, head of global real estate and senior portfolio manager at Cohen & Steers