Both the private and public markets offer access to real estate investment, but new research suggests that one may be more efficient than the other.
In a new study published in the journal Portfolio Management, authors Thomas Arnold, David Ling, and Andy Naranjo found that in a side-by-side comparison real estate investment funds surpassed the performance of private equity funds in the United States, or PERE, by 165 basis points per year.
The study was based on a sample of 375 PERE funds, which the researchers compared to an index of listed REITs and an index of private real estate funds. To accurately assess the results, the authors used a “leap” approach, comparing the realized return of each PERE fund with the return that index investors would have received over the same investment horizon.
“It’s an apples-to-apples comparison,” said Arnold, former head of real estate at the Abu Dhabi Investment Authority. “And on average, you’d be better off investing in public markets, and that will be significantly better.”
Globally, according to the study, REITs outperformed a sample of 255 international PERE funds by an average of 194 basis points.
And when public market risks such as risk, leverage, illiquidity and uncertainty were taken into account, REITs became even stronger. When the sample was adjusted for risk, the share of PERE funds that outperformed the REIT index fell by eight percentage points, while the share of less profitable funds rose by eight percentage points. As the risk increased, the authors found that the performance difference between the PERE return and the REIT index increased.
In this article, researchers recognized that public markets have advantages over private ones, including leverage and liquidity. In public markets, stock analysts act as deterrents for companies from over-leveraging. But, according to Arnold, this level of supervision does not exist in private markets. On average, closed-end private funds have higher leverage, which means they have more debt.
Liquidity is also an issue in private markets. While investors and managers can enter and exit deals as they see fit in the public markets, they have less flexibility when investing in private real estate funds.
“In open markets, you can call your broker and invest today if you want,” Arnold said. “And if you decide to sell in six months, you can sell it. You may not like the prices, but at least there is liquidity, which is not available in the private markets. “
Arnold noted that the results do not necessarily mean that private funds cannot outperform public funds. But he said limited partners should be more strategic about real estate distribution.
“If you had a crystal ball and could find a top quartile private fund manager, you would be very happy,” he said. “But if you take risks, you’re better off placing more on public markets.”
Going forward, Arnold said he expects investors to invest more real estate in the public markets. He also said that, in his opinion, investors will increasingly resist the current fee structure in the private sector.
“The environment has changed dramatically, but the pay structure is much the same as it was 25 years ago,” Arnold said. “It will change slowly, but I think investors will start to resist.”