“If I had a world of my own, everything would be nonsense. Nothing would be what it is, because everything would be what it isn't.”
- The Mad Hatter
The setting for Lewis Carroll’s classic Alice through the Looking Glass is a fanciful alternative world where everything, including logic, is distorted. Comparing the recent returns and valuations of public and private real estate, we may be living in a similar fantasy.
Nearby is a chart illustrating investment returns over the past calendar year (2022). Equities were down -18%, bonds were down -13% and public real estate was down nearly -25%. Yet private real estate was up nearly +7% over the same period?
Identical but Different
Private and public real estate own similar, if not identical assets, yet their return divergence exceeded 3100 basis points (bps) over this short period. Does private real estate have better assets, management teams, debt terms, higher yields, or perhaps some unknown characteristic that drives superior returns? In short, we would argue “no.” In fact, over a multi-decade investment horizon, public real estate has outperformed private real estate by 286 bps per year.
The key difference is in the approach to valuation. Public real estate is traded on exchanges, where its price is established by actual transactions. Participants on public exchanges seek price discovery, and at any time the price of a security is the equilibrium market clearing value between buyers and sellers. No looking glass here.
In contrast, private real estate is valued by periodic appraisals that generally occur once per year. Appraisals are, at best, educated guesses as they are driven by transaction activity that can be stale by a year or more – and their subsequent returns are the “nonsense” so coveted by the Mad Hatter.
To be clear, investors in private real estate are not immune to the market and economic forces that are expressed daily in public markets. The impact on the value of real estate assets from trends such as work-from-home (office buildings) or online shopping (malls and shopping centers) does not discriminate between private and public ownership.
Pernicious Risks
Appraisal-based private real estate returns are generally “smoothed” – meaning volatility and asset correlations are dampened – which can significantly overstate diversification benefits and lead to misallocations when using asset allocation approaches such as mean-variance optimization.
Of particular significance for investors in 2022 was the so-called “denominator effect.” While bonds and equities experienced historic drawdowns, private real estate was positive, with the end result that investors were appreciably over-allocated to real estate at close of 2022. Private real estate is highly illiquid, and investors face considerable challenges as they rebalance asset allocations back to desired levels, often through forced selling at substantial discounts. Sound familiar to recent market headlines?
Asset Allocation Approach
We believe that both private and public real estate have investment merit – each can provide income, growth and diversification benefits for portfolios. It just requires the proper investment “lens” – and wariness of valuation approaches.
An allocation of both private and public real estate may provide investors more flexibility to position and rebalance portfolios as well as less distorted and timelier market information regarding the economic and market forces affecting real estate.
Important Disclosures & Definitions
Basis Point (bps): a unit that is equal to 1/100th of 1% and is used to denote the change in a financial instrument.
Bloomberg US Aggregate Bond Index - A broad-based benchmark that measures the investment grade, US dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, fixed-rate agency MBS, ABS and CMBS (agency and non-agency).
FTSE NAREIT All Equity REITs Index - Tracks the performance of US equity REITs both an industry-wide level and on a sector-by-sector basis.
NCREIF (National Council of Real Estate Investment Fiduciaries) Property Index – Measures the performance of private real estate investments based on periodic appraisals.
S&P 500 Index - Widely regarded as the best single gauge of large-cap US equities. The index includes 500 leading companies and covers approximately 80% of available market capitalization.
Performance data quoted represents past performance. Past performance is no guarantee of future results; current performance may be higher or lower than performance quoted.
One may not invest directly in an index.
AAI000237 6/30/2024
