Just like the title asks: Which is better? Private equity-owned real estate OR publicly traded REITs? Well surprisingly, the answer is BOTH. Yes, that is right, both are needed by strong portfolios. There really is the better deal in this case as they can give similar yet varying results, and oftentimes they work very well together. To learn more, keep on reading.
Publicly listed real estate investment trusts (REITs) or real estate owned by private equity—what makes the better investment? It is a frequently asked issue, and there is no wrong answer. One of the best methods to accumulate money over the long term is through real estate. A well-rounded portfolio will include private equity real estate for long-term growth and to balance stock market swings and REITs for liquidity and diversification.
Congress permitted REITs, one of the first innovations in this asset class, in 1960. Since then, numerous more innovations have followed. Contrary to C corporations, which most businesses use to protect their owners’ legal and financial obligations, REITs are immune from corporate income tax as long as they transfer 90% of their profits to shareholders. According to Forbes, the fact that REITs convert rental revenue into “powerfully steady and predictable dividends,” as well as their unique taxation structure, explains why real estate has become an essential institutional investment.
REIT ETFs Provide Additional Exposure
Exchange-traded funds (ETFs), which were developed in the 1990s, gave rise to REIT ETFs, which provide wide exposure to the reliable, higher-yield returns of commercial real estate. Private equity real estate equity has recently been more accessible to individual investors because of the JOBS Act of 2012, which lowered the required minimum investment and provided an alternative to privately listed REITs and their exorbitant upfront costs. There are now choices to suit everyone’s requirements, therefore it would be incorrect to assume that any one investment vehicle would be the ideal choice for everyone.
However, some proponents of REIT ETFs make that claim. Recently, a comment made by the Robo-adviser Wealthfront attracted my attention. According to CEO Andy Rachleff, Vanguard’s REIT Index Fund has beaten actively managed real estate funds over the past five and ten years on average. He concluded that passive investors should avoid the private markets totally and instead purchase index-tracking REIT ETFs.
On average, that might be accurate. However, if you locate a manager that performs above average, the performance of some real estate private equity funds provides a strong case for picking this investment. This approach was used to grow Yale’s endowment, which saw a 12.1% return over the past 20 years and increased from $5.8 billion to $27.2 billion. Only investment in public securities would have prevented it from achieving those heights. David Swensen, CIO of Yale’s Endowment, advises purchasing public shares from the company with the lowest costs and hiring the best manager you can find in the private sector.
Real Estate Funds Managed by Private Equity Can Produce Higher Alpha
A competent manager continually produces alpha. It may be simpler for Swensen to identify and evaluate high-performing managers given the size and scope of the Yale endowment. But there are cases where smaller managers do better than bigger managers. According to data research, the returns on private equity funds tend to decrease with scale.
Why? Since big managers are too large to buy directly, a significant amount of return performance can be explained by size alone. Therefore, additional layers of fees obliterate returns. Generally speaking, the top quartile manager managing $1 billion or more will do worse than the typical manager managing $300 million. Simply said, Blackstone is the finest of the largest. The good news is that a lot of the more efficient, smaller real estate fund managers are now available to regular investors.
Comparable to a hybrid of stocks and bonds, private real estate
The fact is that multifamily and commercial real estate behaves more like a combination of stocks and bonds since the leases operate like reliable bonds and the actual real estate appreciates over time as the property’s cash flow rises. Because of its low connection to other asset classes, private equity real estate is a necessary component of any portfolio. A portfolio will perform better if it includes both public stocks, including REITs, and private real estate, but only if investors take the time to choose top management. Take one more look at Swensen’s most recent returns. His success has been greatly influenced by private real estate.
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