By Matthew Bechard
Portfolio sat down with Joseph L. Pagliari, Jr., co-author of “Public v. Private Real Estate Equities: A Risk-Return Comparison” (Journal of Portfolio Management), to get his take on the relationship between public and private real estate investments. Pagliari is a clinical assistant professor and the associate director of the real estate program at the Kellogg School of Management, Northwestern University.
Portfolio: Based on data from the NAREIT Equity REIT Index and the National Council of Real Estate Investment Fiduciaries (NCREIF) Property Index, public real estate returns are approximately 500 basis points higher than private equities over the last 20 years or so. It is also true that the volatility of public real estate equities is about 875 basis points per year greater than their private counterparts. How do you think plan sponsors and other institutional investors interpret these differences?
Pagliari: I think most institutional investors view these numbers with a fair amount of skepticism—since this comparison fails to control for a number of important differences between these two indices.
In my paper (co-authored with Kevin Scherer and Rich Monopoli), we attempt to control for some of these differences—as it relates to property-type mix, leverage and appraisal smoothing.
Investors are concerned with a number of other factors that we did not address (typically because the empirical data was not available), including: geographical differences in the two indices; REIT management is often engaged in efforts to increase “franchise” value whereas this is typically not the case with private real estate; REITs often have a number of development (and other value-added) deals whereas the NCREIF Property Index (NPI) consists solely of stabilized deals; and effects of the stock market on observed REIT volatility.
Portfolio: Because of the differences in the return characteristics to the two performance benchmarks, do you think investors tend to overestimate or underestimate the volatility of real estate returns?
Pagliari: A great deal has been said and written about private real estate’s “true” volatility. At this point, most investors and researchers believe that the volatility of the (primarily) appraisal-based NPI return series is understated, due to what is generally referred to as “appraisal smoothing” (i.e., the tendency for such returns to display dampened volatility, to lag the public-market return series, and to exhibit high serial correlation). I believe that institutional investors and their consultants have done a very good job of increasing—often on an ad hoc basis—the observed volatility of the NPI return series.
Portfolio: Your research concluded that it is not the investment vehicle itself—public securities or private equities—that plays the key role in reported performance differences, but rather the individual characteristics of the NAREIT and NCREIF performance benchmarks. What did you conclude are the most important characteristics that help to account for the observed differences in the levels and volatilities of returns?
Pagliari: In the long run, the legal entity used to hold the real estate makes very little difference. We showed that, once you control for the differences in property types and leverage, the long-run return differences vanish from a statistical point of view. However, this might state the case too bluntly.
We found that the 500 basis point differential in returns decreases to 300 basis points once you control for property type and leverage differences—with this difference averaging just 60 basis points during the “modern REIT era” since 1992.
Once you control for the differences in property types, leverage and appraisal smoothing, the long-run volatility differences also vanish from a statistical point of view. As with returns, the nuances of the adjustments seem compelling. We observed that de-levering the NAREIT series by removing the effects of financial leverage reduced the volatility of this series by approximately 550 basis points per year, which reduced REIT volatility by about 40 percent. My experience is that most investors and their consultants underestimate the tremendous impact that leverage has on volatility.
Portfolio: You mentioned before the need to control for differences among property types. Are different property sectors perceived to have appreciably different investment risks?
Pagliari: While we did not report our results by property type in this particular paper, other research clearly indicates that this is the case. For example, just among the stabilized, core property types (apartments, industrial, office and retail), there is considerable variation in risk/return characteristics. To wit, suburban office has had among the lowest returns coupled with among the highest volatility, while apartments have among the highest returns coupled with the lowest volatility.
These historical characteristics speak to the importance of controlling for the differences in the two indices’ property-type allocations. While NAREIT had been an index dominated primarily by retail properties (once the non-core properties are removed), the NCREIF Property Index had been primarily dominated by office properties. So, any empirical comparison would be obscured by the performance difference of the underlying property types if one doesn’t control for these differences.
Portfolio: For many years, plan sponsors were limited to direct real estate investment programs when implementing their real estate allocations. However, today they can choose between direct real estate investments and publicly traded real estate stocks. How do you think plan sponsors compare these two investment alternatives today?
Pagliari: One of the aspects of institutional investing is that there seems to be a fairly significant “clientele” effect whereby the large pension (endowment and union) funds invest primarily in private (or direct) real estate equities, while the smaller funds often invest in public real estate.
For example, there are 10 pension funds that have among the 25 largest commitments to private real estate and also have among the 25 largest commitments to public real estate. If you examine their real estate allocations, you’ll see that their private-market allocations dominate their public-market allocations by a ratio of approximately 6:1. So, my co-authors and I concluded that the big pension funds are pricing something other than just the risk/return characteristics of the underlying real estate assets.
The issues that may be valued by the large pension investors might include: liquidity, governance, transparency, control, executive compensation, etc. However, it’s the large pension funds that can typically drive the best bargains with the advisory firms—forcing them to be competitive with the characteristics offered by the REITs. The ability of the large investors to move back and forth between the public and private markets—admittedly, not without significant costs—has a disciplining effect (on the management of both public and private real estate firms) that is good for all investors.
Portfolio: What advice would you give to an individual investor weighing the option of investing in private vs. public real estate?
Pagliari: For the lion’s share of individual investors, public real estate is certainly the preferable investment vehicle. For most of us, the exposure to the idiosyncratic risks (i.e., non-market risks which otherwise can be diversified away) of holding a concentrated real estate portfolio (because we simply lack enough wealth to be able to create a well-diversified private real estate portfolio) is imprudent.
There are two other investment possibilities besides public real estate that can also avoid this idiosyncratic risk: First, a number of the large advisory firms (i.e., those institutionally oriented investment managers who contribute to the NCREIF Property Index) are starting to open up their commingled investment products to individual investors. As they rectify the problems of heretofore-infrequent valuations, these products may become more of a competitive threat to REITs in the future.
Second, private (non-institutional) investment vehicles oriented toward individual investors are gaining significant momentum. In part because of the heavy upfront fees and costs charged by many of these funds, their structure is reminiscent of the old syndication days (prior to the Tax Reform Act of 1986). Then as now, the fear is that some of the sponsors/promoters of these vehicles are more adept at money-raising activities than identifying and managing real estate investments. If so, the concern is that their lack of investment discipline will adversely influence the real estate market’s overall risk/return characteristics. Of course, it remains to be seen whether or not this comes to pass.
