By Mike Kirby

More than 20 years ago, I bet my career on what I continue to believe to be a self-evident truth: publicly traded REITs provide the highest and best ownership vehicle for investment-grade real estate. Since then, REITs have witnessed an explosion in market capitalization from less than $5 billion to more than $300 billion. Even better, the growth in quality may have outpaced its growth in size.

Most impressively, the REIT vehicle has proven to be very rewarding to investors—per FTSE NAREIT, the 20-year total return on equity REITs has been more than 12 percent per year. During this stretch, REITs have typically traded at material premiums to NAV, and a large body of evidence has accumulated to suggest that REITs truly are a superior vehicle.

However, despite what previously looked to be unstoppable growth, hardly a month now goes by when we don't hear news of at least one credible REIT opting to leave the public space via a privatization transaction. In many instances, these privatizations result in the departure of the existing management team, destruction or downsizing of the business "platform" and large-scale sales of properties. This has occurred despite the fact that a number of the departing companies have been pretty good at their businesses.

Simultaneously, REITs are sponsoring joint ventures, a business which can be very lucrative, at a rapid clip, with much of the money flowing from institutional capital sources. The inflow of this joint venture capital raises a fundamental question of why institutions don't take the more obvious (and, I believe, more profitable) path of investing directly in the REITs they are hiring.

The explanation for these strange goings-on is buried in the mysterious labyrinths of the defined benefit pension plan world. Whereas pension funds previously had treated real estate as the Rodney Dangerfield of asset classes, pension capital of epic proportions is now queued to find a home in the real estate world before it is too late. The flood of capital flowing to real estate from this one source is having a profound impact on the traditional relationship between public and private pricing, and it explains why real estate has been valued more dearly on Main Street than on Wall Street through most of 2006.

Pension funds typically fill real estate allocations by putting the vast majority of their dollars to work in direct investments, i.e. non-public funds that own real estate. Public REITs typically capture only a small percentage of the overall allocation. These allocations are justified by highly suspect arguments about lower volatility, better diversification benefits, lower administrative costs, etc. for direct investments. There is little reason to think the allocations will change in the near future, because the Rube Goldberg-designed decision-making process is fraught with potential conflicts that favor heavier allocations to the direct side. Regardless of the merits, rigid allocation rules can result in pricing distortions, and capital is currently flooding into the private market.

Eventually, REIT valuations will revert to their long-term norm—i.e. premiums to NAV—because capital markets are very good at self correction (privatizations are a key mechanism in this process). However, as long as pension fund capital continues to provide a disproportionately large share of total inflows to real estate, expect to witness further privatization activity.