Private real estate versus REITs – which performs best over the long term?

Real estate investment trusts (REITs) are listed and tradeable on the stock market meaning transactions are usually instantaneous. For private real estate, this is not the case. As such, there is a perception that investors should earn excess returns over the public market for allocating to an illiquid asset, the so-called “illiquidity premium”.

Schroder’s 30-year return forecasts have already estimated returns of private real estate (see here), so it was a natural progression to build upon these forecasts to include REITs. We have found that the reality of returns between the listed and unlisted segments is more complicated than the above perception would have investors believe.

How does private real estate performance differ from REITs over the long-term, and why?

UK experience – marching to a similar tune

In the UK, the industry standard for measuring private real estate is the MSCI/IPD (Investment Property Databank) property index. Looking at the difference between the returns of this benchmark and the listed sector, using a REITs index produced by Refinitiv Datastream, they have both delivered similar returns over the last 50 years (table 1).

Over a shorter timeframe, the past five years, private real estate has outperformed REITs, mainly because REITs have suffered losses during years when equities have sold off (such as 2016 and 2018).

However, it is important to highlight that the MSCI/ IPD property index measures performance gross of leverage, fees and taxes, which overstates the returns an investor would achieve.

The Association of Real Estate Funds (AREF)/ IPD property index - which takes accounts of these costs - is a better benchmark to assess the actual returns from investing in private real estate. Looking at that index shows that UK REITs have delivered a slightly positive excess return over the AREF benchmark during the last 20 and 30 years.

In the US, REITs have been the performance leader

The outperformance of REITs versus private real estate returns is clearer in the US. A comparison of US REITs and the private sector shows that listed property has outperformed over the long run (table 2). Moreover, the excess return delivered by REITs is likely to be understated, as the NCREIF property index is again gross of fees.

Why have REITs outperformed?

One argument for the return of private real estate lagging the listed sector in the long run has been the ability of REITs to take advantage of gearing (or leverage) in their capital structures. For US REITs, there is no restriction on the amount of gearing, with debt taken on by US REITs kept in check by the bond-rating agencies.¹

In comparison, REITs in the UK follow a minimum interest coverage ratio (a measure of a firm's ability to make interest payments). In the aftermath of the Global Financial Crisis (GFC), debt ratios in the US have fallen to around 40% from the highs of 60% in 2008.² Debt has also fallen in the UK, where gearing ratios have declined from around 50% pre-GFC to 25 to 30% now.

Does the higher gearing explain the outperformance? Not quite. Several academic studies have found that investments in US private real estate have produced lower average returns than REITs, even after controlling for differences in leverage.³ In particular, passive portfolios of unlevered core REITs have outperformed their private counterparts by 0.5% per annum from 1994 to 2012.

This is because in addition to higher gearing, REITs have also tended to invest in higher risk assets. In general, REITs have undertaken more development and refurbishment projects than private real estate funds and they also have a higher exposure to niche sectors (e.g. doctor’s surgeries, laboratories, and self-storage), where liquidity is lower than in the mainstream sectors. By comparison, private real estate funds are more focused on “core” income producing assets, which have tenants in place and where the future income stream is relatively predictable.

Where next?

Judging by history, investing in private real estates does not deliver a premium over REITs in the long run. For the US in particular, REITs have provided investors with a clearer higher excess return over the unlisted market. Although there is no guarantee that history will repeat itself, especially for the next 30 years, there is a compelling case for our long-term return forecasts for REITs to be higher compared to the private property sector. However, it is important to highlight that the risk profiles of the two investment types are not the same. Investors in private real estate may not get a return premium, but they are taking on lower risk compared to their listed counterpart. Looking ahead, we will be providing an update to our 30-year return forecasts incorporating REITs, so please watch out for it in January 2021. 

Thanks for thoughts and comments from Mark Callender, Head of Real Estate Research

^{1. Real Estate Investment Trusts: The US Experience and Lessons for the UK, Investment Property Forum, May 2009↩}

^{2. Source: www.reit.com and “Leverage and returns: A cross-country analysis of public real estate markets”, David C. Ling, Andy Naranjo, and Emanuela Giacomini, University of Florida, October 2013.↩}

^{3.“Returns and Information Transmission Dynamics in Public and Private Real Estate Markets”, David C. Ling and Andy Naranjo, American Real Estate and Urban Economics Association, 2015.↩}