Commentary: Winning the horse race — new insights into public and private real estate investment

Over the past five years, institutional participation in the real estate asset class has grown significantly, with alternatives reporting firm Preqin highlighting more than 7,600 institutions with real estate allocations in 2020, an increase of more than 30%.

One of the fastest-growing styles of real estate investment is the closed-end private equity real estate fund, which offers investors easier implementation of investment strategies than direct investment in properties and, in the perception of many investors, higher returns than investment in listed real estate securities due to the illiquidity premium believed to be a characteristic of non-traded investments.

However, we provide evidence in our recently completed research that may prompt investors to take a fresh look at the validity of the illiquidity premium. The research compares the performance of private equity real estate funds to listed real estate investment trusts and was sponsored by Nareit.

Earlier academic research also has explored this issue. However, unlike those earlier studies, most of which compared the performance of private market benchmarks to the performance of REIT indexes over specific time frames, our research uses a "horse race" methodology to match the actual internal rates of return of individual private funds with investments focused in the U.S. against the return of the FTSE EPRA/Nareit U.S. Net Total Return index over each private fund's investment horizon.

Our study includes the results of 375 horse races between specific closed-end private equity real estate funds and the REIT index over various periods of time between 2000 and 2014. Fund returns vary over different periods, and this methodology allows us to better understand the distribution of fund returns over time — something a single private market benchmark composed of an unknown mixture of funds of different vintages does not do. It gives us a clearer picture of whether private equity real estate funds or REITs outperformed during our sample period.

Compiling the basic data from all of the horse races, we found that REITs outpaced private equity real estate funds in 53% of the head-to-head comparisons and outperformed the average private equity fund performance by 165 basis points.

We believe there are other factors to consider, though, in establishing a meaningful comparison of the relative performance of private equity real estate funds and REITs. Relative to REITs, the typical private equity real estate fund is significantly less liquid, uses more financial leverage and requires limited-partner investors to retain liquid assets as dry powder for future capital calls.

All of these factors imply additional risks and costs for the investor, and we adjusted our findings to include conservative benchmarking adjustments to account for differences in leverage, illiquidity and cost-of-waiting on commitments to be called. In comparing the risk-adjusted private fund internal rates of return to the REIT index returns, we found REITs won 68% of the horse races and outperformed the average of fund IRRs by 590 basis points.

On the basis of our research, for funds that came to market between 2000 and 2014, listed REITs bettered the performance of closed-end private equity real estate funds on a risk-adjusted basis in 7 out of 10 head-to-head matchups, indicating there is no basis for assuming that the typical private fund provided an illiquidity premium.

The results also indicate that pension funds, endowments and sovereign wealth funds might benefit from reevaluating the way they structure their real estate allocations. The current paradigm for most institutional investors is to make private real estate, and, increasingly, closed-end private equity real estate funds, the bulk of their real estate allocation, while REITs are used in tactical applications. Our research points to the benefits of reversing that paradigm and giving REITs a larger allocation in the real estate portfolio to gain the benefits of their superior performance, plus their liquidity, lower leverage and transparency. Private real estate could be used more effectively in tactical allocations to maximize its strengths, such as providing exposure to specific geographical locations or other desired exposures less accessible through the public market.

State-of-the-art approaches to real estate investing require an effective combination of both private real estate and REITs.

Thomas R. Arnold is the former global head of real estate of the $702 billion Abu Dhabi Investment Authority and is currently a visiting scholar in the Eugene F. Brigham Finance, Insurance and Real Estate Department, Warrington College of Business, at the University of Florida in Gainesville. David C. Ling is the McGurn professor of real estate, and Andy Naranjo is the John B. Hall professor of finance and chairman in the same department. This content represents the views of the authors. It was submitted and edited under P&I guidelines but is not a product of P&I's editorial team.