Given the unprecedented flow of capital into real estate, many investors have been making inquiries into both public and private real estate investment trusts (REITs). Let's examine this complex question in depth, focusing more on the realities of the REITs themselves and the economics of a potential investment, and less on the differences that exist between the public and private sectors.
In early August, the public REIT market suffered a 7% decline over a three-day period, causing concern among investors that the gradual rise in interest rates was signaling an end to the current real estate boom. Despite the fact that 10-year Treasury notes are currently hovering at around 4%, market uncertainty over recent comments by the Federal Reserve indicating that rates might rise, is likely to continue.
Additionally, given the recent flurry of M&A activity among REITs, many industry experts have soberly predicted that the market has indeed peaked and that REIT values, along with real estate values in general, may start to decline.
Challenging the critics
With all due respect to these esteemed pundits, today's real estate fundamentals do not seem to indicate such a doom-and-gloom scenario. Instead, property fundamentals continue to approve across the board, the flow of capital into every real estate sector continues unabated and the competition for choice properties has never been fiercer.
What's more, the frantic pace of M&A activity seems to be a clear sign of the overall market's vitality rather than its impending demise. For example, ProLogis announced in June its impending acquisition of Catellus Development Corp. for $4.9 billion — a 16.1% premium over the price of Catellus shares at the time. In another recent transaction, ING Clarion Partners formed a private joint venture to purchase Gable Residential Trust, a public REIT, for a 14% premium over its then current share price.
This trend toward transactions at premium prices will most likely continue, with the demand and competition driven almost exclusively by the nature and quality of the underlying properties themselves, regardless of whether the REITs are public or private.
Public vs. private REITs
Private REITs have historically yielded dividends of 7% to 8%, compared with only 5% to 6% for public REITs. However, as a result of buying properties at record-low cap rates, the dividend yields of private REITs have been declining over the past 12 months. And with the share price of public REITs rising in excess of 20% per year over the last three years, the dividend yields of public REITs have also been proportionally declining.
As far as liquidity is concerned, because public REITs are traded on the major exchanges, investors can readily get in and out of these stocks effortlessly at a relatively cheap price. While private REITs are not subject to the daily fluctuations of the marketplace, the advantages of being able to enter and exit the marketplace in a public REIT as well as the potential for its stock to appreciate appear to outweigh the non-fluctuations of an investment in a private REIT.
Private REITs cost anywhere from 10% to 16% in upfront fees, and investor redemptions are generally permitted after two to three years from the date of the initial investment, if at all, and are usually offered at the par price of the offering or less. Management of the private REIT has the right to restrict investor redemptions. For example, due to an increase in investor redemption requests, Wells Real Estate Funds announced in August 2004 that it would not honor such requests unless it was the result of a shareholder's death.
Public REITs also must comply with the financial reporting and governance requirements under the Sarbanes-Oxley Act. They are also subject to quarterly financial reporting requirements which has led to more financial transparency.
Unlike their public counterparts, private REITs are required to do little in the way of disclosure other than the initial offering registration they are required to file with the Securities and Exchange Commission. Although it is decidedly more costly to comply with the required disclosures and SEC filings, most investors would probably agree that increased financial transparency and mandated governance requirements adds a significant amount of security, credibility and confidence to their investment.
As far as clients' questions regarding public vs. private REITs are concerned, we first work to determine their near and long-term real estate investment strategies. Once those goals are firmly established, we next examine the sectors, underlying property fundamentals and management of the REIT — whether public or private. After these issues are resolved, it truly is amazing how easy a final decision can be achieved.
WHAT TO LOOK FOR IN A REIT INVESTMENT
- Underlying economics of properties owned
- Depth, experience and expertise of management team
- The nature, geography and property types of the REIT
- The REIT's fit with your time horizon and overall portfolio needs
- Financial terms of the REIT — entry fees and exit strategy
Scott Farb, CPA, is managing principal in charge of the national real estate practice of Gumbiner Savett, Inc., an accounting firm in Southern California.