Bailard Research Are Publicly-Traded REITs Real Estate or Stocks? It Depends on Your Investment Horizon (And Who Wins: Public or Private Real Estate?) Ronald W. Kaiser, CRE Henry S. Newhall Bailard, Inc., November 03 PUBLIC REITs WIN? REIT pundits are currently declaring publicly-traded REIT managers the clear winner over those that manage private real estate funds for institutional investors. In doing so, they argue that NCREIF s publication of the National Fund Index - Open-end, Diversified, Core Equity (NFI-ODCE) now allows analysts to compare the performance of roughly similar public and private real estate portfolios in terms of property mix and leverage over a long-term period (data since 977). The results are shown in Figure on the next page. At first glance, public continued on page
FIGURE Public vs. Private Real Estate: Who Wins? NAREIT vs. NFI-ODCE (978 9/30/3) 8 FIGURE Public vs. Private Real Estate: A Fairer Look at Who Wins NAREIT vs. NFI-ODCE (993 9/30/3) 8 64 Total Cumulative Return (978=) 3 6 8 4 Total Cumulative Return (993=) 4 NAREIT NFI ODCE* NAREIT NFI ODCE* *Lagged 4 quarters Sources: NAREIT, NCREIF *Lagged 4 quarters Sources: NAREIT, NCREIF real estate (as measured by the NAREIT index), appears to win. In Figure, note that the NFI-ODCE data are shown with a four-quarter lag to the NAREIT data, as it is generally accepted that public REIT prices tend to look ahead to future property market returns thereby acknowledging the existence of the same forward-looking principle that applies to public stock market prices in general. SKEWED DATA GIVES MISLEADING RESULTS It does not take very much digging to find that Figure is a misleading picture. In particular, the starting date of the analysis leads to a result that is greatly biased in favor of public REITs: The /3/77 starting date provided an unusually low entry point for REIT investors. During the 970s and 980s, the NAREIT universe was so small (ranging from $.5 billion in total market capitalization in 977 to $9 billion by 99), that generally only private individuals invested in REITs. As a result, REITs regularly traded at stock market values of 0% to 40% below their underlying estimated property values. Institutional investors were not players until the REIT IPO boom in the early 990s led to enough market capacity to allow institutions to trade. The resulting Modern REIT Era is generally accepted to have begun in 993. If we wait until /3/9 to start the performance comparison, things look a lot different, as shown in Figure. In addition, the ending date of the analysis may also be somewhat biased in favor of public REITs. Given low interest rates and healthy appreciation, the recent environment has been favorable for more highly levered vehicles and, as mentioned below, public REITs tend to carry more leverage than ODCE funds. While difficult to quantify, this at least partially explains why the recovery in public REIT share prices have outpaced ODCE since the trough. The NFI-ODCE, short for NCREIF Fund Index - Open End Diversified Core Equity, is the first of the NCREIF Fund Database products and is an index of investment returns reporting on both a historical and current basis the results of 3 open-end commingled funds pursuing a core investment strategy, some of which have performance histories dating back to the 970s. The NFI-ODCE Index is capitalization-weighted and is reported gross of fees. Measurement is time-weighted. NCREIF will calculate the overall aggregated Index return. The NAREIT, short for FTSE NAREIT All Equity REITs Index, is calculated by FTSE International Limited ( FTSE ). The All Equity REITs Index consists of 0 publicly-traded REITs. Total returns reflect reinvestment of dividends. NOBODY WINS Given the above, over the long run, both methods of real estate investing appear to give roughly similar returns. While it is tempting to draw firm conclusions from the analysis above, the two portfolios of property are different enough to prevent precise comparisons. 03
First, the average leverage in public REITs (as measured by NAREIT) has ranged from 30% to 50% since 99, while the leverage in the NFI-ODCE has run from 0% to 35%. This would indicate that REITs should have outperformed due to their higher leverage. FIGURE 3 Property Type Weights as of 9/30/3 NFI-ODCE NAREIT Industrial 5.% 6.4% Office 36.7%.6% Retail 8.% 8.4% Residential 5.% 5.% Diversified* 0.0% 0.% Lodging/Resorts.% 7.0% Health Care 0.0% 3.4% Self Storage.9% 6.9% Land or Other 0.8% 0.0% Sources: NAREIT, NCREIF *For NAREIT, the Diversified category represents REITs investing in multiple property types. In addition, the property type mix is probably a larger, and unknown, source of deviations in returns. As shown in Figure 3, at 9/30/3, public REITs had substantially less in office buildings than did the NFI- ODCE. Office was the worst performing and most volatile property type in the unleveraged NCREIF Property Index since 99, while retail (the highest weighted property type in the NAREIT Equity REIT index as of 9/30/3) performed very well on a relative basis. However, we know the mix had varied, as NAREIT had a very large office holding in Equity Office Properties that went private in early 007. In 003, Joe Pagliari published an extensive analysis of public vs. private real estate returns in which he found no appreciable differences in performance when he adjusted for the varying mixes of property types and varying leverage. FIGURE 4 Public REIT vs. Small Cap Stocks Cumulative Quarterly Returns (978 9/30/3) Total Cumulative Return (979=) 8 64 3 6 8 4 Sources: NAREIT, Russell NAREIT RUSSELL 000 cap stocks, as represented by the Russell 000 index (dividends reinvested), since 979. Something very similar is going on in these two universes! Thus, it appears that the answer to what influences REIT returns? remains the same as in the 00 Bailard white paper, Public REITs vs. Private Real Estate: Assessing Your Options, it depends on your time horizon. Some investors think of five years as long term. Over this term, the quarterly return correlation calculations in Figure 5 show that the NAREIT index is more heavily influenced by the same factors that influence small cap stocks (a 59% correlation) than by what is going on in private real estate. Even though we have lagged the NFI-ODCE data by four quarters to account for the forward-looking nature of stock market prices, there is still only a 38% to 40% correlation with NAREIT. Ten-year data show the same findings. FIGURE 5 Are REITs Real Estate or Stocks? WHAT REALLY INFLUENCES PUBLIC REIT PRICES? Before we calculate some answers to that question, consider the chart in Figure 4 that shows the cumulative quarterly returns for both NAREIT and small NAREIT Index - 5-Year Periods NAREIT Index - 0-Year Periods REAL ESTATE STOCKS Correlation with NFI-ODCE* Correlation with Russell 000 977-0 99-0 978-0.40.38.59.53 N/A.6 Pagliari, J., K. Scherer and R. Monopli, Public vs. Private Real Estate Equities, The Journal of Portfolio Management Special Real Estate Issue, Sept. 003 *Lagged 4 quarters Sources: NAREIT, NCREIF, Russell 03 3
It turns out that 0 years is a more appropriate long term investment horizon in order for the property market influences to roughly equate to those from small cap stocks both at about a 60% correlation since the inception of the modern REIT era in the early 990s. THE STARTING POINT MATTERS A LOT FOR INVESTOR RETURNS IN PUBLIC REITS Just as we saw earlier in the enhanced public REIT returns from the undervalued starting point in 978, the starting and ending valuations relative to underlying property net asset value is an important driver of return variations. A number of analysts FIGURE 6 All REIT Premium/Discount to NAV 40% 30% 0% 0% 0% -0% -0% //03 3.4% have developed methods for evaluating such relative values, but one firm, Greenstreet Advisors, has a very long data set going back to the beginning of 990, as shown in Figure 6. In Figure 7 below, we segment all the calendar quarterly return data into seven initial valuation categories ranging from +5% overvalued to -0%. Looking at the calculated returns to both NAREIT and NFI-ODCE for the subsequent 0 quarters, we find the following: When public REITs traded at more than a 0% discount to NAV, they substantially outperformed private real estate; When public REITs traded at more than a 0% premium to NAV, they significantly underperformed private real estate; and When public REITs traded within +/-0% of NAV, they have tended to moderately outperform private real estate, which is as one would expect given the greater leverage in REITs. Where are we today? As of //3, Greenstreet s All- REIT premium to NAV is +3.4% not a particularly strong signal one way or the other. -30% -40% -50% Source: Greenstreet Advisors Premium / Discount to NAV Long Term Avg (3.%) FIGURE 7 The Starting Point Matters for Public REIT Returns 990-9/30/3 PUBLIC REIT PREMIUM / DISCOUNT TO NAV # QUARTERS OBSERVED AVERAGE TOTAL RETURN FOR NEXT FIVE YEARS NAREIT (Public) NFI-ODCE (Private) Difference Greater than: 5.00% 3.9% 0.3% 6.3% 0.00% to: 5.00% 7 9.6% 0.99%.73% 5.00% to: 0.00% 0.59% 8.95% -.65% 0.00% to: 5.00% 4 9.56% 7.44% -.3% -5.00% to: 0.00% 8.00% 9.7% -.83% -0.00% to: -5.00% 4.46% 5.% -9.34% -35.00% to: -0.00% 4.70%.89% -.80% CURRENT: 3.4% as of //3 Sources: Greenstreet Advisors, NAREIT, NCREIF 4 03
CONCLUSIONS FOR PROSPECTIVE INVESTORS IN PUBLIC REITs The conclusions from Bailard s 00 paper remain valid. In addition to the two standard investment policy recommendations from that paper ) REIT portfolios should be diversified; and ) investors should be prepared to stay the course and not be scared into selling during bear market sell-offs the other two findings remain quite compelling: If the markets continue to follow historical patterns, long-term investors (0-year horizons) in public REITs can reasonably expect to achieve returns roughly equivalent to those from similarly leveraged private real estate portfolios. Shorter term (five years), a portfolio of REITs is more likely to perform in line with small cap stocks than with real estate. If you acquire public REITs when they are trading more than 0% above their underlying estimated property net asset value, you are likely to underperform private real estate. But, if you time your purchases for periods when REITs are valued about equal to or less than their NAV, there is a good chance of outperforming private real estate. Thus, investors who wish to fill a real estate mandate should consider focusing on direct property investing, not public REITs, if they want to capture the historic long-term return/risk characteristics of real estate as an asset class. 03 5
RISKS All investments have risks, including the risk of loss. Publicly-traded REITs have risks, including market risk and the significant risks associated with their underlying real estate investments. Private real estate risks include illiquidity, changes in supply and demand, and inexact valuation. There is no guarantee any investment strategy will be successful. DISCLOSURE This white paper has been distributed for informational purposes only and is not a recommendation of, or an offer to sell or solicitation of an offer to buy, any particular security, strategy or investment product. This white paper does not take into account the particular investment objectives, financial situations, or needs of individual clients. Charts and performance information portrayed in this article are not indicative of the past or future performance of any Bailard strategy, account or product. Past performance is no indication of future results. This white paper contains the current opinions of the author and such opinions are subject to change without notice. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. Bailard cannot provide investment advice in any state or jurisdiction in which it is not registered or exempt from registration. Published November 03 For more information, please call 800.BAILARD (800.4.573) or visit www.bailard.com. Bailard, Inc. 950 Tower Lane, Suite 900 Foster City, California 94404 6 03