Publicly traded real estate investment trusts continue to trade at much lower valuations compared to private ones. But beyond their relative prices, there are other reasons to favor public REITs, according to Janus Henderson Investors.
“This idea that public REITs are trading at much lower valuations to their private counterparts’ reported values has been written about extensively and is now accepted wisdom,” Janus Henderson portfolio managers wrote in a note Thursday.
However, the “relative valuation gap between public and private real estate is not the most important reason to invest in public REITs today,” they said.
Janus Henderson’s global property equities team prefers public REITs for two reasons.
It wasn’t hard to make money investing in real estate since the global financial crisis. Low interest rates made cheap financing readily available, fueling a rise in property values. But that’s not the case anymore.
“In a world where money is no longer ‘free,’ real estate fundamentals and operating acumen will be the primary driver of real estate returns. In this regard, we think public REITs have a meaningful advantage over their private counterparts,” the portfolio managers said.
During the decade leading up to the COVID-19 pandemic, private real estate vehicles leaned heavily on debt to operate and that won’t continue during the coming decade. “Some might even argue that the performance of certain private real estate funds was more about financial engineering than real estate fundamentals over this time frame,” the managers said.
Meanwhile, public REITs were reducing balance sheet debt during the same period. It was a headwind to their cash flows but U.S. public REITs still outperformed their private counterparts by around 2 percent annually, Janus Henderson found. The asset manager said the outperformance was attributable to “superior real estate fundamentals.”
Public REITs have exposure to more diverse and favorable types of property. In addition to retail, industrial, and apartments that most private REITs are invested in, public REITs are primarily invested in non-traditional property types like cell towers, data centers, self storage, senior housing, and single-family rentals. Public REITs are also big investors in single-tenant, net-lease real estate — commercial property lease agreements in which a tenant agrees to pay both rent and the property taxes.
Janus Hendrson also argues that public REITs have stronger operating platforms, which are costly, complex, and difficult to assemble, but best suited for the investments they make as well as a publicly traded company.
“For investors who agree with our view that the next decade of real estate returns will not be driven by cheap debt, but instead by the cash flow growth of underlying properties, public REITs can be a great place to be,” the portfolio managers said.
The second reason the global property equities team likes public REITs over private ones is because they believe the best properties find the strongest owners, which they defined as those with the best access to money and the lowest cost of capital. Public REITs have access to capital that private funds don’t have right now.
In a low interest rate environment, when debt is cheap, pricey properties are more obtainable. But many properties financed in the 2010s with high loan-to-value ratios will need to be refinanced and when that happens, their cash flows will decline or be eliminated entirely.
Private REITs, Janus Henderson argues, will be financially stressed and continue to face redemption requests and be forced to sell properties. Meanwhile, Public REITs with generally lower debt as well as access to unsecured credit and equity markets, are “ready and waiting” to take advantage of acquisition opportunities.
“A cheap valuation relative to private real estate may be the ‘sizzle’ for investing in public REITs at the moment, but the ‘steak’ comes in the form of an increasingly divergent return outlook, which public REIT investors may likely savor for years to come.”
