Why the “soft” issues matterJune 12, 2019
There have been numerous papers and articles focused on the quantifiable difference between private and public REITs. Performance, risk vs. return, volatility, and correlation have all been sliced and diced in various ways, so rather than do that again, let’s take a step back and look at some of the “softer” differences between private and public REITs; specifically, management, goal alignment, and opportunistic capital raising.
Public REITs are constantly under the microscope and must contend with the demands of analysts and speculative investors. The management team of a public REIT is often focused on meeting or beating the quarterly guidance they have given analysts. They realize that missing earnings guidance may lead to significant stock price declines and, as such, often prompts management to focus on short-term quarterly earnings. Consequently, resources better spent on developing, acquiring and managing properties may be employed to manage earnings and meet short-term market expectations. The pressures for quarterly performance inherent within the public equity markets is in direct contrast to the long-term investment characteristics of real estate as an asset class and to fundamental investing.
There is a growing movement amongst highly respected CEOs, such as Jamie Dimon (JP Morgan) and Warren Buffett (Berkshire Hathaway) to do away with quarterly reporting or at least with quarterly guidance. In an interview last year Mr. Dimon said that “Executives often feel pressure to make quarterly forecasts, but it can often put a company in a position where management from the CEO down feels obligated to deliver earnings and therefore may do things that they wouldn’t otherwise have done.” A few months later, Mr. Buffett admitted that although “I like to read quarterly reports as an investor…. I do not like guidance. I think the guidance leads to a lot of bad things, and I’ve seen it lead to a lot of bad things.”
While, the management teams of public REITs are constantly faced with the short-term/long-term ethical dilemma, their private REIT counterparts are free of this conundrum. The executive team of a private REIT can concentrate on making decisions that drive longer-term value creation in an asset category that, by its very nature, is long-term. Thereby, more closely aligning themselves with the investment horizon of their investors.
Opportunistic Capital Raising
The main growth engine for both public and private REITs is the acquisition of new properties. Since the funding for new acquisitions will come from a mixture of debt and equity, it is imperative that a REIT can get access to new equity capital on a regular basis to take advantage of acquisition opportunities.
However, public REITs are subject to market movements and market volatility in their ability to raise capital and this is where the problem comes in. Normally, the best time to buy anything, and real estate is no exception, is when it is out of favour and prices have been driven down. Generally, public REITs have difficulty attracting capital when the real estate sector is out of favour or when there is a general perception of greater opportunities available in other equity sectors such as technology or healthcare. In fact, during large-sector rotations, public REITs could find themselves bleeding capital simply because “the street” has determined that the short-term outlook for REITs is negative. These types of situations can be very precarious for shareholders of public REITs. On one hand, they want the REIT to buy additional properties at discounted prices, but, on the other hand, to do so the public REIT may be forced to raise additional equity capital at a substantially lower share price, which may be very dilutive for the current shareholders.
Private REITs, by comparison, cater to long-term investors who are usually agnostic to the short-term cyclical activity of the equity markets and as such may be more than willing to invest during downturns to take advantage of unique buying opportunities. Since new shares/units of a private REIT would be issued at the REIT’s net asset value rather than a potentially “fear” driven share price the degree of dilution, if any, would more than likely be minimal.
The “soft” issues of management alignment and opportunistic capital raising, appear to fall in favour the private REIT investor rather than their public counterpart