Illiquidity Premium and Private Equity Funds Versus Real Estate Investment Trust Returns

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The illiquidity premium is the extra value -- over time -- that some investors believe will come from holding illiquid investments. That is, something that is difficult or slow to sell.

For instance, stock shares in a private company are illiquid compared to shares of a publicly listed company. You can sell your shares of Domino's in a few moments just by giving the order to your broker. But if you own private, shares in the unlisted Joe's Pizzaria it may take you months or more to sell out.

Real Estate Investment Trusts do have competition for investment dollars looking to gain the rewards of real estate properties.

REITs are Not Alone in the Commercial Real Estate Marketplace

There are many private real estate companies which do the same basic things as REITs. They develop, buy, operate, refurbish and sell commercial real estate properties.

However, because they are privately owned, as investments they are open only to qualified investors (in the United States, this requires a million dollar net worth or at least $200,000 in income for three years running) or institutions.

Many pension funds, life insurance companies, hedge funds and so on want to benefit from commercial real estate, but of course don't want to own and manage the buildings themselves, because they're not qualified to be landlords. Such institutions have invested from about $200 to $300 billion dollars in real estate.

Of course, they can (and do) also buy shares in Real Estate Investment Trusts.

Why Would Instutional Investors Pick a Private Real Estate Company Over a REIT?

Because of the illiquidity premium they believe exists. It's a lot more difficult to get in and out of private equity funds than REITs, so many investors believe that, in the long run, they'll make more money from private property companies.

However, NAREIT has analyzed the returns of private versus public real estate companies for the period of the early 1990s to 2008.

According to their findings, illiquidity is a disadvantage, not an advantage.

During the period of study, overall property values rose 322%, or a rate of 10.1% per year.

Open-ended Diversified Core Equity Funds using 20% leverage went up a total of 341%, or a rate of 10.4% per year.

Value-Added Private Equity Real Estate funds using 54% leverage rose 430% total, or 12.2% per year.

Opportunistic Private Equity Real Estate funds using 67% leverage went up a grand total of 964%, or 18.4% annually.

And publicly traded equity Real Estate Investment Trusts? Per the FTSE NAREIT Equity Index, (using 40% leverage), REITs went up 1041%, which is 15.9% per year.

Equity REIT Performance Beats Out Private Real Estate Companies

This is great news for small investors, because it means that we have a real advantage over those big-time smarty pants institutional funds who think they're so much better than we are just because they have more money.

We don't have the choice of putting money into private real estate equity funds, so we're forced to buy REITs on the public stock exchanges.

(Except for people who enjoy being active landlords or flipping houses.)

More Institutional Money May Start Flowing into Listed REITs

Institional investors may be getting the message. According to a survey by IREI/Kingsley Associates of the largest institutional funds, in 2010 they plan to raise their allocations to publicly traded REITs from 8.4% to 10.7% of their total real estate portfolios.

Publicly Traded Real Estate Investment Trusts Have Other Advantages Over Private Companies

Of course, there are other differences. Real Estate Investment Trusts are companies that intend to remain in business forever, so good REIT management buys and manages properties for the long term.

Private equity funds are in business for a limited length of time. They must buy assets as soon as they have the money.

They also have to sell assets at the pre-determined end of the fund's life, or to meet redemption requests. They means they may be buying and selling at disadvantageous times.

Plus, they have a fee structure that imposes higher costs on investors than REITs, which must meet transparency rules and compete against each other. John Bogle and others have shown that expenses are an important factor in investment returns.

And during the financial crisis of 2008-2009, publicly traded REITs raised needed capital from the financial markets, which helped them whether the storm. Now, many are in position to look for bargain deals.

Therefore, it does appear that the illiquidity premium is really a myth.

Next: Using Real Estate Investment Trusts to Hedge Inflation -- better than commodities and TIPS bonds?

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