Do Listed REITs and Private Real Estate Walk Together?

In the graph below we see the time series of moving averages of returns on Private Equity Real Estate (properties in themselves, “brick”), and REITs (equivalent to Brazilian FIIs, vehicles that own properties, with their price determined in transactions in Stock Exchanges - we will talk more about the difference between the two in a future edition).

It is easy to see that there is synchrony between them, but with a temporal difference that separates them, suggesting that events or trends in one series are replicated in the other after a period of time. The prices of REITs anticipate the value of the properties carried within them. These indices refer to the American market, but we also see this in other countries, what changes is the time distance between the series.

“But what changes isn’t just the vehicle? If the assets they own have the same profile and geography, how can one have a price gain equivalent to what the other will have in a year (example)?”

The differences between private investments and their public counterparts can be attributed not only to differences in timing, but also in accounting rules and liquidity with a seasoning of human emotions and a pinch of “noise”.

"Hey ?! What ? Flavio, I think you were thinking about something else and ended up writing here, emotions, noises? “.

All of this may seem strange, but no, I'm just thinking here with you, and that's it. I'll give a quick explanation to make it easier to understand:

Liquidity

REITs

?Let's say you have shares in a FII or shares in a REIT listed on stock exchanges and you want to transform this into cash for any reason, such as paying expenses that arose suddenly and the amount is greater than you I had saved up for these surprises. What do you do ? Simple, just send your home-broker a sell order with a limit price. You do this in the morning and when it's mid-afternoon you look at your cell phone screen to see if the order has already been executed. In this specific case, the private index is transacted, that is, it was not the one that comes closest to its real value, unlike indices built based on the valuation of properties, which is the most common we see.

Added to this, the short-term volatility of the public equity market, macroeconomic drivers, the specific real estate sector and remaining “noise” complete the price formation process of REITs.

As a result of this relationship, we see that the spread between the two series has “average return” characteristics, that is, when the difference between them reaches certain limits (which are repeated), there is a greater probability of this spread closing, in the case current situation with REITs rising and private equity falling.

Timing and Accounting Differences

Timing

• REITs exhibit real-time pricing, reflecting immediate market sentiments, macroeconomic changes, and sector-specific news. This immediacy in pricing can lead to significant short-term volatility, which is both a risk and an opportunity for investors.
• Private Real Estate, by contrast, operates on a much slower timeline. Valuations are typically updated quarterly or even annually, and transactions can take months to complete. This delay in reflecting market changes can result in more stable, albeit less responsive, investment performance.

Accounting

• REITs are required to follow strict financial reporting standards, providing transparency and consistency in their financial statements. This allows investors to make informed decisions based on reliable data.
• Private Real Estate investments, however, often have more flexibility in how they report performance and value assets. This can lead to discrepancies in valuation methods and make it challenging to compare performance across different private investments directly.

Emotions and Noise

Emotions

• The public markets, where REITs are traded, can be highly emotional, with prices often influenced by investor sentiment, news, and speculative trends. This emotional component can exacerbate volatility and lead to price movements that do not always align with fundamental values.
• Private Real Estate markets are less susceptible to these daily emotional swings due to their illiquid nature and the longer duration of transactions. This can result in more stable valuations, though not entirely immune to broader market sentiments and trends.

Noise

• REITs are exposed to a wide array of market "noise," including economic reports, geopolitical events, and sector-specific news. This noise can lead to short-term price fluctuations that may not reflect the underlying property values.
• In contrast, Private Real Estate is somewhat insulated from this noise due to the nature of private market transactions and the longer timeframe for information dissemination and absorption. However, significant economic and market shifts will ultimately impact private real estate valuations, albeit on a delayed basis.

Conclusion

The interplay between liquidity, timing, accounting standards, emotions, and market noise creates a complex landscape for investors in both Listed REITs and Private Real Estate. Understanding these nuances is crucial for developing effective investment strategies that leverage the strengths of each investment type while mitigating their inherent risks.

For investors, the key is to recognize the opportunities that arise from the differences in how these two real estate investment vehicles operate. By strategically navigating the temporal differences, accounting practices, and the impact of human emotions and market noise, investors can potentially arbitrage between public and private markets, capturing value that less informed investors might overlook.

In essence, the relationship between Listed REITs and Private Real Estate is not just about choosing one over the other but understanding how each complements the other within a diversified real estate investment portfolio. By appreciating the unique characteristics of each and the dynamics that drive their returns, investors can better position themselves to achieve their investment objectives, balancing the trade-offs between liquidity, volatility, and return potential.