Use Caution With Private REITs Like Blackstone’s BREIT - Is Now a Good Time to Invest in REITs?
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Welcome to Money for the Rest of Us. This is a personal finance show on money, how it works, how to invest it, and how to live without worrying about it. I'm your host, David Stein. Today's episode 414. It's titled, Use Caution with Private Real Estate Investment Trust.

Just a quick announcement. This is the last episode of the year. We're getting ready to take our year-end break. We'll return on January 4th, 2023 with a brand new episode, episode 415. It will be a Q&A episode where we'll be answering listener questions. Thank you for listening to the show this year, for sharing it with your friends, for leaving reviews of the podcast and just being a part of our community.

Four years ago, in episode 230 of the podcast, the episode was titled, Use Caution with Real Estate Crowdfunding. Now we have a follow-up episode, a more narrower topic, Use Caution with Private Real Estate Investment Trust. But in episode 230, we discussed the Blackstone Real Estate Income Trust. The ticker is BREIT or BREIT.

At the time, B-REIT had been operating for just about two years. We analyzed the fund again in one of our premium podcast episodes, plus episode 256.

B-REIT is set up as a perpetual private real estate investment trust. That means it never matures. Traditionally, institutional investors have invested in private real estate transaction. This is offices, shopping centers, apartments. They've done it through private funds, typically a limited partnership structure, and there's a term of 10 to 12 years. But

But with a private REIT, there isn't a term. New investors are coming in and that can fund investors that want to leave. Equity REITs, both public and private, are what are known as indirect investment vehicles. They're indirect because there's a professional money management team selecting the underlying direct investments.

The direct investments for a public REIT and a private REIT are income-producing commercial real estate, offices, buildings, shopping centers, apartments, and even rental housing. Public equity REITs are registered with security regulators such as U.S. Securities and Exchange Commission. And most public equity REITs trade in the secondary market on a stock exchange.

These public equity REITs are very liquid. We can get in and out just like trading any other security.

Private equity REITs are not registered with security regulators. They are bought directly from the REIT sponsor. And in this case, in the case of BREIT, it's bought through Blackstone, although typically there could be a stockbroker involved or an advisor that's representing BREIT, recommending it, and facilitating the transaction.

Private REITs are less liquid than public REITs because the buyer, if an investor wants to exit, is the sponsor itself. In this case, Blackstone. Whereas if you own a public equity REIT, it trades on a stock exchange. And so there's natural buyers and sellers of these securities, much, much more liquid.

Because commercial real estate is an illiquid investment, but it is put in sort of a quasi-liquid wrapper of a private REIT, there's a disconnect there.

And as a result, private REITs limit the amount of redemptions in a given month or a given quarter. In the case of B-REIT, the limit is 2% per month, not more than 5% per quarter. And this was one of the big points we made back in episode 230 and in that PLUS episode is beware of the illiquidity of B-REITs.

these private REITs because these are meant to be long-term investments. They're not meant to get in and out, particularly if everyone wants to get out at the same time, which is what we're seeing now with B-REIT. This fund was attractive because it was at a very low minimum, only $2,500 for investors, and they didn't need to be accredited, so they didn't have to meet the net worth or income thresholds of many private real estate investments.

Blackstone marketed this fund heavily. They hired hundreds of sales and marketing professionals to sell the REIT. They established something known as Blackstone University to help investment advisors learn about the fund and how it can be used for their clients. And it was incredibly successful as an asset-raising exercise.

started five years ago, and they have $69 billion in assets under management, just in this one fund. And this is not an inexpensive fund. This was another point we made in episode 230. This is expensive. The asset management fee that Blackstone gets is 1.25% of assets under management, plus they get 12.5% of any profits above a hurdle rate of 5%.

Now, that's just what's going to Blackstone. In addition, depending on the share class, there could be additional fees that's going to the broker that sold the fund. For example, the asset management fee for the S-class shares is 2%, very expensive.

If we compare that to a public equity REIT ETF, such as the Schwab U.S. REIT ETF, that has an expense ratio of 0.04%. The Vanguard Real Estate ETF, VNQ, has an expense ratio of 0.12%, compared to the 2% going to Blackstone, plus 12.5% of any profits above the hurdle rate.

For those kind of fees, we would expect very, very good performance. But can a private REIT do things different than a public REIT? Public REIT management, they're professionals. They're trying to maximize returns for their shareholders. They're also very smart investors. It's just a completely different structure. Both public REITs and private REITs use leverage. In

In the case of VREIT, there's $69 billion in equity that's owed to the investors. But the total value of the assets bought is $125 billion. There's $56 billion in debt, so about 45% of the asset value is in debt.

Public REITs also have debt. It's measured a little differently, so it's often difficult to make an apples-to-apples comparison. But the average equity REIT in the U.S. has a 34.5% leverage ratio, and that's the total debt divided by the market capitalization of the REITs themselves, which is the price of the REITs times the shares outstanding. So it's sort of a proxy for the value of the company, and debt's about 35% of that.

That leverage can help maximize returns because if you have a low cost of debt and you're buying a real estate asset where the rents are higher than the interest on the debt and then there's a potential for appreciation as the rent's increasing, that can magnify returns. And no doubt, B-REIT has performed very, very well.

If we look at the performance of the S-class, which again had the 2% asset management fee, if we include the sales load, so in many cases they were charging 1% up front to get into the fund, the annualized return since inception was 11.5% net of fees. That's good.

The reason why performance has been very, very good is how Blackstone allocated the assets. 78% of the assets in this fund are invested in rental housing and industrial properties. Those are two sectors that have done incredibly well over the past five years.

If we think about what's going on in the housing market where housing prices spiked and rents are increasing dramatically, and that's pushing up inflation, B-REIT benefited from that because they have rental houses that have benefited from higher rents and then higher valuations.

Those performance numbers were through October 2022. If we compare them to the Vanguard real estate ETF, VNQ, over that same timeframe, its performance has been much worse. It's only returned 4.4% annualized, even though the expense ratio for VNQ is much, much lower.

What's going on here? Why has VNQ done so much worse than Blackstone's B-REIT? Now, certainly the sector allocation would be different. VNQ has 166 holdings, but it's spread among all the different real estate sectors, so it isn't overweighted to rental housing and industrial. But it also has to do with how equity REITs trade on a daily basis.

They are marked to market on a daily basis based on the consensus of investors. Whereas a private REIT, such as BREIT, that net asset value, the value per share is based on appraisals of the underlying real estate that the fund owns. And there's a lag because they're not appraising these underlying properties all the time.

Public REITs also appraise their property and they can calculate a net asset value, which would be the total equity of the fund divided by the shares outstanding. Both a public REIT and a private REIT can calculate and do calculate net asset values. It's just that the public REIT can calculate

sell for less than the net asset value because it's marked a market on a daily basis. And right now, public REITs are selling for about a 15% discount to the net asset value of the asset. Now, it's always tricky figuring out the calculation, but somewhere it's between 10% and 15% discount. Now, there isn't a market price for B-REIT. The price you exit at is that net asset value.

Nori Leach is a senior lecturer at Harvard Business School. She advises pension funds on real estate investments. She says appraisals look backwards and markets look forward, and people are trying to arbitrage and get their money out before the write-downs occur. She's referring to the investors that are trying to get out of VREIT because

because they believed that the net asset value will be marked down in the future because of the lag in appraisals. That's one of the interesting things about public REITs. They're forward-looking investors. They're anticipating that real estate values will fall, and we'll look in a few minutes at what's putting downward pressure on real estate.

But public REITs, being forward-looking, have already marked down their estimates of the underlying value of the property by upwards of 15%, if not 20%. Public REITs are down over 22% year-to-date. Yet, B-REIT is still showing a positive 8.5% return on a year-to-date basis through October.

What's interesting, though, if we look at the returns of the Vanguard real estate ETF through year-end 2021, so before this 22% year-to-date decline, it's returned 10.95% annualized since January 1st, 2017, since the inception date of B-REIT. In other words, it only lagged B-REIT by about

a half of a percent over that timeframe. But then as interest rates started rising, the value of equity REITs have fallen significantly to where public equity REITs are anticipating the value of private real estate is falling. Private real estate, because there's a lag in appraisals, it can take a while for the valuations to catch up.

Many investors in B-REIT know this, and that's what Nori Leach was referring to. They're trying to arbitrage and get their money out.

And that's why in early December, Blackstone announced that they would limit how much investors could withdraw from the fund. In other words, more than 2% of the money in the fund is trying to get out. And Blackstone said, we're going to hold to the minimums of 5% a quarter and 2% a month.

Back in July, there were also big redemptions, and Blackstone made an exception and allowed, I believe, more than 2% out that month, thinking that that would sort of quell the demand, but it really hasn't.

If we look at all non-traded private REITs, they paid out $3.7 billion in redemptions in the third quarter. This is not just a situation with B-REIT. Starwood has a $15 billion private REIT where they've also gated or limited the amount of redemptions.

The amount of redemptions in the third quarter, that was 12 times greater than for the third quarter 2021. According to Robert A. Stranger and Company, they're a firm that tracks this private REIT market.

Blackstone's a publicly traded stock, and when they announced this gate, their shares fell 7% in a day. Blackstone has some reputational damage, but they're just adhering to what was in the documents and what any investor investing should have known.

Now, in the third quarter, B-REIT actually took in $1.2 billion of net assets. There is still more money coming in than was going out, but that compares to the quarter in 2021, third quarter, $7.7 billion inflow.

Many of them are coming from Asian investors, but any investor can see that if there's a risk that private real estate values are falling and it hasn't shown up yet in the net asset value of a private REIT, then they should get out unless they're a long-term investor. And hopefully most of the investors in there are long-term.

A Blackstone spokesperson said, our business is built on performance, not fun flows, and performance is rock solid. Critics would say, yeah, but that's because the net asset values haven't been marked down as private real estate values have fallen.

Nadim Meji, who's the head of Blackstone's Real Estate of America, says that B-REIT is operated with substantial liquidity and is structured to never be a forced seller of assets. That's the concern with B-REIT, that the redemptions were going to be so high or are so high

that Blackstone will have to start selling more of the $125 billion of properties. Now, they're trying to show confidence. Blackstone's president, John Gray, and its chief executive officer, Steve Schwarzman, have both invested $100 million more in B-REIT. And the firm's employees have $1.1 billion of their own money.

in B-REIT. And that's actually what you want to see with a private investment vehicle. You want the professionals of the firm investing their personal assets in it so that they have skin in the game.

And again, this fund has performed well. It will more than likely see a drop in net asset value as new appraisals come in, but it is structured as a long-term fund. The challenge is, is because there's a gate, how much does that tick off investors? They should have known because there's an illiquidity match. There can't be instant liquidity when it's a very long-term investment.

And some have suggested, well, they'll never be able to raise money again because investors are going to be upset. But this wasn't a surprise. Before we continue, let me pause and share some words from this week's sponsors. Let's look, though, at what's impacting the real estate market.

It comes down to interest rates. Low interest rates pushed up value of real estate because commercial real estate investors could borrow cheaply and then go out and buy assets. And what we're seeing now is banks and others have been less willing to lend on real estate. So they're pulling in the reins. At the same time, overall rates are higher. And because rates are higher, it becomes more difficult to service the debt.

And in some cases, there's a negative position where the debt service cost can be higher than the rental income. You never want to be in that situation as a private real estate investor. But because interest rates have gone up, cap rates, which is the income, the net income on a property, net operating income divided by the value itself, cap rates are going up. That puts downward pressure on real estate.

There's not been as many transactions because it's just like with the housing market. If you've locked in a low-interest mortgage, then there's not really a huge motivation to sell your house and go buy something else where you're going to have to take out a higher mortgage. And so there's been a significant drop-off in transaction. There's valuation pressure, downward pressure on prices because interest rates have gone up just because of the mathematics of how

cash flow generating assets are valued. If we look at Green Street, their commercial property index, their price index has fallen 6% from earlier this year. They're expecting prices to potentially in the private side to fall 5%, at least, if not 10%.

I saw a report from Capital Economics. They believe commercial property prices will fall 7% next year, and those falling prices will show up in certainly private real estate returns, which are slowing. If we look at something like the Necroph Property Index, those returns have slowed dramatically this year and could likely fall in the next year as these private real estate assets are marked down.

This is just a function of higher interest rates. But it's that lag that leads for the disconnect between the private REIT net asset value and public equity REIT prices. It's been one of the largest disconnects and smart investors were trying to get out because they don't want to see the prices marked down.

Now, if you're an investor in B-REIT, long-term investor, the fund will probably do fine. It's diversified. They have solid assets. They're a professional management team. You could see the returns drop. The growth in the fund itself might be much less than

William Katz, who's an analyst at Credit Suisse, says our view is the greatest rate of growth is behind B-REIT. He continues, the ultimate question has to be asked about the efficacy of these products if clients only want to get their cash out. I agree with him. If the whole idea was to be able to get your cash out whenever there's a hiccup, then it isn't a great vehicle because it isn't liquidity on demand.

Investors that wanted liquidity on demand in the commercial real estate market should own public REITs. But if you want to be in a longer term investment and benefit from an active management like Blackstone that's able to allocate to different sectors, then you need to give up some liquidity.

Now, is the fund that much better than the public REIT market? I don't think so. Once we adjust for the fees, maybe, but we'll have to see over a longer timeframe after the net asset value has been adjusted. And maybe because they have been in the right sector, they've done very well. And so if you're invested in it, the fund's done great. You shouldn't feel bad. Just recognize that the liquidity provisions that have been there since inception are still there. And now there's a gate.

What we'll have to see is where real estate prices end up with the public REIT market down over 20%. Is that enough? Public REITs are not cheap. If we look at the dividend yield on equity REITs, it's 3.7%. The

The average dividend yield going back the past decade is 4.3%. So even after the 20% plus decline, our dividend yields are not above average. And if we look at the dividend yields of equity REITs relative to 10-year treasuries, typically they've sold at a yield. They've been higher. They've had higher yields by about 1.4% on average than the 10-year treasury. Now the yields are about the same.

If we look at the REIT price to funds from operations, which is sort of equivalent of the PE, equity REITs in the U.S. are at 17.3 versus 16.3, the long-term average. So they're not cheap.

That's one of the reasons that in our Money for the Rest of Us Plus adaptive model portfolio examples, we cut our exposure to equity REITs in half in early January 2022. We exited the Schwab Equity REIT ETF and we've kept a global equity REIT ETF. But after the 40% increase, positive return for equity REITs in 2021, given we saw upward pressure in interest rates, we reduced our

are equity REIT allocation. And that turned out to be the right move as equity REITs have sold off. I also reduced equity REITs in my portfolio. I also sold out of SCHH, the Schwab US REIT ETF. But I also cut my allocation to the double-line real estate and income fund, DBRIX, that I've had for several years now. I took profits there. But we don't know where we'll end up with

With equity REITs, I think we can be fairly confident that the value of private real estate assets is going to fall given the lag in appraisals.

Our takeaway, though, as we think about the lessons here, anytime you're investing in a fund, understand the liquidity terms. We've looked at a number of these type of vehicles of money for the rest of us plus, including a vehicle from Fundrise, one of their interval funds. All these private real estate perpetual funds, they have liquidity provisions.

They have gates. They have redemption limits. Sometimes they'll charge an extra fee if you exit early. And in case of B-REIT, there was a fee if you exited in the first year. And that's how these funds should be structured. Because you

You need the liquidity provisions to match, at least to some extent, the liquidity of the underlying assets. And that's why the gates are there, to protect the other shareholders that want to stay so that the fund isn't forced to start dumping assets at fire sale prices. To understand the liquidity provisions and then understand the opportunity cost of investing in one asset versus the other.

Kelly Nilsson, who's the founder of Brava Financial, this is a San Diego financial planning firm, she asked, well, why would investors in the current environment lock up their money in a real estate fund when government bonds are paying four and a half to 5%, particularly if you see that the private real estate values could be marked down? So now is not the time to look at investing in a private REIT. If you can get out, that's great. But if you're a

These are income-producing assets. The distribution yield on this particular fund, B REITs, 4%. That can compound over time. But if you're only going to get even mid to high single digits with a private investment, given the other opportunities right now for even cash, like we talked about a few episodes ago, not a great time to be investing in private REITs. As for public REITs, I'm holding what I currently have.

I like the funds I have. I think it's around a 3%, 4% allocation of my net worth, so it's not a huge amount, but it's a liquid way to participate in the commercial real estate market and not have to invest in an illiquid private REIT. Now, I also am invested in some private real estate. I do it through some fund-to-funds through my old firm, and I also have a hotel investment

through CrowdStreet. In that case, it's a three to five-year project, one specific hotel project. So I'm not against private real estate investing. I just want investors to be aware of the liquidity issues with these and then recognizing the current environment that private REITs net asset values are likely to be marked down as other commercial real estate properties are marked down due to the pressure from rising interest rates.

That's our look at private REITs. Thanks for listening to the show this year. Have a wonderful holiday season and a happy new year. I have enjoyed teaching about investing on this podcast for over eight years now, but I also love to write. There's a benefit to writing over podcasting, and that's why I write a weekly email newsletter called The Insider's Guide.

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Everything I've shared with you in this episode has been for general education. I've not considered your specific risk situation. I've not provided investment advice. This is simply general education on money, investing in the economy. Have a great week.