How would you describe the relative performance of public and private real estate?
The consensus is that the public real estate index has outperformed the private index by several hundred basis points over various time periods used for comparison. It appears the difference in returns can be attributed to the idiosyncratic nature of private real estate, the management fees incurred, and the deployment period.
A troubling trend is the decline in direct ownership of real estate and the proliferation of fund of funds and a growing chain of fee-based parties between assets and investors. This phenomenon of increased outsourcing in decision making and asset management has exacerbated the return differential.
What does your research reveal about pension funds’ allocations to public versus private real estate?
Defined benefit pension funds’ real estate allocations are approximately a 9:1 ratio of private to public. The overall allocation to real estate as an asset class has more than doubled over the last 20 years. Given the outperformance of REITs over this period, we might have expected a significant shift from using private to public real estate, but that is not the dominant trend. While more pensions use REITs today, private real estate is still the primary vehicle for commercial real estate exposure.
What are some factors behind the disconnect between performance and allocations?
Many privately held assets are not frequently or accurately valued until they are traded. This allows for delayed recognition of performance. Also, the heterogeneity in performance of private real estate is vast, with the bottom quartile failing to return the principle invested during some periods, while the best investments outperform the public market.
One possible explanation for the allocation puzzle is that managers truly believe they can pick winners among private assets or private asset managers, and that prediction is incorrect at least half the time. Another possible explanation is that the unique nature of private real estate and the lack of transparency in valuation of assets is perceived as a benefit, as the true performance on a quarter to quarter basis is obscured. The realized returns take so long to materialize that it delays the performance assessment.
Where could your research go next in order to better understand allocation decisions?
Given the wide range in the realized performance of private real estate, some behavioral research could be done to provide insights into the psychology of allocation decision makers.
The bigger issue is, of course, the potential shortfall to the beneficiaries, whose money is invested by the pension funds. With the tremendous strides in data availability, the accuracy and frequency of private real estate valuations can be improved and standardized to increase the transparency and accountability of allocation decisions. A helpful part of that analysis would be the recognition of, at the very least, the standard deviation of the realized returns on similar investments.