Monday, February 22, 2016

Disconnect Between Public and Private Valuations in Commercial Real Estate

There's an interesting phenomenon right now in commercial real estate in that public valuations are lower than private valuations. On the surface it doesn't make much sense. For one, public companies have cheaper costs of capital and, in theory, should be able to pay more for an asset and still have it be accretive. Second, public companies are incredibly liquid compared to private vehicles, like private equity funds, and investors should be willing to accept a lower return for the liquidity (liquidity premium). Again, this should allow public companies to be able to pay more for an asset, accept a lower return and still be able to satisfy investors. Third, public REITs are operated by some of the best real estate operators, ensuring the portfolio is managed efficiently. Investors should be willing to pay more for top notch management teams. In spite of all these factors, REIT valuations remain depressed versus private real estate valuations.

An example of this phenomenon is Physicians Reality Trust, a publicly traded REIT. Physicians buys stabilized medical office buildings in fairly strong markets. They trade at an implied cap rate of about 6.25-6.50%. Now, go try and buy a well located, stabilized medical office building. There's a decent chance you won't be able to buy anything for more than a 6% cap. In fact, if Physicians Realty Trust sold off each of their assets individually, there's a very good chance the majority would trade below a 6% cap.

Kilroy is another great example. The majority of their assets are class A office buildings in premiere markets, like downtown San Francisco and downtown Seattle. In those markets, class A office buildings will regularly trade at low 5% caps and even sub 5% caps, but today Kilroy trades at an implied cap rate of about 6%. You can buy Kilroy, one of the best real estate investors / operators in the world at a spread of 100 bps.

My question is, why would an investor buy a medical office building, or invest in a private fund, and not just buy Physicians Reality Trust stock? Likewise with Kilroy and investors who want exposure to class A general office? Not only are you buying at a better cap rate, but you have tremendous liquidity, can be confident that the assets are managed efficiently, and can spread the risk out over many properties. It just seems like a no-brainer to me, and that's coming from a guy who works for a private real estate fund.

I understand some of the reasons REITs might trade at a discount. For example, REITs might have greater exposure to short term interest rates due to having more variable rate debt on their balance sheets, whereas a private investor will often lock in a 10 year fixed rate. One could also argue that REITs often employ a conservative capital structure by keeping debt as a portion of total asset value relatively low, whereas private investors might take on more risk and have a higher leverage ratio to juice their returns. There's also an implied risk with investing in a REIT in that you're not just betting on their current portfolio and the current real estate market. Instead, since there is no defined liquidity event for REITs, you have to believe that the REIT will recycle capital efficiently almost indefinitely.

Even with these cons, the discrepancy in private and public valuations just doesn't make sense and it'll be interesting to see if / when the gap closes. In the meantime, I'd expect more private companies buying out REIT portfolios similar to what's recently happened with Excel Realty Trust, Biomed, and Equity Residential.

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