In the market’s current upheaval brought on by rising interest rates, one interesting story to emerge has been major private REITs gating redemptions to investors. When I say major, I mean Blackstone’s $69 billion REIT and Starwood’s $14.6 billion REIT. The amount of redemptions by investors in these highly interest rate-sensitive REIT assets will have reverberating effects across the real estate market for months to come and there are some important learning point for investors and advisors.
The situation is a classic example of manic Mr. Market and the disconnect between public and private assets. This article will discuss the arbitrage opportunity between public REIT valuations and private REITs which is a leading reason behind investor redemptions, in my opinion.
What does “Gating” of Redemptions Mean?
The gating of redemptions by Blackstone has meant that only 43% of investor redemption orders got filled in this latest month. Some investors and their advisors might be upset, but within the REIT offering, there are probable clauses which state redemptions are limited to the greater than 2% of its monthly NAV and 5% of its quarterly NAV.
Redemption limits are in place for private investment funds because the real assets of these investment portfolios are not easily liquidated, as selling property takes time. The limits on how much can be redeemed each month helps stagger the needed sale of the portfolio as to not flood the market for these private assets and impact the valuation for realized sale prices by selling in a hurry.
In the market’s recent example with Blackstone, the 43% of redemption requests filled represented $1.3 billion and there is now a backlog in redemptions as the implied $3.0 of redemption orders was not fully process by the REIT. As units are redeemable to the REIT, the company will now have to sell assets from its real estate portfolio to pay investors their redemptions. The steps Blackstone is beginning to take in order to be able to redeem units will be discussed more later. Spoiler… they are selling assets!
Arbitrage Opportunity between Public vs. Private REITs
The main reason, in my opinion, for the sale/redemption of private REITs is the price discrepancy of shares on a price-to-book basis compared to their publicly traded peers. The difference between private REITs and public REITs are that public REITs are traded between investors on public stock exchanges while private REIT’s are subscribed to and redeemed directly from the underlying company, often through financial advisor networks and banks on a weekly, monthly or quarterly basis.
The unit price which investors redeem at in private investment fund markets is set by the company, often at the net asset value (NAV) per unit class as calculated from the financial statements. For real assets seen in the private markets such as real estate or private debt, this 1-to-1 price to book value or NAV is generally appropriate, but keep in mind it is not market-based and is driven from historical financial statements, external appraisals, and/or internal underwriting.
Accounting Side Note: Keep in mind that accounting standards are different across countries and under IFRS 9, real estate assets are held at fair value based on appraisals or internal underwriting, but companies using GAAP standards in the US generally follow ASC 820 and apply the cost model, which means real estate assets are carried at historical cost less depreciation. As such, NAV valuations from financial statements by private REITs in IFRS jurisdictions are appropriate approximations of unit price (still stale appraisal-biased valuations though) while U.S. GAAP financial statements have the fair value of assets and thus equity distorted by depreciation. This means unit prices set by private U.S. REIT’s management are generally far different from their price-to-book value as calculated from the financial statements.
Unfortunately, in the current market environment with rising interest rate, the discounted cash flow of highly leveraged REITs have changed significantly. The public markets have already priced this in with public REITs trading around 70% of price-to-book value! Private fund managers such as Blackstone have been slow to adjust valuations of the underlying portfolio assets and unit price. This has presented investors with a cross-asset arbitrage opportunity to take advantage of the discrepancy. While assets are not identical across the REITs, when we start talking +$10 billion balance sheets, how different can one REIT’s portfolio be from another?
In finance, the stale and subjective fair valuation process is called appraisal bias and leads to the smoothing of returns. The appraised values could be more rational in the long-term than the manic Mr. Market movement public REITs are exposed to, but for sophisticated investors, it looks to be representing an opportunity to trade for similar assets at a much better valuation. Only time will tell where valuations settle between public and private markets but the asset sales needing to take place for redemptions are likely to affect the market and set new cap rates for the real estate industry.
The Price Discrepancy Between Public and Private REITs
As of November, Blackstone’s REIT was posting trailing 12 month (TTM) year returns of 10.6% compared to the Vanguard Real Estate Index Fund ETF (VNQ) being 28.8% lower than its 52-week highs. Starwood does not post 1-year returns for its REIT, but YTD returns as of November were 8.74%, which if annualized would come out to 9.5%. The opportunity to trade these private REIT units for public REITs is noticeably enticing!
The story is the same in Canada and more obvious where IFRS 9 accounting standards are used. The major public REIT’s such as RioCan and CapREIT are trading at 0.81x and 0.76x price to book value with their stock prices down 25%.0 and 24.7%, respectively. The Vanguard FTSE Canadian REIT ETF is down 24.8%. On the other hand, major private multi-billion Canadian REIT’s such as Avenue Living and Centurion are posting TTM returns of 13.4% (Nov 2022) and 18.1% (Sep 2022), respectively. There is clearly the same disconnect between the public and private REIT markets.
While not perfect arbitrage, this cross asset arbitrage is still an appealing switch for investors: public REIT’s trading at deep discounts to net asset value (or book value) per share while private REITs have not yet lowered their NAV per unit prices investors are able to redeem shares at.
Closing the Arbitrage Gap
Arbitrage happens rarely and valuations gaps can close quickly depending on asset type and liquidity in the market. In the current market environment with rising interest rates, the valuation adjustment has been significant for highly leveraged REITs, and private REIT managers have been slow to reflect this in the NAVs. The redemption by investors will likely take place until REIT management lower the NAVs of these private funds to reflect public market expectations.
Helping the convergence of public and private markets will also be subsequent property sales by private REITs. With our BlackStone example, investor redemptions mean that the company now has to work to sell properties in order to order to raise the cash for the redemption requests. This is one of the reasons behind Blackstone’s recent sale of their $5.5 billion MGM Grand and Mandalay Bay stakes in Las Vegas.
Blackstone is just one REIT, albeit a $69B one, but there are other private REITs in the same redemption and asset sale situation. The combined sales will likely have some effect on real estate markets and the cap rates used in valuations.
Takeaway for Investors
The situation is a classic example of manic Mr. Market and the disconnect between public and private assets. For long-term investors, the price-to-book value discount for public REIT’s is already attractive. The opportunity to sell similar private REITs and buy discounted public assets is an arbitrage opportunity sophisticated investors can look to take advantage of.