By Scott Crowe, Chief Investment Strategist, CenterSquare
With core real estate pricing above pre-recession peaks, private equity investors are increasingly seeking “develop-to-core” strategies, pursuing development projects to create core real estate rather than competing to purchase it. Core real estate funds increasingly include a “develop-to-core” allocation, dedicating 0 to 10 percent of funds as a means to enhance yield and take advantage of cyclical strength in property fundamentals. However, what may be less obvious to investors is a compelling alternative to traditional private equity “develop-to-core”: A dedicated REIT allocation as a proxy for development exposure. Here’s why:
- Best-in-class developers: U.S. REITs are already best-in-class developers, with a long track record of building core properties in major markets nationally. They are some of the most prolific developers of core properties, such as large industrial distribution warehouses, creative office and multifamily, but they also develop in niche sectors like student housing.
- Focus on REITs with more development exposure: The average U.S. REIT has less than 10 percent exposure to development. However, by honing in on a subset of REITs most active in development, a portfolio of REITs with over 20 percent of NAV in development exposure can be constructed, consisting of apartments, office, industrial, and even student housing and data centers.
- A more advantageous fee structure: As an investor in a REIT, one is both General Partner and Limited Partner: there is no promoted return and the investor has unlimited participation in the upside. In addition, the equivalent of the management fee for this exposure can be thought of as the company’s G&A (general and administrative expense) as a percent of equity, which is relatively efficient at approximately 50 basis points.
- Exposure at a discount: Lastly, and most importantly, when the REIT market is priced at a discount to the private market as it is now, development is priced at a discount. According to CenterSquare’s analysis, a portfolio of the most active REITs in the market as discussed above would provide indirect ownership of its respective development businesses for $0.77 on the dollar, resulting in an attractive yield on development.
Of course, REITs feature unique risks relative to private equity real estate, including higher measured volatility, which must be weighed carefully. However, as the real estate cycle matures, it is clear the U.S. REIT market has already priced in uncertainties about the near- and medium-term, with implied cap rates that reflect concerns about supply and interest rate risk. We believe that accessing “develop-to-core” through the REIT market can provide an investment in world class projects, with best-in-class management teams, and at a discount to NAV.
The statements and conclusions made in this column are not guarantees and are merely the opinion of CenterSquare and its employees. Any statements and opinions expressed are as of the date of publication, are subject to change as economic and market conditions dictate, and do not necessarily represent the views of BNY Mellon.