2022 has not been a great year for real-estate investments.
The S&P US REIT Index, which tracks publicly traded Real Estate Investment Trusts, is down
about 23% year to date, which is a lot worse than the S&P500 which is down only 15% over
the same period.
But, not all REITS are down.
Nontraded real-estate investment trusts seem to be doing just fine.
The Blackstone Real Estate Income Trust is up around 9% year to date as of last month.
Look at that, it’s the only one that is up.
So, let’s do a little googling to see what they are doing so right.
Oh…
Seems there is a problem…
There is a headline here…
Blackstone limits withdrawals at $125bn property fund as investors rush to exit.
Well, why would people want their money back??
Blackstone have managed to buy the only properties that are not down this year, and people want
their money back?
There is no satisfying some people…
There is even a quote from a Blackstone spokesman in the article, “Our business is built on
performance, not fund flows, and performance is rock solid.”
In truth, I’m not sure that up 9% is actually rock solid.
Rocks aren’t up 9%, I mean the nature of being rock solid is that you don’t move
around very much.
These Blackstone guys need to hire some of the laid off crypto marketers.
A better line might be, we reached out to Blackstone for comment and a spokesman replied
with an emoji of a rocket and the moon.
I mean that is why people want out – rock solid?
If people wanted rock solid, they could buy a bag of rocks, and not have to pay a management
fee.
Here is a chart from Jefferies showing how redemptions have risen over the last few months.
I’m starting to think that people might not trust these private equity guys.
I mean, if you’re not going to trust a guy in a polyester fleece vest, who will you trust??
A cynical view, (which I of course never take) is that nontraded REITs are exactly the same
as publicly traded REITs.
They invest in property, but instead of selling shares on the stock market, they raise money
directly from wealthy individuals, and these investors can only cash out once in a while
through the funds’ sponsors.
So how can this fund be up, when everything else is down?
Well, the valuations between the two types of fund differ because public REITs are valued
at whatever their shares are trading at on the stock exchange, while nontraded REITs
are valued monthly by their sponsors – Blackstone for example – who work with independent
appraisers, who analyze the value of the commercial property in the portfolio.
Now of course, If I was an independent appraiser for Blackstone, I might take a bit of a shortcut,
and say all of the other REITS are down 23%, so this one is too.
But that is possibly why I am not an independent appraiser for Blackstone.
They’d probably take one look at me and say – he is the kind of guy who’ll take
lazy shortcuts.
So, they hired a guy, who looked at each individual property in the 125 billion dollar portfolio,
(who knows, maybe he drove around in his car) and he recognized how much better these properties
are than the other ones that are down.
Must be exhausting work though…
Now, Goldman Sachs argues that the Blackstone REIT’s geographic tilt towards residential
property in the American ‘Sun Belt’ means that Camden Property Trust and Mid-America
Apartment Communities are the best public equivalents to this Blackstone fund.
They are down 32% and 27% respectively year to date, so worse than the average REIT.
Now, nontraded REITs are part of a growing market for private investments that appear
to be less volatile than public investments.
Nontraded REITs have raised more than $92 billion over the last five years, according
to The Wall Street Journal.
The 23% decline in the S&P REIT index, might be explained by investor concern about rising
interest rates, falling property values (apartment buildings have fallen 14% in value over the
last year, and industrial buildings are down 9% over the same period) and there has been
recent weakness in rents too.
Combined, these factors make real estate investments a lot less attractive in the current market
environment.
People are also just less excited about rental yields now that interest rates are higher.
The Blackstone Real Estate Income Trust charges a 1.25 per cent annual management fee, and
a 12.5 per cent performance fee on its annual total return, (subject to a 5 per cent annual
hurdle and a high water mark).
The fund has shown a return of over 13% per year after fees since inception in 2017.
Last year it earned $1.4bn in fees for Blackstone which made up one fifth of Blackstone’s
overall fee revenues, according to Goldman Sachs.
So this fund does matter for Blackstone.
But one way or another, the value of nontraded REITs seems to be rising according to the
returns being released by Blackstone and other firms in the same space, and I’m sure they
are right – I mean why would they mislead us?
The firm explained to the Wall Street Journal last month that the stock market is almost
always more volatile than the value of the properties that they own and that publicly
traded REITs began the year at excessive prices, and that is part of the reason they have fallen
so much.
Now, nontraded REITs do allow investors to cash out, if necessary (and we have seen that
they have been doing so), but sponsors can freeze redemptions if too many investors want
to cash out at the same time, as obviously it is not easy to quickly sell real estate
to return money to investors.
The Blackstone fund allows for 2 per cent of assets to be redeemed by clients each month,
with a maximum of 5 per cent allowed in a calendar quarter.
And the fund had to suspend redemptions as too many are coming in right now.
In October, the fund received $1.8bn in redemption requests, or about 2.7 per cent of its net
asset value, and it has already received redemption requests in November and December exceeding
the quarterly limit.
So, Blackstone only approved 43 percent of the redemption requests for the fund in November,
according to a notice it sent to investors on Thursday.
Now, before we get into why investors might be paying up to invest in funds like this
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Now while investors in funds like this can redeem their investments at NAV (or Net Asset
Value) if the fund has not suspended redemptions, they are also able to just sell their stake
in the fund to other investors, who might want to buy it.
There are specialist firms who focus on secondary-market trading of these private investments, and
investors can sell through these brokers but will need to be willing to offer a discount.
So it’s basically up 9% year to date as long as you don’t want to sell it.
Now we talked a bit in a recent video about venture capital funds – in particular the
ones that invested in FTX.
A few of the big firms who invested in FTX have written that investment down to zero,
and for most of them that investment was a small percentage of their overall portfolios.
But many of these funds are still coming under fire for not taking larger markdowns on the
rest of their holdings in the face of this year’s steep drops in public stock prices.
When a lot of these funds are invested in technology startups, it is maybe reasonable
to believe their returns might be similar to the Nasdaq 100 index which is down 28%
year to date, or Cathie Woods Ark innovation fund which invests in the best technology
stocks and is down more than 60% year to date.
Investors in these private funds – who have not written down their investments - possibly
have inflated ideas of their portfolios’ value.
So, the majority of private funds are claiming to be up right now, In fact on average, private
equity funds are claiming to be up 3.2% year to date, while everything else is down.
Just to be clear, these are not hedge funds, they don’t trade in and out of their investments,
they don’t go short, they just happen to have picked the best nonpublic companies to
invest in.
This happened during the credit crunch too, where it seemed even more egregious.
I should be clear that private equity funds are quite different to hedge funds, as hedge
funds usually invest in liquid markets and are required to mark their portfolios to market
every month.
The Economist describes investors in Private Equity funds as being like babies who love
the game of peekaboo, if they can’t see their losses, they don’t believe that they
exist.
But is that really how Private Equity investors actually think?
Are private equity investors really that foolish, or do they understand that their investments
are down, but just like being told that they are up?
And if people get that PE investments are actually volatile but they just don’t see
the volatility, what’s all the excitement about?
Why pay high fees for something like that?
Cliff Asness of AQR, in his 2019 piece, “The Illiquidity Discount” argues that for some
investors, this pricing opacity may actually be a feature rather than a bug!
Liquid, accurately priced investments let you know precisely how volatile they are and
they smack you in the face with it he argues.
So, can private equity investors be compared to Odysseus in Homer's Odyssey who resists
the bewitching song of the sirens by having his ship's crew tie him to the mast, while
they are ordered to block their own ears with beeswax to prevent themselves from hearing
the song.
Is the illiquidity there as a rope to prevent these investors from making a foolish mistake?
There is an idea in finance of the liquidity premium, which is the extra return a rational
investor should demand in order to agree to invest in assets that can’t easily be sold
at fair market value.
You would naturally want to own assets that can easily sold at (or close to) their fair
market value, and so should only agree to invest in something that is difficult to sell
if you will make a higher return.
We see this in bond markets where illiquid (off the run) bonds typically have a higher
yield than the more liquid (on the run) bonds.
But if investors actually realize that accurate and timely information will just make them
worse investors as they’ll use that liquidity to panic and sell at the worst possible time,
are they paying high fees and accepting a lower return because they feel that illiquid
or very infrequently and inaccurately priced investments made them better investors as
essentially it allows them to stop micromanaging their portfolios given low measured volatility
and very modest paper drawdowns?
Cliff Asness refers to the way private equity firms provide this service as “Volatility
Laundering”.
He asks in his piece “how honest are these investors with themselves?”
Are investment committees being told “we like these investments, even with lower overall
returns, because we’ll all be better off in the long term if we just have less information?”
A new paper from The University of Florida analyzed nearly twenty years worth of private
equity real estate fund data and concludes that private equity fund managers don’t
appear to manipulate interim returns to fool their investors, but rather do so because
their investors want them to.
In the paper they argue that “If a General Partner boosts or smooths returns, perhaps
by strategically timing asset purchases and sales or by misstating the values of underlying
assets, investment managers within Limited Partner organizations can report artificially
higher Sharpe ratios, alphas, and top-line returns, such as IRRs, to their trustees or
other overseers.
In doing so, these investment managers, whose median tenure of four years often expires
years before the ultimate returns of a PE fund are realized, might improve their internal
job security or potential labor market outcomes.”
They go on to argue that return manipulations can also produce significant paper wealth
for investors.
For U.S. public pension investors, this can marginally improve funding statuses or alter
required contribution funding rates.
Because PE returns are often quoted in IRRs, such return manipulations can even permanently
window dress the PE fund’s end-of-life returns, which possibly protects LP investment managers
in bad states.
Now this approach, will have worked better in the past, as even for investors with their
eyes squeezed tightly shut, some light is leaking through due to the increasingly active
secondary market for trading stakes in private equity funds.
$57bn worth of fund stakes changed hands in the first half of this year, according to
Jefferies.
Interestingly in different market environments these things can trade at a discount or at
a premium.
In 2019 there was so much demand for private equity that investors paid a premium to buy
private equity stakes in the secondary market.
Right now, the average stake is trading at around a 15% discount to NAV.
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