2009 Volume 12 Issue 1

Private vs. Public Real Estate Markets

Private vs. Public Real Estate Markets

How are these markets related in terms of risk and return?

Investors should be aware that the indices tracking the returns of publicly traded real estate companies (public real estate) and private commercial real estate cannot be compared at face value. First, the private commercial real estate return indices suffer from artificial “smoothing” effects of infrequent, appraisal-based valuation data, and second, the public real estate returns include the effects of leveraging used by real estate companies. Although the underlying values of the properties are similar. For these reasons and more, the private and public real estate returns/risk characteristics are dissimilar.

This article highlights the informational inefficiency that exists between public and private real estate markets: prices from publicly listed real estate markets lead and predict prices in private real estate markets for as much as a year or more.

Image: Stephen W. Morris

Global Real Estate Equity Market

Within the last decade, the global real estate market has come a long way. The increase of capital flows into the real estate sector, the growth in variety and number of investment vehicles, and the increased recognition among institutional investors of the potential for real estate within a multi-asset portfolio have contributed to the worldwide expansion of both the private commercial real estate equity market and public real estate equity market (publicly traded property companies).

The size of the global investable universe of private commercial real estate equity market has grown from approximately USD $6.2 trillion at the end of 2003 to more than USD $8.0 trillion in 2006,[1] with the U.S., Japan, and UK markets making up approximately half of the investable universe.

The growth of the public real estate equity market has been even more dramatic.

The total market capitalization of the FTSE EPRA/NAREIT global listed real estate index (composed of 300-plus publicly traded real estate companies around the world) more than tripled within the last six years, with the total market capitalization at the end of 2007 reaching approximately $800 billion.

Public Real Estate Total Market Capitalization[2]

During 2007, the total market capitalization of publicly listed real estate around the world fell significantly from their tops due to a combination of market factors: rising interest rates, mergers and acquisitions of public REITs, concerns of an economic slowdown, and the U.S. subprime mortgage crisis (Read Dr. Park’s explanation of the causes of the sub-prime mortgage meltdown here). After a seven-year stretch of market-leading performance, the real estate market as a whole is currently undergoing a correction period.

Real Estate Investment Trusts

In an effort to give small investors access to real estate investments that traditionally were available only to institutions or wealthy individuals, the U.S. Congress passed the REITs Act in 1960, allowing for the creation of Real Estate Investment Trusts (REITs). A REIT is a special corporate organizational form, under the tax laws, for companies that own and operate income-producing real estate. The benefits of the REIT organizational form for investors include liquidity, limited liability, and professional management, while avoiding taxation at the corporate level (similar to mutual funds for stock investors). In order for a company to qualify as a REIT in the United States, it must comply with the requirements of Internal Revenue Code § 856. Among other things, a REIT must invest at least 75 percent of its total assets in real estate, derive at least 75 percent of its gross income as rents from real property, and distribute at least 90 percent of its taxable income to shareholders in the form of dividends. Because REITs must pay out almost all of their taxable income to shareholders, they generally provide reliable and significant dividends for investors. Currently, there are about 170 REIT companies trading on the major U.S. stock exchanges.

On a global basis, not only has the market capitalization of the publicly traded real estate grown, the number of countries adopting REIT structures has also increased significantly. Although listed real estate does not have to be in the form of an REIT, the trend reflects investors’ preferences for REIT-like vehicles, evidenced by the increased market capitalizations in countries where REIT structures already exist. The U.S. REIT experience has shown the potential benefits of including public real estate equity assets in a mixed-asset portfolio: enhanced returns, lower trading costs compared to direct real estate investment, liquidity, accessibility, and diversification. These lessons have spurred other countries, including the UK and Germany, to adopt REIT-like legislations.

Countries Adopting REIT Regimes [3]

CountryREIT Legislation Enacted
United States1960
South Korea2001
United Kingdom2007

Return Characteristics of Public and Private Real Estate

Historically, one of the most interesting questions for public and private equity real estate has been the relationship between these two markets in terms of risk and return characteristics.

The most well-known private real estate performance benchmarks around the world are the NCREIF (U.S.), the PCA (Australia), and the IPD indices in various European countries. Pubic real estate benchmarks include NAREIT (U.S.), S&P/ASX200 LPT Index (Australia), GPR (Global), and FTSE EPRA/NAREIT (Global). Taking these total return indices at face value, public and private real estate markets in the past have behaved differently, with public real estate showing greater volatility.

Comparison of Private and Public Real Estate Returns [4]

Mean Return11.7416.4111.9816.369.7613.97
Standard Deviation4.1816.004.8022.723.5616.10

Furthermore, correlation studies of private and public real estate indices show that, while both have low correlations with bonds and large-cap stocks, they also have low correlations with each other, and in general, public real estate displays a higher correlation with small stocks.

Asset Class Correlations [5]

BondsLarge StocksSmall StocksPublic Real EstateReal Estate
Large Stocks0.251.0
Small Stocks0.010.591.0
Public Real Estate0.150.310.671.0
Real Estate-

As for the portfolio diversification effects of publicly listed real estate securities, the private real estate portfolios with 10 percent mixes of REITs resulted in higher risk-adjusted returns for all three countries (see below). The results imply that a holding in U.S. REITs would lead to improvements in portfolio performance even if the optimal portfolio already contains private real estate.

Impact of Adding 10 percent U.S. REITs to Private Real Estate Portfolio[6]

PrivateMixed (10% REITs)PrivateMixed (10% REITs)PrivateMixed (10% REITs)
Mean Return11.7412.2111.9812.429.7610.43
Standard Deviation4.183.884.804.703.563.84
Sharpe Ratio1.551.791.551.681.151.24

Several other studies show similar results. According to a portfolio diversification study performed by Ibbotson Associates in 2006,[7] adding REITs to a wide selection of diversified portfolios, from 1972 to 2005, enhanced risk-adjusted returns as compared with portfolios without REITs. Furthermore, research sponsored by the European Public Real Estate Association showed significant portfolio benefits to using real estate securities from six European countries.[8]

Despite these findings, however, investors should be aware that public and private real estate indices cannot be compared at face value due to the appraisal-based smoothing effects in private real estate and the leveraging effects in public real estate. For these reasons and more, the private and public real estate risk and return characteristics appear to be dissimilar at face value, although the underlying values of the properties are similar.

Appraisal Smoothing and Leveraging Effects

In the case of private commercial real estate, since market transactions are relatively infrequent, the standard practice is to use professional appraisals on a quarterly basis (or even less frequently) to derive market values. The appraised valuation data are then used to generate indices for the private real estate market. When the availability of price information is limited in the private real estate market, due to lack of trades or confidentiality of transactions, appraisers must make an assessment of value based on fundamental variables and must efficiently extract relevant information, while filtering out “noise” from the asset market. This process often leads to appraisal smoothing or appraisal lag. There is substantial empirical evidence documenting the existence of appraisal smoothing in the private real estate market.[9]

The existence of appraisal smoothing significantly reduces the usefulness of real estate rates of return series computed from unadjusted appraisal data, particularly because the variance measurement is artificially depressed. This type of smoothed series underestimates the riskiness of the real estate asset class and also distorts its correlations with the rates of returns of other assets.

On the other hand, the publicly listed real estate market does not suffer from appraisal smoothing; however, it does contain the effects of leveraging. While private commercial real estate values are measured on an all-equity basis, the returns generated by publicly listed real estate companies include the aggregated leveraging effects of these companies.

Because of these two crucial differences, public and private real estate indices cannot be easily compared at face value. Taking the private and public real estate performance benchmark indices for the U.S., UK, and Australian markets for a 10-year period and applying unsmoothing for private real estate and unlevering procedures for public real estate,[10] produces the following results:

Unsmoothed and Unleveraged Comparison of Private and Public Real Estate Markets[11]

These results support the finding in Pagliari et al[12] that when smoothing and leveraging differences are accounted for, the differences in the average returns and volatility of the private and public real estate performance indices are not statistically significant.

Price Discovery

In finance, “price discovery” refers to a process by which new and relevant information becomes incorporated into the market price of an asset. If there are many market participants and high volumes of trades, information is incorporated quickly into prices. If there is a lack of reliable information and a low volume of trades, there is inefficiency in the information flow, which leads to a market price that deviates from fundamental value.

Of particular interest in the nature of relationship between the private and public real estate markets is whether there is price discovery occurring between these two markets, after correcting for smoothing and leveraging effects. In other words, when two markets have a common component value (real estate) and these assets are traded in two different markets simultaneously (public and private markets), the important question is whether relevant price information is discovered first in the more informationally efficient market (public) and then transmitted to the less efficient market (private). This effect can be tested and evidenced empirically by positive lagged correlation in the returns across the two markets.

The result from the above study supports the finding in previous studies,[13] which indicates that, in the U.S. and UK property markets, the private real estate market contains some amount of predictability by the publicly listed property market, with the price information not fully transmitting to the private market for as much as a year. This effect of informational inefficiency appears to be strongest in the UK, followed by the U.S., and then Australia.


This article suggests several practical implications for investors. First, despite the widespread claim that publicly listed real estate offers unique return characteristics with portfolio diversification effects separate from private real estate, the difference in the risk and return characteristics between the private and public real estate markets are due to leveraging and appraisal smoothing effects. Second, from the risk-adjusted return perspective in the medium- to long-term, investment in public real estate can produce comparable average results as investment in private real estate, considering leverage and appraisal smoothing. Third, in the short- to medium-term, because the paths that the unadjusted indices take are sufficiently distinct from one another, broad index-level investments in the public real estate market can be used tactically to diversify investments in the private real estate market. Fourth, based on the evidence that the prices from the publicly listed real estate market lead and predict the prices in the private real estate market, for as much as a year or more (due to inefficient information flows between the two markets), there are potential arbitrage opportunities.

In recent years, the global real estate market has evolved as a distinct asset class that merits inclusion in the mixed-asset portfolio. This article highlights the differences and similarities between the public and private real estate risk and return characteristics. The results from the author’s study indicate that investments in publicly listed real estate companies, in particular, can create distinct opportunities for enhanced risk-adjusted portfolio returns for global investors.

[1] UBS Global Asset Management.

[2] FTSE/NAREIT/EPRA Global Real Estate Index.

[3] Updated from EPRA 2004 REIT Survey, UBS, Cohen & Steers.

[4] NAREIT, NACREIF, IPD, GPR, PCA, 19952005.

[5] Lehman Aggregate Bonds Index, S&P 500 Index, Ibbotson Small Stock Index, NAREIT, NCREIF Property Index, 19782005.

[6] NAREIT, NACREIF, IPD, GPR, PCA, 19952005.

[7] Ibbotson Associates, “Portfolio Diversification Through REITs,” research presentation, sponsored by NAREIT, 2006.

[8] G. Newell, “Diversification Benefits of European and Global Property Stocks,” EPRA, research report, 2003.

[9] R. Barkham, D. Geltner, “Price Discovery in American and British Property Markets,” Real Estate Economics, 23, no. 1 (1995): 2144; J. Clayton, D. Geltner, S. Hamilton, “Smoothing in Commercial Property Appraisals: Evidence from Individual Appraisals,” Real Estate Economics, 29, no. 3 (2001): 337360; J. Fisher, D. Geltner, “De-Lagging the NCREIF Index: Transaction Prices and Reverse-Engineering,” Real Estate Finance, 17, no. 1 (2000): 722.

[10] R. Barkham, D. Geltner, “Price Discovery in American and British Property Markets,” Real Estate Economics, 23, no. 1 (1995): 2144.

[11] NCREIF, NAREIT, IPD, GPR, PCA, U.S. Treasury, Reserve Bank of Australia, Barclays Capital, 19942005.

[12] J. Pagliari, K. Scherer, R. Monopoli, “Public Versus Private Real Estate Equities: A More Refined, Long-Term Comparison,” Real Estate Economics, 33,no. 1, (2005/3): 147187.

[13] J. Gyourko, D.B. Keim, “What Does the Stock Market Tell Us about Real Estate Returns?” Journal of the American Real Estate and Urban Economics Association, 20, no. 3 (1992): 457486; F.C.N. Myer, J.R. Webb, “Return Properties of Equity REITs, Common Stocks, and Commercial Real Estate: A Comparison,” Journal of Real Estate Research, 8, no. 1 (1993): 87106; R. Barkham, D. Geltner,” Price Discovery in American and British Property Markets,” Real Estate Economics, 23, no. 1 (1995): 2144. (link no longer accessible).

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Author of the article
Abraham Park, PhD
Abraham Park, PhD, is an assistant professor of finance at Pepperdine University’s Graziadio School of Business and Management, where he teaches real estate finance and corporate finance. Previously, Dr. Park was a lecturer of economics and real estate finance at University College London. His research is in the areas of real estate finance, construction, and franchise real estate. Dr. Park has over 12 years of experience in law, Silicon Valley technology start-up ventures, management consulting, hedge funds, and global real estate research and investments. He has worked and lived in the U.S., Asia, and Europe. Dr. Park holds an MPhil and PhD from the University of Cambridge, a JD and BA from the University of California-Berkeley, and an MPP from Harvard University. Dr. Park currently holds the Julian Virtue Professorship at Pepperdine.
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