Martin Pelletier: Comparing a non-listed asset with market can help reduce risk of picking wrong investment

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We moved into our new home this past weekend and I had a conversation with my realtor that left me thinking about the emotional biases we have on the things we own.

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I’ve found that if we are not careful, these biases can end up owning us rather than the other way around since they have influence over our perception of value, often inflating it above what it is worth to someone else.

The only way we discover this is by marking to market the particular asset in question, such as listing a house. If it is priced too high, it simply won’t sell, and if it doesn’t sell, then that value you perceive is clearly not the real value at that moment in time. It doesn’t matter how much you previously paid for your home, the dollar value of the renovations you put into it or how wonderful it has been to you and your family.

We also see this type of thinking in private versus public-market investments, including real estate. We’ve seen private investments being marketed as a safe, low-correlation asset class to public markets simply because they are not marked to market. In reality, they are no different than your home because their value moves up and down; we just don’t see it until we actually list it.

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For example, after adjusting for valuation lags, real estate investment trusts (REITs) and unlisted real estate had comparable volatilities of 18.9 per cent and 17.9 per cent, respectively, from 1998 to 2019, according to a study by the National Association of Real Estate Investment Trusts.

Over the longer term, public real estate has done better if you average it all out, while recognizing fund selection could change this for better or for worse. More specifically, unlisted real estate produced an average net annualized return of 8.7 per cent over the period, nearly 200 basis points less than REITs. Therefore, REITs offered higher returns and less volatility than comparable private real estate.

In today’s environment, public REITs were net sellers at peak prices in 2021 to 2022 while private real estate investors were buying a record amount of property, according to Chilton Investment Co. LLC. Also, instead of financing purchases with short-term floating rate debt like many private players do, public REITs used low interest rates to reduce floating-rate exposure and extend fixed maturities.

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And yet we’re seeing private real estate funds reporting minimal impacts to their net asset values, even though larger and safer REITs are down 20 to 40 per cent from their highs and trading 10 to 15 per cent below their net asset values.

So, why would you own private real estate now when you can switch into the same asset at a much lower valuation? This is akin to choosing not to sell your house privately at a substantial premium compared to a similar listed house on MLS? It just makes no sense.

As a next step, investors can compare REITs to the broader market. One study found that REITs are not as lowly correlated to the market as you might think. Taking this a step further, we put together a portfolio, 34 per cent in the iShares iBoxx $ Investment Grade Corporate ETF and 66 per cent in the iShares Russell 2000 Value ETF, and compared it to the iShares U.S. Real Estate ETF going as far back as possible (2003).

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The 34/66 portfolio returned a compounded annual growth rate of 7.54 per cent, while the iShares REIT ETF posted a slightly higher annualized 8.14 per cent. However, our portfolio had a standard deviation of only 13.96 per cent, while the REIT was nearly double at 21.16 per cent. This means the bond and small-cap portfolio offered much better returns per unit of risk.

Now, a home is a place you live in, and an investment is something you use to grow your wealth, so it’s important to separate the two. That said, transparency on both is the only way to obtain true price discovery; the rest is simply an opinion.

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This doesn’t mean the market always gets it right — the opposite often happens — but if you want to sell or buy, at least you can weigh it against the value of a comparable non-listed asset to reduce the risk of picking the wrong investment. I’m sure that’s something we all want to move into.

Martin Pelletier, CFA, is a senior portfolio manager at Wellington-Altus Private Counsel Inc, operating as TriVest Wealth Counsel, a private client and institutional investment firm specializing in discretionary risk-managed portfolios, investment audit/oversight and advanced tax, estate and wealth planning.


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