Private REITs 101 Revisited: Do You Invest In BREIT Or A Diverse Public REIT Portfolio?

seekingalpha05-03

Blackstone's NAV REIT, BREIT, raised $66 billion from 2017 to 2022, surpassing all publicly-listed REITs in equity raised in 2022 alone.BREIT's ability to redeem shares at reported NAV distinguishes ...

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At the time I wrote the last piece, I was curious. A new breed of private REITs (NAV REITs) was touted for its higher level of efficiency, improved liquidity options and name-brand sponsorship. The recent NAV REIT stampede was impressively led by Blackstone, whose Blackstone Real Estate Investment Trust ('BREIT') raised a jaw-dropping $66 billion from its 2017 introduction through 2022. In fact, in 2022 alone, raising less money than the prior year, BREIT took in more equity than all publicly listed REITs combined. By the end of first quarter 2024, the REIT had an equity net asset value of $59 billion, which would currently place it as the nation's fourth-largest public REIT if it were listed. Last year marked the first year when BREIT redeemed more shares than it issued. In 2023, the REIT issued nearly $7 billion in new shares. New share issuance would have been much lower were it not for a $4.5 billion investment received in the first quarter from the University of California (\"UC\") in no-load Class I shares. To garner the investment, Blackstone offered improved terms unavailable to BREITs other investors. UC gets to receive an 11.25% annual return preference over a six-year hold period, with the return preference collateralized by $1 billion of Blackstone's own BREIT holdings. Absent the preferred UC investment, 2023 share redemptions outnumbered share issuances by over 5:1. That discrepancy would likely have been far larger had BREIT fulfilled all its redemption requests. The ability to have share redemptions is a key differentiator between NAV REITs and historically illiquid non-traded real estate investment vehicles. Under BREIT's terms, stockholders can redeem their shares at reported NAV, subject to an aggregate limitation of 5% per quarter. Between November 2022 and January 2024, redemption requests outpaced this limitation, resulting in the proration of requests. The fulfillment/request divergence briefly stopped in February 2024 before a March resurgence, when just 15% of redemption requests were fulfilled. Company Filings Company Filings BREIT's Real Estate Investment Strategy In assembling BREIT's portfolio, Blackstone sought a \"high conviction, thematic portfolio\" offering safety and high-performance characteristics. The result is a large, diverse portfolio broadly centered in sunbelt states with 85% of the rents derived from rental housing, industrial and data center real estate - three sectors prized for their reliability that unsurprisingly also rank among the most highly valued in the publicly traded REIT space. BREIT With a portfolio centered in highly desirable real estate situated in growing, well regarded markets, BREIT has posted annual returns since inception of 10.5% for its Class I shares, which have no load, and 9.5% for its high load Class S shares. Both returns handily crush the performance of VNQ (the Vanguard REIT ETF that mirrors the MSCI US Investable Market Real Estate 25/50 Index designed to capture the large, mid and small-cap segments of the U.S. equity universe). BREIT's performance has been almost impervious to rising interest rates, which have notably hurt overall public REIT performance. When interest rates began to pick up prior to the pandemic in 2018, public REIT performance suffered, but BREIT's momentum remained. And when the upward movement in interest rates resurfaced in 2022, BREIT again emerged relatively unscathed, widening its alpha creation, while its publicly traded counterparts suffered. BREIT, Vanguard, FRED The Many Barriers to Non-Traded REIT Outperformance For BREIT to outperform its public peers is no small trick. In its 2023 year-end stockholder letter, BREIT stated, \"we believe our differentiated sector and market selection is at the heart of our outperformance.\" But against its ability to make prudent investment selections, while also having a higher target leverage than public peers (60% of NAV), BREIT faces serious outperformance headwinds that include the following: The Load. Non-traded REITs charge their investors a bundle for the privilege of ownership. The front-end load for an S Class share in BREIT runs just over 9%, with 3.5% being paid up front and the rest charged annually in the form of \"Stockholder Servicing Fees\" over seven years. Public shareholders can buy a share in any REIT for essentially nothing through a discount broker. That said, the REITs themselves do have comparatively modest loads, which will start with the IPO (~5%) and then follow on offerings (in the area of 1.5% for at the market (ATM) offerings). Front-Ending Dividends. The approximate 9% load for a Class S share of BREIT is understated. That's because non-traded REITs begin accruing and making distributions the minute they receive investor money. The BREIT Class S yield has averaged 4.6% since inception and stood at 4.2% at the end of the first quarter. Paying out cash immediately when you have yet to make real estate investments with the equity raised means that early distributions are made with an investor's own cash. So, if it takes six months to deploy the equity raised into new real estate, then half a year's distributions, or about 2.3%, could be added on to the 9% front end load, raising this burden to more than 11%. Dividend Payout Ratios. When it comes to dividend policy, public REITs are again more efficient. Dividends are determined based on the free cash flow of the company, with companies generally striving to have a spread between free cash flows and the number of dividends distributed. When I was leading my last REIT, our dividends amounted to about 70% of adjusted funds from operations, or AFFO. AFFO is not the same thing as Net Cash Provided by Operating Activities on the statement of cash flows. But analysts tend to view it as the gold standard of expected recurring free cash flow available for dividends after all expenses and real estate maintenance capital expenditures are paid. In the case of public REITs, AFFO retention offers a way for companies to reinvest free cash flow into new real estate, which can compound investor returns and add to AFFO growth per share. Non-traded REITs tend to miss out on this added AFFO per share growth with their typically high dividend payout ratios. In the case of BREIT, my analysis illustrates that the company has yet to be able to cover its dividend payments (see the analysis later), which serves to detract from future AFFO per share growth potential. External Growth. External growth has often been meaningful for public REITs and is the growth shareholders realize from the new issuance of shares. On the one hand, new share issuance takes away AFFO per share by diluting it. But if the REIT's traded AFFO multiple exceeds its investment AFFO multiple (the multiple at which it buys real estate at cost), then it's an effectively being able to issue new stock at prices exceeding its NAV. Existing shareholders benefit from the dilution by getting their large cut of the spread. Non-traded REITs cannot offer external growth for their shareholders because they issue new shares at NAV. Meanwhile, quality public REITs often trade at premiums to their real estate NAV, with investors paying up for management, efficient capital stacks, liquidity, diversity, and growth potential. Borrowing Costs: Most high-quality public REITs have investment-grade ratings, enabling them to bypass secured debt from conduits and lenders in favor of direct debt issuance to bondholders in a highly liquid marketplace. This access enables them to have lower cost borrowings than their private, more levered counterparts. BREIT's borrowings are largely secured, and the company is unrated. Management Fees. Internally managed public REITs have no management fees. They run themselves at cost. That said, the leadership teams do receive generous compensation packages in the form of cash and equity participation. Non-traded REITs like BREIT are externally advised, which means that shareholders are paying the personnel at Blackstone, in addition to supporting Blackstone's overhead and profits. The management fees charged to BREIT are material. An October 2023 paper by David Harris of Uniplan compared the G&A loads of Prologis (PLD) and Equity Residential (EQR) to BREIT for the first half of 2023. BREIT's management fees amounted to 10.3% of revenues and .65% of gross assets, versus 2.5%/.24% for EQR and 4.6%/.39% for PLD, respectively. The gap between BREIT's management fees and the G&A costs of large public REITs over time can get much worse. That's because BREIT was not entitled to performance participation fees for 2023. Such fees were a regular feature between 2017 and 2022. During those years, the performance fees, which give the manager 12.5% of the returns above 5%, averaged nearly 150% of the base management fees, which would more than double Mr. Harris' reported G&A disparity. Jack Bogle, founder of The Vanguard Group, famously noted that \"In investing, you get what you don't pay for. Costs matter.\" He would likely be unimpressed with non-traded REIT cost structures. BREIT's Financial Performance When I last wrote of BREIT, I spent little time on its financial performance. At the time, the company was growing so fast and raising so much new capital, its business model was not fully evident. It is now. The company had net redemptions in 2023 and a shrinking asset base. At the end of 2023, the company reported the following: 1)Securities are shown net of non-recourse liabilities For the year, rental revenues rose 16.8% relative to the 2022 full year. However, if one just looks at the fourth quarter of each year, the growth was a more modest .79%, which pairs same store NOI increases with modest asset shrinkage over the course of the year due to stockholder redemptions and resulting asset sales. AFFO and FAD BREIT regularly discloses both AFFO and funds available for distribution (\"FAD\"). The difference between the two is centered in the following four items, together with their impact on non-controlling interests. To arrive at reported FAD, BREIT does the following: Adds to AFFO:  Management fees Realized losses on financial instruments  Subtractions from AFFO:  Recurring tenant improvements, leasing commissions, and other capital expenditures Stockholder servicing fees Realized gains on financial instruments  When it comes to REITs AFFO has no universal definition, which means that disclosure of the elements is important. As a former REIT CEO, I can tell you that REIT analysts will make their own adjustments. Playing the analyst role for this article, I, personally, see no difference between AFFO and FAD. Whenever I have endeavored to compute and report our AFFO, I have assumed that it reflected normalized cash that would be available for distribution. In the case of BREIT, Blackstone takes the unusual step of adding back its management fees to compute FAD. I, personally, do not concur with this. BREIT's rationale is that the fees are not taken in cash, but instead taken in the form of iShares that require no cash outlay. But the fees taken by Blackstone are fully earned, the payment in shares is at their option, the shares received are at NAV and the BREIT shares taken are fully redeemable with no restrictions (unlike the stockholder quarterly limitations). What's more, BREIT has redeemed shares in 2019, 2020, 2021 and 2023. Here, it's worth noting that the redemptions were not shown as a deduction from their reported FAD. And lastly? BREITs management fees are reported on Blackstone's corporate financial statements as revenue, amounting to more than a third of Blackstone's base reported real estate fees in 2023. In 2023, BREIT reported management fees of $839.2 million, adding this back to compute reported FAD. However, in the third quarter of 2023, Blackstone redeemed $833.1 million in shares at NAV. Here's what BREIT's reported FAD has looked like cumulatively since inception through the end of 2023: Author From my perspective, BREIT's true cumulative FAD (and it would be my AFFO) is the $1.28 billion after the management fees that have been fully earned and paid for with consideration. Most of the fees reside in retained iShares, but Blackstone has converted $1.49 billion of the shares to cash. What's The Dividend Payout Ratio? If you look at public REIT disclosure or write-ups in Seeking Alpha, there is virtually a universal focus on dividend coverage. In the case of non-listed REITs, this is not the case. In fact, if one searches BREIT's 10-K's, there is no discussion pertaining to dividend protection or dividend payout ratios. Given BREIT's reported cumulative FAD since 2017, what is the cumulative payout ratio? It depends on how you compute it. Author / Filings If you look at it the way I do, which is to make the FAD fully loaded with the management fees that Blackstone is entitled to take in cash and comparing this to the amount of dividends declared, then the cumulative payout ratio calculates to a mind-numbing 670%. But about half of BREIT shareholders have elected to \"reinvest\" their dividends, meaning that BREIT doesn't need to come up with the cash to pay them. In that case, the payout ratio is still high at 328%. The only way the payout ratio falls below 100% is if you use BREIT's reported FAD and compare the company's cash flow before management fees to the net dividends paid in cash. It's true that BREIT didn't have to come up with the cash to pay Blackstone, since just around $1.5 billion of its over $6 billion in fees have so far been received in cash. Still, as an analyst or investor, I want to know how the company does when its reported costs and dividend obligations are paid for in cash. After all, since Blackstone received full consideration for its management fees in shares, it's as if two transactions were happening. First, the fees were paid. And second, Blackstone purchased $3.525 billion in shares (net of their redemptions). Likewise, stockholders received taxable dividends amounting to $8.6 billion, with 51% of them using that money to purchase another $4.4 billion in new shares. By the way, backing out BREIT's fees, net of redeemed shares, from cash flow gets you a FAD payout ratio of nearly 88%, but using only the net stockholder distributions that were paid. If you have been a BREIT stockholder since 2017 and have been reinvesting your distributions, you were probably hoping that your reinvested dollars could be put to use buying more real estate. Based on the preceding calculations, this does not seem to be the case. About half of the collective $4.4 billion in reinvested dollars, together with the proceeds from $3.525 billion in net stock sales to Blackstone, benefited those stockholders who elected to take their distributions in cash. The other half could be used for real estate investments or to purchase shares from those redeeming stockholders wanting to cash out. AFFO Yields and Multiples Just as non-listed REITs make little mention of dividend payout ratios, there's no discussion of AFFO or FAD yields, or of AFFO or FAD multiples, when it comes to metrics. As with dividend payout ratios, these are among the most important valuation metrics used for public REITs but are absent in the private sphere. So, what was BREIT's dividend yield in 2023? BREIT has four classes of investment, ranging from the higher load D, S and T classes to the no-load I Class, meaning that there are four dividend yields. But, if I simply take the declared distributions and compare those to reported NAV, the weighted 2023 yield amounted to approximately 4.5%. The weighted BREIT yield for 2023 was low relative to the yield available on government securities, but exceeded the yields available on many high-quality public REITs that operate within the company's investment sectors. Of course, BREIT's declared dividend payout ratio (using my definition of FAD/AFFO which includes management fees) well exceeded its AFFO. For 2023, my computation of BREIT's payout ratio was a stunning 303%. What does that make BREIT's AFFO/FAD yield? For 2023, the FAD/AFFO yield would have been a mere 1.5%, meaning that BREIT's AFFO/FAD multiple would have been in the area of 67.5X, well above that of public peers. Business Model Anyone who knows me knows that I am a fool for business models. Whether you're talking about REITs or other corporate sectors, companies having the best business models invariably win out over the long term. I computed BREIT's 2023 AFFO/FAD yield to be just around 1.5%, so I decided to work from the top down to understand the company's real estate yields at cost and at NAV. Understanding the BREIT business model is complex because more than 10% of its assets are either non-consolidated real estate or investments in real estate securities. Moreover, BREIT intelligently invested in interest rate hedges, which have served to insulate the company from the meaningful rate increases that started to bite in 2022. To understand BREIT's business model, I started with its reported rents less direct property operating costs and compared the result to its investment in its real estate at cost. For 2023, the gross yield, or cap rate at cost, approximated 4.6%. To arrive at an NAV yield involves estimation. At the end of 2023, the company reported its NAV to be $60.7 billion. Of this amount, unrealized net real estate and real estate debt appreciation amounted to $9.7 billion, or nearly 16%. Marking up real estate yielding 4.6% at cost by 16% would arrive at an effective NAV cap rate of 3.8%. That's the cap rate earned by new investors at the end of 2023 who were buying BREIT shares. To get closer to an AFFO yield, you have to load the 3.8% cap rate with the company's general and administrative costs and management fees. That got me to a 2.9% yield before interest expense, income on real estate investment securities, hedging income and other income. The net impact of all this is simply going to be the delta between the 2.9% and the 1.5% AFFO/FAD yield. Here's what this looks like if I chart the calculations for every period reviewed: Author / Filings There will be a lot of volatility when spreading the BREIT numbers, especially through 2022, when the company's assets were growing at a breakneck pace. So, to try to be closer to reality, I used annualized fourth quarter numbers when creating this chart. With the company's asset growth curtailed (and dropping) in 2023, the variability lessens. Comparing BREIT to Select Public Peers When comparing BREIT to quality public peers operating across some of the same investment sectors, the contrast is stark. The public peers that follow are centered in real estate, comprising almost 70% of the BREIT portfolio. They offer a median implied cap rate approximately 1.6% higher than BREIT, a median AFFO yield nearly triple BREIT's, meaningfully lower leverage, solid investment-grade credit ratings and dividend payouts well below 100%. Given a choice to invest in BREIT or a diverse public REIT portfolio, my recommendation is simple: Take the public portfolio route. Author / BREIT / KeyBanc As you can see (above), this nine stock REIT portfolio is weighted similar to BREIT property sector weightings and include:  Prologis (PLD) EastGroup (EGP) Terreno (TRNO) Rexford (REXR) Digital Realty (DLR) Invitation Homes (INVH) American Homes (AMH) Equity Residential (EQR) Essex Property (ESS)  Final Thoughts The disparity of the metrics between BREIT and the public companies selected raises an obvious question. Would BREIT's shares have a value anywhere close to their reported NAV were they a public company? Given my analysis and the above comparative table, I can't see this. What I do see is ample support for why redemption requests have so outpaced new equity raising in 2023. In my view, investors are wise to redeem their investment at NAV and then reinvest the proceeds into a select portfolio of comparable REITs or a REIT ETF. At the very least, my recommendation would be that they accept their distributions in cash.  Note: Brad Thomas is a Wall Street writer, which means he's not always right with his predictions or recommendations. Since that also applies to his grammar, please excuse any typos you may find. Also, this article is free: Written and distributed only to assist in research while providing a forum for second-level thinking.","kind":null,"is_publish_news":null,"is_publish_highlight":null,"is_publish_live":null,"is_publish_wemedia":null,"editions":null,"symbols":[],"gpt_button":1},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":0,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.22.4","shortVersion":"4.22.4","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2432092763"}