There’s a big trend reshaping real estate investing right now, and it needs to be addressed.
The old boundaries between publicly traded real estate investment trusts (“REITs”) and private capital are blurring. In some cases, they’re outright evaporating, as one REIT after another decides to tap into alternative funding sources.
I’m not talking about tiny companies with limited options either. In just the past few months, we’ve seen:
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Realty Income (O), with its $58 billion market cap, sign a $1 billion joint venture to grow its already enormous net-lease retail empire alongside Apollo Global Management’s (APO) massive insurance arm.
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Prologis (PLD), with its $127.4 billion market cap, announce a $1.6 billion joint venture with Singapore’s sovereign wealth fund, GIC, to build high-grade industrial properties in the U.S.
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Digital Realty Trust (DLR), with its $62.43 billion market cap, complete its first hyperscale data-center fund with $3.25 billion of funding “from a diverse group of global institutional investors, including public pensions, sovereign wealth funds, endowments and foundations, corporate pensions, insurance and asset managers, and family offices,” according to its press release last Monday.
The latter venture has Digital Realty maintaining just 20% ownership but full managerial duties. CFO Greg Wright says this is the wave of the future. “Private capital is playing an increasingly important role in how” his company “prudently and efficiently” scales PlatformDigital – its self-described “global meeting for data collaboration” – to deliver “a trusted foundation and methodology for scaling digital business.”
REITs of this size and influence have almost always relied on traditional banks to scale their operations further. And I can’t think of another time when private capital has lined up to fund a REIT.
But times are clearly changing, and trends are shifting. There’s no denying that.
It’s only a matter of whether it’s for the better or worse.
Why Public Companies Are Seeking Private Capital
Under the right circumstances, it actually does make sense for REITs to consider partnering with private money. With the key word being “consider.”
REITs (by law) must pay out at least 90% of their taxable income (annually). This forces them to rely more on leverage than many other companies.
Yet equity capital becomes more expensive when its share prices trade below net asset value (“NAV”). My regular readers know full well that REITs have been suffering from market malaise for years, thanks to higher-for-longer interest rates, placing them in quite the pickle.
That’s what makes private capital options so attractive right now, since they can provide REITs with limited-dilution equity. Meanwhile, the lender can get access to quality real estate run by competent, established, and profitable management.
It can be an all-around joint venture win when done right. But doing it right does take a lot of negotiating since each party has its own set of preferences.
While they share an ultimate goal to profit, REITs know their shareholders prefer simplicity, transparency, and steady dividends. Whereas private partners look for structure in the form of preferred returns, hurdle rates (i.e., their minimum rate of return), and/or partial control of the assets at stake.
Those expectations don’t always naturally mesh. And shareholders have been automatically suspicious of attempts to make them work in the past… as happened with net-lease REIT W.P. Carey (WPC) years ago.
Despite its reputation for quality execution, WPC faced a clear image issue when it set out to manage non-traded funds under its CPA® platform. Analysts weren’t convinced it could handle third-party finances while running a public REIT.
And they had no problem saying so.
Thanks to WPC’s excellent management team, the actual business in question wasn’t really that questionable, in my expert opinion. Even so, there was enough bad sentiment surrounding it that the stock suffered for a prolonged period.
In 2022, WPC exited the CPA® non-traded REIT business, effectively marking the end of its managed non-traded platform. And investors have been in a better mood about the situation since.
The Rise of the ‘Platform REIT’
Yet, as we’ve so recently seen, that’s not the end of REITs’ private capital saga so far. This landlord category appears determined to evolve.
They’re still bound by the same laws as always, where they have to derive the majority of their income from real estate ventures. But their standard mode of operandi is changing.
Instead of only owning assets and collecting rent, some are starting to look more like hybrid asset managers. They’re partnering with other institutions to purchase properties, collecting partial rent but full management fees, and recycling capital like a private equity platform would.
In short, REITs are transforming into capital allocators instead of corporate landlords. They’re evaluating each project they approach individually and financing them accordingly. This allows them to grow more quickly and efficiently.
In which case, shareholders could reap some very nice rewards.
The risk in that “could” is the very issue analysts addressed with WPC at the turn of the decade: The more complex an operation is, the greater the risk of it becoming destructively complicated.
REIT shareholders are used to special treatment, where their dividend payments are the top priority. But the more business partners these landlords bring in, the more loyalties they have to honor.
This opens the question of who gets paid first.
Unlike those WPC analysts of yesteryear, however, I don’t think the automatic reaction should be negative. I only think it should be more vigilant, with shareholders demanding clear and consistent transparency about fees, profits, and contractual rights within each new joint venture that’s formed.
And if a REIT refuses to or otherwise can’t handle that new level of sharing? Then we should take our own financial contributions elsewhere.
The Right Kind of REIT Can Handle It
When it comes to the kind of high-quality companies Wide Moat Research researches and recommends, I expect management will prove more than capable of handling the complexity. I even think this evolution could do us a favor by separating the wheat from the chaff.
Companies that can’t survive this kind of change aren’t likely to thrive during recessions of any size, much less the kind this century has seen so far. In which case, we don’t want to get involved with them regardless.
Whereas those that can – those leading the charge from positions of strength with their business eyes fully open – could very well produce the most resilient REITs we’ve ever seen.
This emerging hybrid structure is already allowing these corporate landlords to capitalize on opportunities more quickly than they otherwise could have. And, when handled well, that should lead to more flexibility and better cost of capital.
So, my final thought on the matter is to keep doing exactly what we’ve been doing all along: searching out the highest-quality REITs available at undervalued prices. That practice hasn’t failed us yet.
And I see no reason to think it will now that new players are entering the game.
Regards,
Brad Thomas
Editor, Wide Moat Daily
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