The National Associate of Real Estate Investment Trusts (NAREIT) publishes an ongoing survey and index of members’ total returns. Based on the latest survey the average annual return of and on capital for equity REITs calculated from 1972 through 1998 was 14.35 percent. This time span covers a period of unusually high inflation as well as severe downturn in the real estate markets following the Tax Reform Act of 1986. This time span may be considered representative of a full economic cycle due to these offsetting swings in the real estate markets, but it does not generally represent the returns that investors would demand for more illiquid securities, according to Chris Germain, a San Fancisco based investor.
In general, the REITs underlying the NAREIT data are highly liquid (meaning they can be readily and easily sold), pay dividends, and are well diversified. More illiquid real estate investments will not return cash to the investor until the maturity date, are substantially illiquid, and are not diversified. For these reasons, a substantial premium for illiquid real estate investments is justified above the historical rate earned on REITs.
One approach to estimate an appropriate return is to analyze rates of return in the stock market. Illiquid real estate is analogous to a non-dividend-paying small capitalization stock that has restricted marketability for an extended period. Ibbotson Associates in its annual yearbook Stocks, Bonds, Bills, and Inflation (SBBI), reports and compares historical investment returns for a variety of instruments.
The average return for small capitalization stocks over the history of the index was 17.6%. (Restricting calculations to the 20 years from 1980 through 1999, small company stocks show a compound rate of annual return of 15.46%.) To help correct for any bias in the underlying fundamentals, we have looked at the spreads between the stock indices and long-term bonds. Given the 30-year Treasury yield of 5.88% (week ending November 10, 2000, the historical premium for small company public stocks (11.7%) would indicate a long-term average yield expectancy of approximately 17.5%.
These rates of return, however, are for freely traded securities. A number of studies indicate that for stocks with temporary or other significant restrictions from trading, there is an approximate 30 to 35 percent “lack of marketability” discount from freely-traded value.
The mean discount attributed to restricted marketability by these studies of 33.4% translates into an annual required rate of return of 585 basis points above the average rate of 17.5%, or 23.3%, as indicated for the historical return on freely traded small company stocks. Using the long-term total return on the Equity REIT alternative as a base, the subject required rate of return would be indicated at 20.2% (14.35 + 5.85).
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