Disclaimer: The information and examples presented here are for reference and educational purposes only. The views, opinions and suggestions expressed here are those of the author and do not constitute legal advice. This article is not in any way indented to give investment advice or recommendation to buy, sell, lease or any form of investment. We shall have no liability or whatsoever for any loss or expense whatsoever, related to investment decision made by the reader. The information provided here is on an "as-is" basis with no guarantees of completeness, accuracy, usefulness or timeliness and without any warranties of any kind whatsoever, express or implied. While every responsible clause is taken to ensure the accuracy of information presented, no responsibility can be accepted for any loss of inconvenience caused by any error or omission.

Are REITs perfect substitutes for real estate?

In a recent article by David Dickinson and Professor Sing Tien Foo REITs are not perfect substitutes for physical real estate investments due to its heterogeneous PB ratios but is still an attractive instrument that provide exposure to the physical real estate market.

This is because 2 very different considerations are applied to REITs, that being the value of the underlying physical asset and the value of the REIT unit, both affecting its REITs PB (Price-to-book) ratio. These two values are also traded in different markets which gives it a "unique dual market structure", being the private market for physical real estate and the stock market for the REIT units.

Information for physical real estate market is is not as accessible to the public, especially commercial real estate to specialized properties like healthcare. Hence physical real estate valuation can be challenging due to its heterogeneity and specialty. Although information for a REIT can be found publicly, there are various approach to value a REIT and the valuation can be especially sensitive to the stock market volatility due to its liquid nature.

The authors opined that the PB ratio should converge to 1 in the long run as investors arbitrage between the two markets. However, REITs are not perfect substitutes for physical real estate.

Now let's have a quick look at some of the key characteristics of physical real estate vs REITs:

Physical real estate are illiquid in nature, comes with high transaction cost, longer transaction time and with government intervention or policies. REITs on the other hand, are more liquid, comes with low transaction cost, shorter transaction time and less government intervention or policies. Physical real estate requires maintenance for its premises, while a REIT requires real estate management services.

Investors investing in REITs are subjected to less restrictions compared to investing in physical real estate. However, a REIT investing in physical real estate are subjected to more restrictions and governance compared to an individual (or people) investing in physical real estate.

Physical real estate is also indivisible and heterogenous - no one property is the same, whereas a REIT is divisible and homogenous across its units.

Therefore, both physical real estate and REITs cannot be exactly be used in the same way as the other and its utility are not exactly identical.