How Texas TRS capitalised on the spread between public and private real estate

In March 2022, the Federal Reserve began tightening the interest rate screws to combat inflation, sending the valuations of US public real estate investment trusts (REITs) into sharp decline. Prices fell by 31% in less than six months. 

In contrast, rather like a cartoon character that runs off the cliff but refuses to fall, private real estate market values stayed elevated. Indeed, they actually went up by 3.9% in Q2 2022.

Many pointed to this anomaly, but The Teacher Retirement System of Texas (TRS), one of the biggest public pension plans in the US, went further to see if it could capitalise on the marked divergence between the two markets. Director Brendan Cooper pulled together a team to develop an appropriate strategy, modelling different scenarios. They called the gambit SPREAD, standing for “strategic public REIT execution and delivery”.

The SPREAD team had limited experience of public markets. “We don’t cover REITS every day,” says Cooper. “We are 100% benchmarked to the NCREIF private US index. The more we deviate from the benchmark’s strategy, the more it is scrutinised.”

He continues: “This strategy was unique. We had to create a relative-return model, but also an absolute-return framework, because the absolute-return framework is something that we typically do in the course of an investment.”

They considered three different investment strategies – active externally managed, active internally managed or passive internally managed. They plumped for the third option, partly because of their skillset, but also because SPREAD “was an opportunity-driven strategy and we feared that otherwise, that opportunity would probably close”. says Cooper. “We saw the opportunity, as a lot of people did, and said we need to create a framework that is able to be articulated internally to our investment committees and to create a real thesis with real numbers on it.”

TRS decided to develop precise modelling using two key assumptions. Firstly, the public-private cap-rate spread would revert to the five-year average (1.55% at underwriting). 

Secondly, this would be achieved by bringing public cap rates down and private cap rates up by an equal measure. After applying existing REIT leverage and deducting a ‘fee drag’ that represented average REIT general and administrative expenses, the investment was expected to deliver a 21.5% one-year forward return.

The timeframe was clearly important. “The model allowed us to go through scenario analysis, and to say if this gap persisted,” Cooper says. “If the REITs underperform for some period of time, are we comfortable in that scenario holding on longer?”

One quarter of the commitment was invested in December 2022, half was deployed in March 2023, and the remaining quarter was invested in October 2023. Average invested capital over the holding period was $246m (€220m). Two-thirds of the position was sold in December 2023; one third in January 2024. The investment yielded a 17.1% internal rate of return and $47m in profit.

Executing the strategy was a nail-biting affair for the TRS team. Cooper speaks of “the emotional winds of the public markets” and how they “can be brutally draining”. He says: “We are a dedicated team that pretty much exclusively operates in the private markets. We’re used to getting a mark every quarter, and usually, even those are smoothed out across multiple quarters. So when you see daily movements, based on whatever the Fed may be saying or doing on any given day, and all of a sudden your portfolio is down 4% or 5% in a day, that’s not something that we’re used to.”

Exiting decisions were particularly difficult. “We had debates. There was some healthy disagreement at the end, based on when we expected the Fed to pivot. Public markets are highly reactive to interest rates,” Cooper says. “But overall, the gambit was a huge success. If we had invested the same amount of dollars and put it into our private benchmark at the same time that we actually put it into the REIT strategy, we would have lost $35m. Instead of that, we made a profit of $47m. Now that’s alpha.” 

Could others do the same?

The TRS move has garnered a lot of attention in US real estate circles. Cooper says: “We’ve talked to a number of our peers about this, and people have sent us notes. A lot of people saw this, but they tell us, we didn’t really have the infrastructure or the process in order to actually execute.”

TRS is fortunate to have a special investment committee process, where for time-sensitive deals or strategies it can accelerate decision-making. The committee was also comfortable with ignoring the denominator effect, as real estate exposure of TRS temporarily strayed beyond guidelines. As Cooper sums up, “I think some institutions have less flexibility than we do”.

Nonetheless, Edward Pierzak, senior vice-president of research at US REIT association Nareit, is keen for others to explore REIT strategies. “There’s still opportunity from our perspective,” he says. “The spread between public and private cap rates is still 120bps. The gap is only about half closed from its peak.”

Pierzak also notes many US real estate teams are considering REIT strategies for a variety of reasons. “Investors can get fairly easy and cost-effective access to certain sectors that either they do not have ready access to in the private markets or where there is a pricing disparity,” he says. “Or maybe they just want quick access, because a lot of times a private strategy takes some time to execute. REITs can be a fast route to instant diversification of the portfolio across a variety of other sectors.”

He points to action from “some very sophisticated investors” like the National Pension Service of South Korea. “They looked at their portfolio and said, look, we have some gaps, and we maybe want some exposures,” Pierzak says. “In fact, they went ahead and created a custom index that really was going to reflect their needs and then ultimately went out and hired active REIT investment

managers to beat that new index. They put a billion dollars behind that, and the idea is for that to grow through time.” 

Pierzak has also seen investors use this route to invest in specific sectors, such as apartments. “They thought the pricing was really much more attractive in REITs than private and again trying to capture that, looking at that cap spread. Just as Texas Teachers saw it across the market, some folks have looked at it on a sector-specific basis.”

As for TRS, Cooper is not done yet. “There could be a number of different iterations: a different strategy that may be useful in a different market, or a different point in time, or maybe just-sector based – potentially in Europe,” he says. “This was kind of version 1.0, and it may evolve.”