Blackstone’s Giant Real Estate Fund Faces a Test

Blackstone (ticker: BX) describes Breit as an “institutional-quality real estate platform that brings private real estate to income-focused investors.” Now one of the largest U.S. real estate investment trusts, Breit owns nearly 5,000 properties, mostly multifamily dwellings and warehouses, as well as the real estate assets of Las Vegas hotels/casinos including the Bellagio and MGM Grand.

Though not publicly traded, it’s sold by major brokerage firms and financial advisors, with a relatively low minimum investment of $2,500. In just five years, Breit has become a lucrative part of Blackstone’s industry-leading real estate franchise, generating $1.8 billion in fees last year and $1 billion in the first six months of 2022.

That rapid growth could have a downside. There has been concern recently about Breit’s outlook, including how it is valued and whether investor redemptions will increase from low levels. BofA Securities analyst Craig Siegenthaler estimated in July that net flows, or sales less redemptions, have essentially moved to “break-even” after inflows averaging $2 billion a month for the past 18 months.

In response to analysts’ questions about Breit on Blackstone’s earnings conference call in July, CEO Stephen Schwarzman said that Breit and other Blackstone offerings provide “enormous value” to investors, “who remember it and they appreciate the firm. That builds our brand. That helps us raise money.”

Recently, however, a cloudier outlook for Breit and other Blackstone retail products such as the Blackstone Private Credit Fund appears to be weighing on Blackstone stock, which at about $102, is down 30% from its November peak.

A Barron’s analysis of Breit suggests that investors should be cautious and instead consider publicly traded real estate investment trusts, or REITs, that look more attractive. Breit has gone up in price this year while public REITs have moved lower. Breit has relatively high fees, offers limited liquidity, and is more leveraged than comparable public companies.

Blackstone says Breit has appreciated this year because strong financial performance has more than offset the impact of higher interest rates. It says Breit has “delivered exceptional performance” for investors and is “exceptionally well positioned,” given its focus on apartments and warehouses.

Apartments are benefiting from double-digit rent increases, and warehouse demand has been strong. “These are the best fundamentals that I have seen in these two sectors in my entire career,” said Blackstone President Jonathan Gray on a recent webinar.

Breit’s fees are comparable to its private institutional real estate funds, and Blackstone says Breit’s leverage is modest relative to many private real estate funds.

One of Breit’s big selling points, a distribution yield of roughly 4%, is above the REIT average of about 3%. But the distribution isn’t fully earned based on a key REIT cash-flow measure. The distribution yields differ somewhat among its four share classes.

Breit differs from public REIT peers like

Prologis

(PLD),

Mid-America Apartment Communities

(

MAA

), and

AvalonBay Communities

(AVB), which can be bought and sold on public markets. Breit is the only buyer of its shares, and caps monthly redemptions at 2% of the fund’s net asset value and quarterly redemptions at 5%.

Breit says its shares should be considered to have “limited liquidity and at times may be illiquid.” Breit has met all redemption requests since its inception. With inflows that have totaled about $35 billion in the 18 months ending on June 30, the fund has been on a buying spree. For instance, Breit and another Blackstone fund have a $13 billion deal to acquire one of the largest owners of housing for college students,

American Campus Communities

(ACC), which is expected to close in the next few days.

Breit’s growth has been driven by excellent portfolio selection and ample returns. Nearly 80% of its assets are in rental apartments and industrial properties, including warehouses geared toward e-commerce, which have been the two strongest real estate sectors in recent years.

Breit’s total return has averaged 13.5% a year since inception, compared with 7% for the Vanguard Real Estate (VNQ) an exchange-traded fund whose holdings are dominated by the largest public REITs. “It has done a terrific job picking sectors,” says Dave Bragg, an analyst at Green Street, an independent real estate research firm.

Breit’s value has held up amid the fallout in financial markets and in the public REIT sector this year. Breit’s total return this year through June has been about 7%.

On the other hand, the Vanguard ETF had a negative 13% total return through the end of July, while comparable public REITs like Prologis, AvalonBay, and

Camden Property Trust

(CPT) are off 15% or more based on total return. Breit has suffered just three down months since its inception in January 2017.

Breit can rise while comparable public companies are falling because it tracks private real estate markets, which can move more slowly than more volatile public markets. Blackstone prices the fund monthly based on its financial performance and other factors, including interest-rate changes.

Blackstone points to the strong performance of Breit’s portfolio—net operating income was up 16% in the first half of 2022—for the positive returns this year. Public REITs also have reported good results, but their stocks have dropped due to higher interest rates and concerns about a recession.

“When public REITs trade at discounts to underlying value of their assets, it’s a great buying opportunity,” says Bragg of Green Street. “We don’t think investors should be buying in the private markets when the public market opportunities are so great.”

He calculated that the big public REITs on average were trading recently at about a 15% discount to their net asset values.

As an alternative to Breit, investors could consider well-run public alternatives such as Prologis, a leading owner of warehouses, or multifamily REITs such as AvalonBay or Mid-America Apartment Communities. Barron’s wrote favorably on the apartment REIT sector recently.

Redemption requests by Breit investors appear to be picking up. Siegenthaler’s analysis showed that sales were roughly matching redemptions. “Given that Breit generated $9.8 billion in inflows in first-quarter 2022 ($3 billion plus per month), the fact that its flows may have slowed to break-even was surprising and occurred earlier than we expected,” he wrote. He nonetheless has a Buy rating on Blackstone and expects retail flows to Breit and other vehicles to reaccelerate in a recovery.

Blackstone noted on its recent earnings conference call that investors requested $2.9 billion of redemptions from its retail funds including Breit during the second quarter.

Blackstone says it isn’t worried. “In this period of extreme market volatility, a deceleration in fund-raising is unsurprising, but Breit net flows are still positive on the back of strong performance,” the company tells Barron’s.

Asked on the July conference call how it would handle a period of redemptions beyond redemption limits, Gray, who built the firm’s real estate empire, pointed to a “significant amount of a liquidity” at Breit. Gray himself recently invested $50 million in the fund.

Keefe, Bruyette & Woods analyst Robert Lee wrote earlier this year that alternative managers are eager to attract “locked-up capital” from individual investors. While that is not an issue when times are good, he said, “there is a risk that in times of stress, individual investors may realize they aren’t so happy with the lack of access to their capital.”

Breit levies a base annual fee of 1.25% of net assets and has an incentive fee of 12.5% of the annual total return if it achieves at least a 5% return. Bragg estimates that Breit’s fees are two to three times those of public REITs and funds, depending on the vehicle chosen by the investor.

Breit had a net asset value of $68 billion—equivalent to an equity market value—and a total value including debt of $116 billion at the end of June. Breit calculates its leverage ratio at 42%—debt divided by total value. Comparable public REITs are about half that level. The fund had $46 billion of debt outstanding at the end of the first quarter while a comparably sized Prologis had $18 billion.

No public REIT analysts follow Breit. It doesn’t issue earnings news releases or hold quarterly conference calls. It files quarterly 10-Qs and annual 10-Ks, but its financial statements, like those of public REITs, are complex.

REIT investors look at net income, but focus more on other measures such as funds from operations and funds available for distribution, which add back sizable depreciation expenses. The idea is that most of the depreciation is a phantom noncash expense since the underlying real estate isn’t falling in value.

Breit, unlike most big public REITs, has operated in the red based on net income. It lost more than $800 million in each of the past two years based on generally accepted accounting principles, or GAAP, and about $650 million in the first six months of 2022.

For 2021, it calculated its funds available for distribution at $1.3 billion, but that did not cover its distributions to shareholders of $1.6 billion. About half of Breit holders reinvested their distributions last year, reducing cash outlays.

Breit’s calculation of its funds available for distribution, a non-GAAP financial measure, excluded $1.8 billion of management and incentive fees paid to Blackstone in 2021. The reason is that the payments were made in Breit shares rather than in cash. But fees are fees regardless of whether they’re paid in stock or cash. Breit buys back stock paid to Blackstone, meaning Blackstone effectively gets cash. Breit includes management and incentive fees as an expense in its calculation of its GAAP net income.

The Breit distribution is nearly all a return of capital due to its losses. In contrast, most big REITs pay dividends at least partly from net income.

Blackstone says Breit’s net income is depressed by greater depreciation expense relative to public REITs. That high depreciation results in a tax-advantaged distribution, benefiting investors, it says. Breit says it has fully funded the distribution from cash flow from operations, a GAAP metric that excludes the management and incentive fees, since its inception.

Over its first five years, Breit has scored, thanks to smart sector allocations and a real estate bull market. But with a lofty price and high fees, it could be hard-pressed to repeat its historical returns and beat the public REITs. And it has yet to be tested in a sustained economic downturn or a period of net redemptions.

Write to Andrew Bary at [email protected]