Real Estate Investment Trusts (REITs)
Real estate investment trusts – REITs (pronounced "reets") — are funds that allow investors to pool their money into a fund that profits from investments in real estate or by financing real estate. By giving REITs tax advantages, Congress has enabled not only investors to benefit from a steady and reliable income, but has also lowered the cost of financing real estate, thus extending property ownership to more people. REITs have higher Sharpe ratios than most other types of investments, meaning higher returns with lower risk. REITs are considered value investments because they have low growth rates but pay high dividends.
Changes in the tax code in 1960 allowed the creation of these pass-through conduits: though REITs are corporations, they can deduct dividends paid to investors, thus avoiding double taxation and increasing the amount available to be distributed. Nowadays, almost 30 countries have similar types of funds based on the REIT model.
Advantages of REITs include:
- liquidity, more than 160 REITs trade on major exchanges
- reliable income in the form of dividends
- lower beta, meaning that REITs rise or fall less than most other types of securities
- supply and demand do not fluctuate nearly as much as for other types of securities, since there is a continual need for real estate
- stellar investment returns: for instance, equity REITs outperformed stocks over the 30 years before March 28, 2013.
REITs are much like mutual funds, in that they are pooled investments managed by professionals. However, while mutual fund managers mostly buy and sell stocks or other securities, managers of REITs actually manage real estate properties or mortgages, so it is more of an active business that involves selecting properties to buy, sell, lease or develop, and deciding whether to finance those properties with equity or debt. UPREITs are a special type of REIT that, rather than owning real estate directly, own a controlling interest in companies that own real estate. UPREITs are often formed by combining real estate limited partnerships, where the partners receive interests in the UPREIT, which can be retained or sold to the public.
Technically, the investment interest in REITs is measured in terms of units rather than shares, so investors of REITs are referred to as unitholders rather than as shareholders. Nonetheless, the terms REIT shares and REIT shareholders are often used.
Because REITs pay a dividend, most people buy REITs for their income, so the value of REITs tends to vary inversely to interest rates, like bonds. Profitability usually increases when interest rates fall, but if interest rates rise, then REITs may decline, both because REITs have to compete with other investments paying a higher income and because interest expenses increase. However, the interest rate sensitivity of REITs is less than that of bonds. Equity REITs, especially, are not as interest-rate sensitive, since there is a greater demand for rentals as interest rates rise, allowing an increase in rents, and real estate can still appreciate, especially for commercial properties. Although higher interest rates decreases the demand for residential properties, the demand for rentals increases, since people still need a place to live. Higher interest rates usually increases the demand for commercial properties, since interest rates usually rise as the economy heats up, so businesses increase their investment to handle the increased business, which increases the demand for commercial properties. On the other hand, mortgage REITs are much more sensitive to interest rates.
Over longer terms, REITs are more highly correlated with the real estate cycle. The value of REITs will depend, to some extent, on the demand for property. There are various metrics, most of which are published monthly, that measure demand for property:
- absorption rates
- new construction
- permits and construction spending, and
REITs are generally less volatile than property prices, because of their greater liquidity, so REITs are considered a defensive investment, in that they decline less during bear markets but also rise less in bull markets. Moreover, because there is less correlation with the stock market, REITs can be an important component of an asset allocation program to lower overall risk.
Most REITs are publicly traded, but some are private, while others are public, but not listed. Publicly traded REITs are registered with the Securities and Exchange Commission (SEC) and trade on a stock exchange, and are self-managed, with a Board of Directors. Public non-listed REITs are registered but not listed on an exchange, are externally managed, and also have a Board of Directors. Private REITs are not registered and not publicly traded, so they are illiquid. Like public non-listed REITs, they are externally managed, but have no board requirements.
Investor Alert! — Public Non-Listed REITs are a Bad Investment
Public non-listed REITs (aka nontraded REITs) are registered with the SEC but they do not trade on public exchanges. Why, you may ask, do REITs bother with the long, expensive SEC registration if they are not going to be publicly traded? Because public non-listed REITs are "sold" rather than bought. Without SEC registration, the REITs could only be marketed to accredited investors. Although they are wealthier and presumably more sophisticated about investments, they constitute a very limited market and are tougher to sell to. With SEC registration, public non-listed REITs can be sold by broker-dealers and their representatives, investment advisors, and financial planners to the public. To compensate them for their sales effort, a hefty sales commission of up to 15% is charged. If the REITs were publicly traded, then they would not be able to charge their fat sales commissions. Naturally, sales commissions are subtracted from the amount invested, reducing returns for the investor. Furthermore, according to a recent study, nonlisted REITs underperformed publicly traded REITs by 3.6%, and because they're not traded, they are highly illiquid, making them difficult to value.
REIT Evaluation: Dividend Yields, Net Asset Value, Net Operating Income, Cap Rate, Funds from Operations
There are several methods for measuring the quality of REITs in terms of its underlying business:
- vacancy rates of properties held by the REIT
- quality of the underlying real estate properties or mortgages
- the trustee's or management's percentage ownership of the REIT
- the manager's expertise and history of managing real estate or financing
Obviously, lower vacancy rates, better properties, more creditworthy mortgagors, and a higher percentage of ownership and experience by the management or the trustee all point to a higher quality REIT. However, an easier metric to determine, and one that can be compared with other investments, is the dividend yield and the annualized total percentage return.
The dividend yield is simply the dividend divided by the unit price.
Dividend Yield = Dividend ÷ Unit Price
There are 2 methods of calculating the annualized total percentage return. The simple calculation uses the arithmetic mean, where the total return, in the form of dividends plus capital appreciation, is divided by the number of years that the REIT was held:
Annualized Total Return using Arithmetic Mean = (Total Return – Initial Investment) ÷ Initial Investment ÷ Holding Period in Years
The geometric mean method calculates the rate for compounded interest, which will be slightly lower than the one calculated using the arithmetic mean:
- divide the end value of the investment by the beginning investment
- divide 1 by the number of years in the holding period
- raise the result from step 1 to an exponent equal to step 2
- subtract 1 from the result, which equals the compounded annual gain as a decimal.
- To convert it to a percentage, simply multiply by 100 or move the decimal point 2 places to the right.
Annualized Total Return using Geometric Mean = [(Total Return ÷ Initial Investment)] (1 ÷ Holding Period in Years)
So if your initial investment in the REIT was $100 and the total REIT percentage return after 4 years was $140, then:
- $140 ÷ 100 = 1.4
- 1 ÷ 4 = 0 .25
- 1.4(0.25) = 0.0878 = 8.78% = geometric mean
- The arithmetic mean = ($140 - $100) ÷ 100 ÷ 4 = 40% ÷ 4 = 10%
There are several metrics to gauge the viability of a REIT. Net asset value (NAV) measures a REIT's value as the excess of assets over liabilities. However, REITs claim a considerable amount of depreciation on the properties, resulting in a book value that is much less than fair market value (FMV). Hence, the NAV of a REIT is calculated using the fair market value of its assets rather than their book value.
Net Asset Value = Fair Market Value of Assets – Liabilities
Net operating income (NOI) is a better indicator of the long time viability of a REIT, since operating income or expenses does not include one-time items, such as the sale of property. NOI is based on regular business income and expenses, not on extraordinary items.
Net Operating Income = Operating Income – Operating Expenses
Another measure of a REIT is the capitalization rate, or cap rate, which is the income from normal business operations divided by the value of its property portfolio:
Cap Rate = Net Operating Income ÷ Property Value
Sometimes the cap rate is reported as pro forma, which includes projections that have not been realized, so they could turn out to be wrong — something that a potential investor should keep in mind when performing due diligence for a REIT.
One problem with using cap rates is that the value depends on the assessed value of the property, which can vary depending on how the property value is determined, such as from cost of funds, expected rents, or other methods. Another consideration is that cap rates can be misleading, because a rising cap rate can be due to an increasing NOI or because property values are decreasing. Less fluctuating is the forward implied cap rate, which divides NOI by the enterprise value, which is the assessed value of the business by the market, equal to the market capitalization + company debt + other potential liabilities:
Forward Implied Cap Rate = Net Operating Income ÷ Enterprise Value
The performance of REITs are also measured by the funds from operations (FFO), which is basically cash flow from operations, equal to NOI, then adding back depreciation and amortization, since these tax deductions do not require an outlay of cash; therefore, they can be used to pay dividends. Gains or losses from the sale of property or investments are not considered when calculating net income, because these are generally one-time events. So the FFO measures the viability of the REIT, including the ability to continue making dividend payments, since such payments depend on a steady cash flow.
Funds from Operations = Net Operating Income + Depreciation + Amortization
Sometimes different REITs are compared using a price-to-FFO ratio (P/FFO), similar to the price-to-earnings ratio used to compare stocks. The inverse of this ratio, FFO/P, which is the earnings yield for a REIT, is also sometimes used.
Types of REITs: Equity, Mortgage, or Hybrid
REITs are primarily classified as being either equity REITs or mortgage REITs. Some are hybrid REITs, a combination of the 2 types.
Mortgage REITs, also known as mREITs, as the name implies, supply financing for properties. Interest is earned either directly from mortgages or from mortgage-backed securities. MREITs can either buy mortgages from 3rd parties or underwrite the loans directly. The same factors that impact MBSs also impact mREITs: changes in interest rates, prepayments, and the potential for credit events, such as foreclosure or bankruptcy.
Equity REITs own property, such as offices, shopping centers, medical facilities, apartments, student housing complexes, hotels, and even timberlands and cell phone towers. Equity REITs can be further classified as diversified, industrial, mortgage, office, residential, retail, and specialized.
Diversified REITs may have a combination of commercial or residential properties or different types of commercial properties.
Retail REITs primarily lease properties to retail establishments, such as malls. The rent received can be classified as either minimum rent or overage rent. Minimum rent is the minimum that the retailer must pay, whereas overage rent is a percentage of the tenant's sales. Usually, the 2 types of rent are combined, so tenants pay both a minimum and overage rent.
Office REITs lease offices for longer terms than other types of property, often 7 to 10 years. Consequently, office REITs tend to lag the market when market rents change. If the market rate falls, then office REITs will generally do better since their lease rates are locked in; however, when the leases expire, then the office REITs will be generating less income, lowering their value. On the other hand, when market rates rise, then the rents charged by office REITs may be below-market, but their value may rise as leases expire. The value of office REITs also depends on the quality of the buildings that they own. Buildings are graded according to 3 classes: class A, B, and C, with class A being the highest quality. The tenancy rate is also important and can be predictive of future earnings. For instance, if the office REIT rents to government contractors, then that will tend to be more stable than renting to retailers. Indeed, renting to government contractors may even be anti-cyclical to the regular business cycle, since the government tends to spend more money when the economy is in a recession.
Residential REITs focus on renting residential properties with more than 4 units, including apartments, manufactured homes, and student housing. Because residential REITs rent the properties, they are impacted inversely by factors that promote home ownership, such as lower interest rates and better job growth in the area. On the other hand, factors that increase renting, such as higher interest rates and lower job growth will favor residential REITs.
Industrial REITs focus on warehouses and other buildings for logistics, such as packing, storage, distribution, and transport, so industrial REITs are sensitive to industrial demand.
Specialized REITs represent properties not included in the other types of REITs, such as healthcare, hotels, and self-storage.
Taxation of REIT Dividends
REITs are modeled after mutual funds, avoiding double taxation even though most REITs are taxable corporations, because, unlike C corporations, they are permitted to deduct dividends paid to their investors from their taxable income. However, to receive preferential tax treatment, the REIT must satisfy the following tax rules:
- have a minimum of 100 shareholders
- 50% of the shares cannot be held by fewer than 6 shareholders
- must have a long-term investment horizon
- primarily own or finance real estate
- at least 75% of income must be earned as rent, real estate interest, or from the sales of real estate assets
- at least 75% of the corporation's assets must be real estate
- at least 90% of its income, not including capital appreciation, must be distributed annually to shareholders
- at least 95% of its income must be passive, thus subjecting income from REITs to the passive activity rules
Although the income received by REIT holders is often referred to as dividends, they are taxed more like distributions from a limited partnership. Note that these distributions do not receive the preferential tax treatment accorded to qualified dividends from other securities. As a pass-through entity, REITs do not pay taxes on money distributed to investors. Instead, the investors pay taxes on the amount distributed to them. The tax rate that applies depends on the source of the REIT income: ordinary income, capital gains, or return of capital. Ordinary dividends are taxed at the taxpayer's ordinary, marginal rate. If the REIT earned some of the income from selling assets, then some of the distribution may be composed of long-term capital gains. If the REIT held the property for longer than 1 year, then the long-term capital gains rate applies, which will be 15% for most taxpayers and 20% for those in the 39.6% tax bracket. Low-income taxpayers — those in the 15% tax bracket or less — will not have to pay any tax on this portion of the income. Note that whether the long-term capital gains rate applies depends on how long the REIT held the property: it does not matter how long the taxpayer held the REIT units.
However, there is one wrinkle in the capital gain distribution from a REIT. Since most of the capital gains comes from the sale of real estate, and because REITs, like other taxpayers, depreciate the property while they hold it, the portion that has been depreciated is subject to recapture — formally referred to as unrecaptured §1250 gain — at the lower of 25% or the taxpayer's marginal tax rate.
There is a special loss rule that applies to REIT dividends. Any losses incurred in the sale of REIT units that were held 6 months or less are treated as long-term capital losses to the extent of any capital gain distributions received before the sale plus any capital gains earned by the REIT, but not distributed to the taxpayer.
Any portion of the distribution that is attributed to a return of capital is not taxed when received, but it does lower the tax basis of the REIT units, which will increase any capital gains or reduce any capital losses when the units are sold by the taxpayer.
After the end of the year, the taxpayer will receive a Form 1099-DIV, Dividends and Distributions from the REIT that will list the total dividends paid, with the different portions — ordinary income, capital gains, unrecaptured §1250 gains, and return of capital — listed in different boxes.