Welcome to the concrete jungle
Real Estate is boring. That’s what I really thought. After spending a summer leafing through government leasing documents that was pretty clear. Checking page after page for signatures, entering rent figures into excel, and trying to understand tenant improvements did not get my blood pumping. A 19-year-old needs more action, more excitement. So at the end of the summer I steered myself away from real estate and towards any other career path, hoping for something that was more dynamic. Maybe I could learn to trade biotech stocks… that would be exciting!
It was 8 years and 2 jobs later before I officially confirmed the naiveté of my 19-year-old self. I found myself sitting in a conference room across the table from the world’s top real estate CEO’s, discussing multi hundred million dollar development deals, portfolio acquisitions, and stock or bond offerings. At my desk I could watch their stock prices tick up and down throughout the day, as investors moved huge amounts of capital into and out of these companies. It was abundantly clear that this type of real estate was not boring. In fact it was extremely high stakes, with multi-million square foot properties changing hands in single deals, large mergers and acquisitions of companies, multi-billion dollar IPO’s, and bigtime egos clashing and competing.
I had truly entered the concrete jungle, and for a 27-year-old nerdy quant analyst it was both exciting and terrifying.
As I learned the rhythm of this strange intersection between the stock market and real estate, I realized that I had found my place. This world had pace, action, and the prospect of big wins and big losses. It was everything I had learned to love about the stock market, but with more structure and sanity. Real estate was the bedrock, but the universe was much more dynamic as stock prices constantly change. My winding journey had led me into the world of publicly traded real estate investment trusts (REITs), the apex predators in the real estate ecosystem. It certainly seemed like a far cry from my days flipping pages in a DC leasing office.
Most investors encounter REITs at some point in their investing lives. The concept of a REIT is easy to understand and attractive, but the complexity of the REIT universe is often daunting and can be overwhelming. Many investors do not know where to start, which is why we have developed this primer. By starting with the basics, we hope to condense and organize the REIT universe into easy to swallow bites.
In the following pages we will cover the nature of REITs and why they exist. In later white papers we will explore the universe of sectors and companies, as well as how REITs stack up against other common investment options. By the end we hope our readers will leave with a more nuanced view of REITs and what makes them tick.
High quality commercial real estate is the bedrock of the REIT industry
The best place to start with REITs is with the definition. The term REIT stands for Real Estate Investment Trust, and REITs are just that; trusts formed for the purpose of investing in real estate. REITs buy or develop commercial buildings, usually focusing on a single property type such as high-rise apartments, warehouses, office buildings, or retail centers like malls. At their core REITs are simply real estate portfolios that generate rental income from tenants that occupy their space. Imagine pooling your money with 3 friends and buying 10 warehouses in 5 different cities that were leased to 15 different tenants. This portfolio owned by 4 shareholders and focused on buying warehouses would effectively behave like a miniature REIT.
Note that a portfolio of 10 warehouses would be comparable to a “mini” REIT. Most REITs invest on an institutional scale, meaning the properties they own are top quality, extremely well located assets. As we will discuss below, the costs of becoming a REIT are significant, as are the benefits, so REITs tend to be sophisticated property owners simply based on self-selection.
You have to be a successful real estate investor to run a public REIT.
This is one reason the publicly traded REIT’s have historically been a great investment. They do not represent a generic sample of the commercial real estate market, they represent the top tier. The industry is literally built on high quality commercial real estate. This type of real estate traditionally holds its value incredibly well, and REIT management teams are experts in buying, selling, and developing real estate. Think high rise office properties in midtown Manhattan and San Francisco. Luxury apartment buildings in Los Angeles and Dallas, and super high end retail assets along Chicago’s famed magnificent mile. This isn’t the 2-story office/flex building your local broker is selling. These portfolios are the real deal; iconic irreplaceable assets collected and cared for over years by seasoned professionals.
So the basic concept of a REIT is very simple; investors pool their money and assemble a commercial real estate portfolio. But what makes REITs different from other commercial property owners? To find out lets hop in the DeLorean and take a trip back to 1960.
*** There are also REITs that give loans to property owners, which are referred to as mortgage REITs. We can set these companies aside for now, and focus on REITs that actually own buildings, which are referred to as equity REITs. For our purposes when we say REIT we mean equity REIT.
REITs were created to simplify commercial real estate investing
If you google the Cigar Excise Tax Extension of 1960, the results are surprisingly heavy on real estate and light on tobacco. This is because this tax extension also contained the REIT act, which Dwight Eisenhower signed into law on Sept. 14th, 1960. Before the law was enacted, commercial real estate investment was limited to institutions or anyone fabulously wealthy enough to be able to buy a large commercial building. In other words most people had no way of investing in commercial real estate, it was simply too expensive for the average investor.
By passing the REIT act, congress enabled large real estate owners to make a deal with the general public; allow the average joe to own a share of your commercial real estate, pay him a dividend generated from the income of the property, and pay zero corporate taxes as long as you operate within a set of REIT rules. The REIT industry was born.
Amazingly by today’s standards, Congress passed a law that benefited both the average investor and the well-capitalized real estate owner. Intentionally or not they had solved two problems that have faced every real estate investor since Ugg bought the first cave network in 32,000 BC …liquidity and investment size.
By allowing owners to sell shares to the public, and allowing those shares to trade on the stock markets, REITs enable investors to buy and sell real estate exposure almost instantaneously in dollar amounts of their choosing. Anyone who has ever gone through the process of buying or selling a house knows how valuable the convenience of liquidity can be. Imagine if you could sell your house within a day by logging into E-trade and clicking a button? That’s how easy it is to get commercial real estate exposure through the REITs. At the same time, you don’t have to rustle up $5 million to get a stake in a commercial warehouse, you can do it with as little as $50, and as much as $50 million. It took Ugg 60 days to close the first cave.
So let’s quickly re-cap. Commercial real estate has always been illiquid and expensive, so congress passed a law to create publicly traded REITs which are liquid and investible in smaller dollar amounts. Now large real estate owners have the option of becoming publicly traded…i.e. they can become stocks traded on the New York Stock Exchange, and average joe investors can invest in commercial real estate without exposing themselves to large specific risks. This is a deal that benefits everyone, and in hindsight was a revolutionary and powerful idea.
How powerful? Since 1960 the publicly traded REIT universe has grown at a rate of 54%/year. That’s not a typo….its 100,000 times larger now than when it began. This growth stems from the fact that the REIT structure benefits both investors and large real estate owners.
Back to the future…
Fast forward to today, and the key difference between a REIT and a non-REIT property owner is REIT’s do not pay corporate taxes. The trade-off is that they are required to pay out 90% of their taxable income in the form of dividends to their shareholders. In order to achieve REIT status, a real estate company must file an application with the IRS and meet a variety of criteria regarding their investor base and the way they generate income. In short, they must derive the majority of their income from real estate and have over 100 shareholders. This is again the reason REITs tend to be larger real estate companies. Small property owners usually don’t have the bandwidth to file for REIT status or corral 99 other investors into their company structure.
In addition many REITs register with the SEC and file quarterly financial statements that are available to the public. This allows them to go through the IPO (initial public offering) process and trade on the stock exchanges. These are the REITs that most people are familiar with and are the largest and most sophisticated real estate companies on the planet. These “publicly traded” REITs are the companies you can follow on google finance and might see featured on CNBC. Their close cousins “non-traded” REITs tend to be inferior investment vehicles, and so like the mortgage REITs for now we will set them aside. See the appendix for a brief explanation of why we ignore non-traded and mortgage REITs.
So why become a REIT? It’s clearly quite a bit of work, filing reams of documents with the IRS and SEC, then spending the money necessary to become a publicly traded stock. Are there disadvantages to achieving REIT status and going public?
REIT-speak: Cost of capital, unsecured debt, and other confusing phrases
There are two primary reasons for becoming a REIT, one of which should already stand out. As we already mentioned, REITs pay no corporate taxes. Zippo. The second reason is that becoming a publicly traded stock gives REITs an additional source of financing. Since it’s still very expensive to buy or develop large properties, REITs need capital, which they can get from either the bond market or the stock market.
Private real estate owners do not have access to the stock market, and therefore often raise capital at a higher cost.
Cost of capital can be a confusing but important concept. Simply put, for a real estate company, a lower cost of capital is good. Think of the mortgage on your house as capital, and the interest rate you owe as the cost of that capital. Boom cost of capital. As we said, lower is better, which holds for commercial real estate investors just as it does for individuals. This is why REITs seek out as many options for raising capital as possible. By becoming stocks, they can issue equity, and if they become large enough, they can issue what are called unsecured bonds. These are just large bonds that are uncollateralized and usually cheaper than their smaller brethren; “secured” bonds. Becoming a REIT allows all these financing options, which again for an owner of commercial real estate is an incredible advantage.
The downside: a glimpse into the emperor’s wardrobe
Since not all large real estate owners exist as REITs, and there are very sophisticated private real estate firms in the industry, there must be some downsides to the REIT journey. One of the primary components of life as a REIT is radical transparency, which can be viewed as an asset or a liability. For investors, having more information is usually a good thing, but there are times when this can work to the disadvantage of REITs and REIT investors.
In instances in which property type fundamentals are slowing, new supply is coming online, or the macro environment is challenging, there is no hiding it in the REIT space. Having to continually update shareholders on property fundamentals can have negative impacts on a firms cost of capital; if shareholders adopt a negative view of an individual REIT or REIT sector. As investors tend to anchor to each other, some REIT management teams have difficulty dealing with a chorus of criticism when things get tough, and improper management messaging to shareholders can cause further harm to share prices. Put more simply, managing shareholder expectations is difficult, and for REIT management teams it is a full time job.
Not all companies are willing to take on the challenge of managing a large group of public shareholders. For them the additional value created through a superior cost of capital is not worth the time and dollar commitment required to run a public company. Having a volatile cost of capital can be a real challenge, and some real estate investors shy away from REITs for this exact reason.
Liquidity and volatility: Two sides of the same coin
The ability of REIT stock prices to fall during periods of bad news is related to the liquid nature of REITs that we discussed earlier. The compromise REIT investors must accept as a byproduct of owning a liquid product is that REITs are much more volatile than private real estate funds. Remember, when we say REIT we are broadly referring to the publicly traded REITs, or REITs that are traded as stocks on the NYSE, NASDAQ, etc. The nature of publicly traded companies is that their stock prices change pretty much every minute that the stock market is open. That means REITs are constantly changing in value based on the whims of stock market investors.
This high level of transparency coupled with daily liquidity leads inevitably to volatility, and for those investors that are very risk averse, volatility is not a positive. If you can’t mentally or physically handle the possibility of a REIT dropping 20% over the course of a few weeks, the public REITs are not for you. For those with risk tolerance, however, volatility can actually be viewed as an opportunity.
Completing the picture: REITs as real estate stocks
The dual nature of REITs is incredibly important to understand. They are both real estate portfolios and publicly traded stocks, and their power as an investment allocation arises from this duality. In order to realize the benefits of having a liquid real estate investment option, investors must be willing to accept stock price volatility. The chart below illustrates this trade-off, and distills the dual nature of REITs as stocks and real estate portfolios.
Boston Properties (BXP) is one of the largest owners of office properties in the US. They own iconic assets in New York, San Francisco, Washington DC, and not surprisingly, Boston. The chart above shows in blue the consensus value of Boston Properties “Net Asset Value” or NAV, which represents analysts’ view of the take-out value of their real estate. Said another way, if BXP decided to sell all their buildings in the private market tomorrow, the blue line represents the estimated price they would get. The orange line represents BXP’s stock price, which clearly moves around more than the blue line.
There are a few things to note on this chart. First of all, the orange line tracks the blue line over time. It moves away for periods of time, but always converges over the longer term. This is the dichotomy between stock market and real estate investors at work. Real estate prices simply change much more slowly than stock prices. The second thing to notice, is that very pronounced dips in the stock relative to the real estate value look like excellent buying opportunities. That’s certainly interesting…so are they? Is REIT investing that easy?
Not quite, but this is an excellent place to start. Buying REITs when they trade at large discounts to NAV can be described as a traditional “value investing” strategy in REITs, and does actually add value if implemented systematically. Without getting too deep in the weeds, buying the largest discounts to NAV each month across a 160 REIT universe going back in history worked incredibly well from 2011 to 2015, but has worked less well since. We point this out because this is the opportunity inherent in REIT volatility. While swings in REIT stocks can be frustrating to the risk averse, for specialists they are the most important part of the game.
Wrapping it up: Liquid, high quality real estate exposure
The REIT industry has grown and changed massively over the past 50 years and is now a dominant force in the real estate market. Publicly traded REITs have their hands in the building, buying, and selling of the markets top real estate assets, and their reach only continues to grow. As an investment option they offer investors of all sizes the ability to create a diversified real estate portfolio that is liquid and concentrated in top quality real estate. As the industry continues to expand and evolve, investors that can handle volatility will continue to benefit from the depth and optionality of the REIT market.
Stay tuned for the next installment in our REIT series as we explore the historical performance of REITs and compare them to other asset classes. As a compliment to a portfolio of stocks and bonds, REITs offer a very powerful diversification tool, and can be a compelling stand-alone investment.
While mortgage REITs offer similar liquidity to equity REITs, their portfolios are much more opaque and they offer much less opportunity for growth than equity REITs. Historically their performance is far inferior to the equity REITs, and from a market cap perspective they are a much smaller slice of the total REIT universe. While there is certainly a time and place for owning the mortgage REITs, their behavior is sufficiently different for us to exclude them from our analysis. This is a practice observed by most REIT index funds and dedicated REIT investors as well, so we are acting in-line with industry convention by excluding them.
The non-traded REIT industry also behaves in completely different fashion from the public REIT industry. Non-traded REITs by their nature do not offer the liquidity of the public REITs, and actually in many cases have worse liquidity than other private real estate funds. The non-traded REITs also have a history of not only poor but actually borderline criminal corporate governance practices. Until recently, many of these funds charged up to 15% in various fees to investors, with little to no ability to exit the investment. This almost complete disregard for investor well-being is the main reason we exclude them here.