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Greg MacKinnon is director of research at the pension Real Estate Association, PREA. As the director of research his role is to provide research in white papers, and data and thought leadership to the association’s membership. Members are primarily institutional investors in commercial real estate, so, despite the name of pension real estate, members include both pension funds, such as the big public pension funds and corporate pension funds, and also include sovereign wealth funds, family offices, insurance companies, endowments, foundations and large institutions that invest in commercial real estate. Membership also includes investment managers who are putting together funds aimed at institutional investors.
What is a REIT
Starting off just with absolute basics a REIT is a Real Estate Investment Trust. Essentially the idea is if someone's not familiar at all with REITs but they're familiar with say mutual funds equity mutual funds, then it's a similar type of idea. In an equity mutual fund rather than going out and picking individual stocks and buying those stocks yourself, you hand your money over to the mutual fund manager in a lump sum and then the manager goes out and picks a good portfolio for you. It's an actively managed fund. It's a similar idea with REITs. Rather than going out and trying to find particular properties to buy, you invest in a REIT and the management team is going to invest in particular properties.
Now what makes REITs different than the mutual fund is that they are publicly traded on a stock exchange. REITs trade just as any other stock do. If you want to put money into shopping malls, for example, there are a number of REITs that specialize in shopping malls. All you have to do is to go into a brokerage account. You can do it online or in person, or however you normally do your stock trading. Buy buying a shopping mall REIT, you have essentially invested in a portfolio of shopping malls. Similarly there are REITs that specialize in office buildings, in industrial space, in apartment buildings – all kinds of different things.
So really they function like a stock. It's a fairly easy way for someone who is not really well versed in the real estate industry in general to get exposure to real estate. It is no harder and it costs no more in terms of brokerage fees than buying into any other stock.
Fees are going to be going to be variable across different REITs but the easiest way to think about it is because they are traded stocks, first of all, to actually make the investments you have to pay the normal fee you would pay your broker for any other kind of stock investment which, these days, is relatively negligible especially if you are investing a fair amount of money.
If you put your money into a REIT mutual fund, then the mutual fund managers will likely charge you a certain fee to be in the fund. Those are similar to regular equity mutual funds. For a passive index fund based on the REIT index, it's probably going to run about 10 basis points a year so 0.1%.
The fee structure is similar to investing any other kind of stock. Now, in terms of how the actual REIT itself is getting paid, it's set up like a regular company. It gets paid the same way any other kind of regular company does. One thing that some investors will do to get an idea of the kind of implicit fees or costs associated to being in a REIT relative to some direct private market investment in real estate, is that every REIT is going to have an entry for general administrative costs on their income statement. That is the cost of running the organization. All the money they're making from investments in an office buildings or malls or warehouses or whatever, some of that money is going to have to actually go to run the company and that's going to come out in the general administrative cost.
That obviously varies from company to company and REIT to REIT, but across all REITs it runs about 90 basis points a year. Now, that's always going to go up and down over time and like I said it varies across REITs but you're looking at about 90 basis points as the cost of running the company. You throw in, let's say, 10 basis points a year because you're a passive index fund of REITs because you want to be diversified, and then you're up to about 1 percent, essentially, as a total cost – plus any dollar brokerage fees for actually buying the shares if you're buying shares directly.
So, investing in REITs is not necessarily a high cost or a high fee avenue to get at real estate.
For a lot of investors one of the things that makes REITs attractive as an equity is the high dividend yields. One of the benefits of the REIT structure in general is that REITs are not subject to corporate income tax on any money they pay out as dividends. That makes them distinct from a regular company like General Motors or IBM or something like that. As long as they pay the money as dividends to shareholders they're not subject to corporate taxes; they're passing through the profits from the real estate they hold directly to the shareholders. One of the rules REITs are subject to, however, is that to get that benefit they are required to pay at least 90 percent of their taxable income each year as dividends. In short, the concept behind them is that they really should be acting kind of as pass through securities. There are the investors on one side, and there are the actual brick and mortar buildings on the other side and then between them are the REITs running the buildings, collecting the rents, putting in the capex and that sort of thing.
The profits from those buildings are basically flowing through the REIT tax free to the shareholders. If you compare them to regular equities there is a substantial difference in the dividend yield, which is what makes it attractive to income seeking investors. [At time of podcast] the NAREIT index, REIT yields were running about 3.8%, and on the S&P 500 it's under % - so not quite double, but substantially higher nevertheless.
The Real Estate
Typically REITs are investing in quality real estate although most REITs will specialize in one particular type of real estate, for example in shopping malls, or in strip center retail, office buildings, warehouses. There are a number that specialize in nontraditional types of real estate such as seniors housing, student housing, cell towers, billboards – there’s even one or two that own prisons. There's a lot of non-traditional or alternative property types that are represented in the REIT world so REITs as a whole are a good way to get access, especially for small investors, to a well diversified portfolio of commercial real estate. It's also a good way to get access to some of these types of real estate that no one's going to go out on their own or buy – like a cell tower, for example. But if you invest in a cell tower REIT, you’ll be investing in hundreds of cell towers across the country so will be well diversified.
The Liquidity Premium
There is a theory that when something's more or less liquid in that you can buy and sell them at a moment's notice there is a premium to the underlying real estate which is obviously much harder to sell on a moment's notice. So REITs are more liquid than the underlying real estate. The theory says that because more liquidity is an advantage, you should get a higher return where there is less liquidity where you don't have that advantage.
There's all kinds of academics have been trying to find that liquidity premium for years. No one's actually been able to tell if it actually exists or not. Certainly, liquidity is an advantage, but if you don't mind locking up your money for a longer period of time, you may want to look at directly investing in real estate. A lot of people see REITs relative to direct investing in private market real estate, but because REITs trade on the stock market they are more liquid and they're also more volatile.
So, as with any stock, the price is going to go up and down each day, each minute, month after month, with the animal spirits of the market. So maybe REIT prices goes up more they really should. Maybe they go down more than they really should. You do have a lot more volatility in REIT prices than you see in the values of the actual properties that they hold. That's the downside of the liquidity argument because they're in a more liquid market.
One disadvantage of REITs is that when there's a broad market correction in the equity market when the underlying real estate market turns down as well, you can get a big effect on REITs. That came out in a big way in that financial crisis back in 2009. The REIT index was down well over 80 percent at one point. But a lot of that it turned out was overblown. You did you did see a drop in underlying values of actual properties but not nearly to that extent. So a lot of that 80% drop was just people getting carried away in the equity market and selling too fast because they were able to sell too fast.
The underlying direct private market real estate markets a lot more so slow moving and doesn't react all that much to news on a day to day basis. The slower moving aspect is bad in the sense that you have less liquidity but it's good in the sense that you don't have these giant panics that happen one day and then get reversed the next day like you might have in the REIT market.
Long Term Perspective
A lot of institutional investors place their allocation to real estate as well as to other private market types of assets based on this idea that they are able to be very patient capital and can afford to wait years. They can wait out any downturn in the market and therefore they prefer to go to the private markets because they expect to get a bit higher return.
That said, REITs over the long term have a somewhat higher return than the corresponding sort of direct market underlying real estate. The downside is they had somewhat higher returns but also with much more volatility over time so there is more risk in that regard. Over the long run there's a very high correlation between REITs and the underlying real estate because, as you would expect, if REITs are being affected on a daily basis by the animal spirits of the market, those things will tend to cancel out over time.
At the end of the day, investing directly in real estate is one avenue to access that kind of investment, and investing in REITs is another avenue to access that kind of investment. And they have somewhat different characteristics and one may be more advantageous for some investors and the other may be more advantages for other investors. But they're both alternative ways to get into real estate so that they both have advantages and disadvantages.
Facts, figures, and details
Primer on Crowd Fund Real Estate
Episode 018 - Real Estate Value Investing
Greg was a guest in the first NREF podcast series. Well worth listening to that episode if you are a crowd fund real estate investor as he explains how investing in higher cap rate properties, in less expensive markets nationwide, consistently deliver higher returns on a risk adjusted basis than focusing on quality properties in expensive cities. These results underscore the idea that Value Investing is as valid for real estate as it is for most other asset classes, be they stock, bonds, commodities, etc. and point to alternative real estate investment strategies you may want to consider further. Listen to the episode by clicking the play button below, or for access to the full shownotes for that earlier episode, go here...