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About REITs
Tuesday, 28 June 2011 04:20

The US is still by far the largest market, though Australia can probably boast the highest penetration with about 70% (apparently) of all investment grade commercial property owned by A-REITs. The US has about 125 REITs but most other countries (except Canada, Australia & Japan) have less than 20 so there is still huge potential for expansion globally.

Broadly speaking, REITs must pay out 90%+ of dividends (or share equlivalents) to shareholders of their net income, and hold 75%+ of their assets in direct real estate and / or obtain 75%+ of their income from real estate. Due to their favourable tax status the effects of Corporate Income Tax and depreciation allowances are mitigated (or eliminated), so REITs are a particular favourite of pension funds and pensioners ie those that rely on a steady uninterrupted income steam, with the bonus carrot of capital gains. Because REITs are usually buildings, there will typically be a demand from them, which is reflected in steady-ish income. Further, different REITs have different attitudes to debt (Muslims on religious grounds), and most governments also strictly control the amount of debt that can be held. This can represent an opportunity for developers too, such as in Asia, where they often "sponsor" REITs, or banks (to get bad debt off the books without 'giving it away', or for more nobal reasons).

The market cap of the US industry has grown by more than 21% per year since 1990 (from about USD$9bn to USD$850bn - up 9,650%), whilst the number of REITs has increased by 2.5% (from about 120 to 210).

Most REITs operate in a particular sector so that the management can be specialists in that field, and so the REIT can focus on its core strengths and advantages. However, a significant minority can be described as “diversified” but even these tend to focus on a couple of sectors (such as Grade A offices & Prime retail).

Whereas tenants come and go over a full cycle as trends change, landlords have the benefit of leasing to the next tenant in line, sacrificing very little cashflow / long-term value, and we can be almost sure that the values of the underlying properties will be worth more, not less, than they are today. Factoring in the annual rental (or dividend) income, it would be very difficult to imagine a scenario where an investor could lose money over a full cycle on a diversified portfolio of quality commercial real estate (or REITs). The main sectors are : -

  • Office REITs
  • Retail REITs
  • Industrial REITs
  • Residential REITs

Other sectors include : -

  • Health and / or Retirement Property REITs - Link
  • Storage REITs
  • Mortgage REITs (indirect property investment via “debt” or paper) - Link

And even

  • Timber REITs
  • Vineyard REITs
  • Data Centre REITs - Link
  • Prison REITs
  • Solar Energy REITs
  • Death REITs (cemeteries & funeral parlours)
  • Wast Management REITs (facilities & land-fill are being considered)
  • Electricity & Gas Infrastructure (are being considered)
Exchange Traded Funds track these individually or collectively. Many REITs start off being private or Non-Traded REITS - Link
A REIT is a typically a trust fund that holds or invests in properties, usually income producing though some countries permit a small level of development and / or investment in real estate "indirectly" too. Nonetheless, most of a REITs income must be generated from rents, and they are obligated to distribute most of the profit as dividends to the "unit" or shareholders. REITs must normally have a portfolio of at least 3 properties but some have hundreds.
What are REITs?
Unlike Unit Trusts, REITs are traded on stock exchanges so give investors access to both a return on capital and a return of capital, through appreciation to the share price (hopefully), and the dividends derived from them, normal stocks and shares.
Why are REITs seen as good investments?
Most of a REITs income is from the rents of commercial properties. There will always be market demand for such buildings, though the rents can and do yo-yo (go in cycles), even if they are old and have redevelopment potential, since REITs usually don't invest in "secondary" buildings, in secondary" locations. Therefore, the income streams are perceived as being steady and so, to a degree, predictable, and thus attractive as income producing assets. Furthermore, due to a country's REIT legislation there will be tax (or the equivalent) breaks offered by the government, in return for the REITs agreed to distribute (usually) 90% of their profit as dividends.
Buying and owning a large buildings if prohibitively expensive and too time consuming for "mere mortals," so REITs open up an avenue through which "normal people" can invest in these buildings, and share in the profits that would / were otherwise the exclusive preserve or large property companies, developers, or pension and other funds. Investors in REITs also get the diversification benefits of owning a part of a portfolio, which means the risk is further spread. And perhaps best of all, the shares can easily be sold and are relatively very cheap (although some REITs are private" or otherwise "closed" with restrictions on selling).

"Listed equity REITs have returned 12% pa on average for nearly 43 years (since 1972). That's better than large-cap stocks, it's better than small-cap stocks, it's better than foreign stocks, it's better than bonds and commodities and every other asset class I know of. Why have they outperformed so consistently? I think a big part of the answer is that REITs don't waste their earnings - they distribute earnings to shareholders, and then ask again for capital when they want to make investments. That's the REIT difference, and it has paid off for investors for a long, long time" (Brad Case, NAREIT Research).


In late-2014, a CEM Benchmarking report (covering 1998-2011), listed equity REITs generated the highest net return of all asset classes, offering an average annual net return of 11.31%, ahead of private equity at 11.1% and non-real estate real assets (including commodities, infrastructure and natural resources) at 9.85%. In gross terms, private equity was the best performing asset class at 13.31%, followed by REITs with 11.82% and non-real estate real assets at 10.88%. But, if you subtract costs and take into account the fact that private equity also takes riskier positions, REITs become the best-performing asset class. However, REITs were also judged to be among the most volatile of asset classes at 20.17%, but behind non-US stocks at 24.02% and US small-cap stocks at 20.58%.


Why do companies agree to put their portfolio into a REIT?

A good example is perhaps some of the hotel brands who held and operated large real estate portfolios which, by spinning-off the buildings ownership, enabled them to both focus on their core business ie hotel management, whilst simultaneousy obtaining a some cash to invest in new management opportunities. Many of Asia's huge developers are another good example, as they can get a reasonable price for some of or all of their assets, and the cash to redeploy in new ventures. Tax is an important consideration here, and some countries legislation provide developers with more incentives to convert than others.


What distinguishes a good REIT from a bad one?

This is a bit like asking what is and isn't a good investment? Similar to buying housse, properties can be either "cheap" or "expensive" depending upon the nature of the property cycle (which is always a subjective issue); the tenant covenant strength / ability to pay the rent; the WALE (weight adjusted lease expiry); and importantly, the quality of the management. Some companies are better at managing property portfolios than others, and some properties easier to "reposition" than others. REITs also need to be yield "accretive," or be continuously seeking ways to increase rental income / Net Asset Value such as by buying higher-yielding properties. Conversely, a good REIT will off-load properties that have limited prospects over the short to medium term. Lastly, the amount of debt a REIT is carrying is important, as has become increasingly clear since the credit crunch. Although it is important to use debt to leverage financial capacity, some REITs have been caught holding too much debt (easy to say with the benefit of hindsight).


Why do REIT unit prices fluctuate more than changes in rental income?

Being listed on a stock exchange has many advantages, but also some disadvantages, one of which is that, to a degree, all companies "rise on an incoming tide" and so they fall. Companies have and always will delist because the management think "the market" undervalues them. In the case of REITs the arguement is even stronger since the individual value of the component parts ie the buildings, should provide an indication of the asset value, since the value of the portfolio is largely the same as the assets of the company / REIT (given the appropriate adjustmnets for debt, taxes and management of course). These are closely scrutinised by market analysts. Playing the stock market has always involved risks, but at least with REITs one should be reasonably able to predict rental income (the upside and downside) which makes them, theoretically, "safer" then ordinary company stocks, whose dividends can be retained.

Here is the return and standard deviation of portfolios built solely from two investment indexes: the Wilshire REIT Index & the S&P 500 Composite from December  1977 to May 2016. During this time period, the correlation between REIT and US stock indexes was only 0.58. The greatest return came from a portfolio balanced 85% S&P 500 & 15% Wilshire REIT Index and the lowest volatility from a portfolio balanced 73% Wilshire REIT Index & 27% S&P 500.


Sensitivity by Sector:



Many REITs grow to such a large scale that they are limited with organic growth opportunities and they are forced to either invest in sub-par deals, expand into other sectors (such as outlet centers for SPG), or prune of divest of assets, sometimes via separate more sector focused REIT spin-offs (which they act as sponsor in the short or long-term).


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Last Updated on Thursday, 07 July 2016 17:05