Real Estate Investing Through REITs

The Benefits of Property Ownership without the Hassle

Real Estate Investing through REITs
With REITs, you can buy real estate investments just like stocks in a brokerage account. There are no direct closing costs, mortgages, realtors or contracts. There are many different kinds of REITs, some specializing in properties such apartments. Getty Images

Prior to the onset of the industrial revolution, wealth and power were measured primarily in terms of the amount of land owned by an individual or family. Although the twentieth century saw the rise of securitization and the resulting increase in stock and bond ownership, real estate investing can still prove a profitable option for those who are actively engaged in an asset allocation program or just looking to diversify their current portfolio.

Real estate investment trusts, or REITs, can be a convenient way for the average investor to profit without the hassle of direct property acquisition. That is why we included this comprehensive essay in our Beginner's Guide to Real Estate Investing.

Prior to 1960, only wealthy individuals and corporations had the financial resources necessary to invest in significant real estate projects such as shopping malls, corporate parks, and health care facilities. In response, Congress passed the Real Estate Investment Trust Act of 1960. The legislation exempted these special-purpose companies from corporate income tax if certain criterion were met. It was hoped that the financial incentive would cause investors to pool their resources together to form companies with significant real estate assets, providing the same opportunities to the average American as were available to the elite. Three years later, the first REIT was formed.

The original legislation had some significant drawbacks, however, in that it required the executives in charge of the business to hire third parties to provide management and property leasing services. These restrictions were lifted in the Tax Reform Act of 1986. Thirteen years later, in 1999, the REIT Modernization Act was passed.

The law allows REITs to form taxable subsidiaries in order to provide specialized services to tenants that normally fall outside the purview of real estate investing. Although the law still has some limitations as to the types of services that can be offered, it is expected that the quality of service at REIT-managed properties will improve significantly as a result of its passage.

Requirements for REIT Status

According to Ralph Block in Investing in REITs: Real Estate Investment Trusts, every REIT must pass these four tests annually in order to retain its special tax status:

  1. “The REIT must distribute at least 90 percent of its annual taxable income, excluding capital gains, as dividends to its shareholders.
  2. The REIT must have at least 75 percent of its assets invested in real estate, mortgage loans, shares in other REITs, cash, or government securities.
  3. The REIT must derive at least 75 percent of its gross income from rents, mortgage interest, or gains from the sale of real property. And at least 95 percent must come from these sources, together with dividends, interest, and gains from securities sales.
  4. The REIT must have at least 100 shareholders and must have less than 50 percent of the outstanding shares concentrated in the hands of five or fewer shareholders.”

    In addition to the prevention of double-taxation, REITs offer numerous other benefits which include:

    Professional Management

    In most cases, the investor that buys a rental property is left to her own devices. REITs allow the investor the opportunity to have her properties managed by a professional real estate team that knows the industry, understands the business and can take advantage of opportunities thanks to its ability to raise funds from the capital markets. The benefits are not limited to the financial prowess of the management team. Owners of REITs aren’t going to receive phone calls at three a.m. to fix an overflowing toilet.

    Limitation of Personal Risk

    REITs can significantly limit personal risk. How? If an investor wanted to acquire real estate, it is likely he will take on debt by borrowing money from friends, family, or a bank.

    Often, he will be required to personally guarantee the funds. This can leave him exposed to a potentially devastating liability in the event the project is unsuccessful. The alternative is to come up with significant amounts of capital by reallocating his other assets such as stocks, bonds, mutual funds, and life insurance policies. Neither alternative is likely to be ideal.

    Purchasing a REIT, on the other hand, can be done with only a few hundred dollars as share prices are often as low, if not lower, than equities. An investor that wants to invest $3,000 in real estate will reap the same rewards on a pro-rated basis as those who want to invest $100,000; in the past, it simply wasn’t possible to get this kind of diversification in the real estate asset class without taking on partners or using leverage.

    Liquidity

    Unlike direct property ownership, a REIT offers liquidity and daily price quotations. Many investors mistake this for increased risk. After the average real estate investor has acquired a house, apartment building or storage unit, he becomes primarily interested in the future rental income prospects, not the potential sale value of the asset if he put it back on the market. Indeed, if the investor holds the property for twenty years, he is likely to have lived through significant boom and busts in the real estate cycle. In most cases, it is safe to assume that because of the lack of daily quoted resale value, the investor has never stopped to consider that his real estate fluctuates just as would any common stock (albeit to a much smaller degree.) In this case, the lack of quoted price is mistaken for stability. As Benjamin Graham said in his 1970’s edition of The Intelligent Investor:

    “There was then [during the Great Depression] a psychological advantage in owning business interests that had no quoted market. For example, people who owned first mortgages on real estate that continued to pay interest were able to tell themselves that their investments had kept their full value, there being no market quotations to indicate otherwise. On the other hand, many listed corporation bonds of even better quality and greater underlying strength suffered severe shrinkages in their market quotations, thus making their owners believe they were growing distinctly poorer. In reality the owners were better off with the listed securities, despite the low prices of these. For if they had wanted to, or were compelled to, they could at least have sold the issues – possibly to exchange them for even better bargains. Or they could just as logically have ignored the market’s action as temporary and basically meaningless. But it is self-deception to tell yourself that you have suffered no shrinkage in value merely because your securities have no quoted market at all.”

    In other words, despite the fact that the quoted price of the REIT may fluctuate on a daily basis, the economic reality of direct real estate investing is no different. In essence, it is as if the owner of a REIT simply didn’t pick up the paper and examine the price offered to him by Mr. Market. Taking it one step further, this perceived disadvantage is actually one of the perks of owning REITs. Unlike direct real estate holdings, they are a liquid asset that can be sold fairly quickly to raise cash or take advantage of other investment opportunities.

    Excellent Tools for Retirement or Income for Living Expenses

    A significant portion of the return attributed to investing in REITs is due to the large cash dividends. Because dividend distributions of this kind are taxed at personal income tax rates which have historically been 39.8% (thanks to the Bush tax cuts, this rate has been lowered to 35%), Uncle Sam can take a significant bite out of your profits. One way to counter this is to hold your real estate investments in your IRA or other retirement accounts. Decades of tax-free compounding can result in hundreds of thousands of dollars more in retirement savings.

    REITs are also especially suited to retirement portfolios because the cash dividend not only provides income upon which to live but establishes a phantom floor to the share price. In a market free fall, for example, the dividend yield will eventually become attractive enough to prevent further sell-offs (assuming the fundamental business isn’t in jeopardy.) This can result in greater stability at times of market crises.

    The term equity REIT refers to a corporate entity that is engaged in the acquisition, management, building, renovation, and sale of real estate. This type of real estate investment trust offers the greatest potential of reward and as such tends to be favored by professional money managers. Equity REITs often operate in a specific area of expertise. Some examples include:

    • Residential REITs
    • Retail REITs
    • Office and Industrial REITs
    • Healthcare REITs
    • Self-storage REITs
    • Hotels and resort REITs

    Residential REITs

    This type of REIT specializes in apartment buildings and/or other residential properties leased to individuals. The biggest danger for residential REITs is over construction within a particular geographic area during a declining economic environment. In such cases where supply is increasing as demand is decreasing, the management team is forced to reduce rents to keep occupancy rates stable.

    An Example of Residential REIT: Avalon Bay Communities
    According to Reuters, Avalon Bay Communities (AVB), known for its luxury apartment communities, “is a real estate investment trust that focuses on the development, redevelopment, acquisition, ownership and operation of apartment communities in high barrier-to-entry markets of the United States. At February 27, 2004, the Company owned or held a direct or indirect ownership interest in 131 operating apartment communities containing 38,504 apartment homes in 10 states and the District of Columbia, of which two communities containing 1,089 apartment homes were under reconstruction. In addition, at that date, AvalonBay owned or held a direct or indirect ownership interest in 11 communities under construction that are expected to contain an aggregate of 3,493 apartment homes when completed. It also owned a direct or indirect ownership interest in rights to develop an additional 40 communities that, if developed in the manner expected, will contain an estimated 10,070 apartment homes.

    Retail REITs

    There are a number of specialties in the field of retail REITs, including malls and shopping centers. The particular benefit for the former is that construction costs are significant; measured in the tens or hundreds of millions of dollars. This high barrier-of-entry cost helps keep expansion under control, making excess supply a lesser concern.

    An Example of Retail REIT: Regency Realty Corp.
    “Regency Centers Corporation is a real estate investment trust that owns and operates grocery-anchored shopping centers in the United States. As of December 31, 2003, the Company's portfolio of real estate investments included 265 shopping centers in 22 states with 30.3 million square feet of gross leasable area (GLA) and was 92.2% leased. Geographically, 19.6% of its GLA is located in Florida, 19.5% in California, 16.8% in Texas, 6.6% in Georgia, 6.3% in Ohio and 31.2% spread throughout 17 other states. Regency owns and operates its shopping centers through its operating partnership, Regency Centers, L.P. (RCLP), in which the Company owns 98% of the operating partnership units. Regency's operating, investing and financing activities are generally performed by RCLP.” – Reuter’s Business Summary

    Office and Industrial REITs

    The office sector of the real estate investment trust market has historically been the largest. The primary drawback is the fact that office rents normally have much longer lease terms meaning that in times of declining rent and lower occupancy, those tenants that do sign leases will have lower, less-profitable rates locked in for many years. This can also be a blessing, however, if a property is filled during a time of short supply and high demand. Office REITs are, as can be imagined, highly cyclical. Industrial REITs, on the other hand, tend to generate steady, predictable cash flow thanks to high lease renewal rates and low capital expenditure and maintenance requirements.

    An Example of Office and Industrial REIT: CenterPoint Properties Trust
    “CenterPoint Properties Trust is a real estate investment trust that owns and operates primarily warehouse and other industrial properties in the metropolitan Chicago, Illinois area. CenterPoint seeks to create share value through customer-driven management, investment, development, and redevelopment of warehouse, distribution, light manufacturing, airfreight and rail-related facilities. The Company also develops multi-facility industrial parks that are strategically located near highways, airports, and railroads. At December 31, 2003, the Company's investment portfolio of operating warehouse and other industrial properties consisted of 187 properties, totaling approximately 34.4 million square feet, with a diverse base of approximately 284 tenants engaged in a variety of businesses. At December 31, 2003, CenterPoint had accumulated control of a large land portfolio exceeding 3000 acres upon which 50.1 million square feet of warehouse and other industrial properties can be developed.” – Reuter’s Business Summary

    Health Care REITs

    Health care REITs build, acquire and lease specialty buildings such a hospitals, nursing homes, medical buildings and assisted-living facilities. This REIT sector is fairly immune to the recession, although they are largely dependent upon the financial health of the lessee which, in turn, rely on the medical reimbursements provided by the U.S. Government. Federal changing in health policy would obviously have a significant effect on health care REITs.

    An Example of Health Care REIT: Health Care REIT, Inc.
    “Health Care REIT, Inc. is an equity real estate investment trust (RIET) that invests in healthcare facilities, primarily skilled nursing and assisted living facilities in the United States. The Company also invests in specialty care facilities. During the year ended December 31, 2003, the Company had investments in 328 facilities located in 33 states and managed by 47 different operators. The portfolio included 219 assisted living facilities, 101 skilled nursing facilities, and eight specialty care facilities. In October 2003, the Company sold its investment in Atlantic Healthcare Finance L.P.” – Reuter’s Business Summary

    Self-Storage REITs

    The self-storage REIT sector is somewhat recession resistant. More surprisingly is the fact that corporate customers make up a significant portion of storage rentals. Barriers to entry are significantly lower than other types of REITs due to the smaller amount of capital necessary to construct a storage facility.

    An Example of Self Storage REIT: Sovran Self Storage, Inc.
    “Sovran Self Storage, Inc. is a self-administered and self-managed real estate investment trust that acquires, owns and manages self-storage properties. As of March 1, 2004, it had 265 owned and/or managed self-storage properties consisting of approximately 15.5 million net rentable square feet, situated in 21 states in the eastern and midwestern United States, Arizona, and Texas. Sovran Self Storage manages 11 of these properties for Locke Sovran I, LLC, an unconsolidated joint venture that is 45% owned by the Company. As of March 1, 2004, all but two of its properties conducted business under the trade name Uncle Bob's Self-Storage. The Company's self-storage facilities offer inexpensive, easily accessible, enclosed storage space to residential and commercial users on a month-to-month basis. All properties have a property manager on-site during business hours. Customers have access to their storage areas during business hours, and some commercial customers are provided 24-hour access.” – Reuter’s Business Summary

    Hotel and Resort REITs

    In the world of real estate investing, the hotel and resort sector is the one most closely tied to the overall economy. When times are bad, people travel less for business and pleasure, cutting right to the heart of these company’s bottom lines. As a result, investors in hotel REITs have to concern themselves not only with overbuilding but the economic outlook of both the geographic area in which the hotel or resort is located, as well as that of the entire country as well.

    An Example of Hotel and Resort REIT: LaSalle Hotel Properties
    “LaSalle Hotel Properties is a self-managed and self-administered real estate investment trust that buys, owns and leases primarily upscale and luxury full-service hotels located in convention, resort, and major urban business markets. As of December 31, 2003, the Company owned interests in 17 hotels with approximately 5,600 rooms/suites located in 10 states and the District of Columbia. Independent hotel operators manage the hotels. Substantially all of the Company's assets are held by, and all of its operations are conducted through, LaSalle Hotel Operating Partnership, L.P. The Company is the sole general partner of the operating partnership with an approximate 98.3% ownership as of the fiscal year ended October 31, 2003. The remaining 1.7% is held by other limited partners.” – Reuter’s Business Summary

    Why REITs Sell Properties

    If the purpose of a REIT is to acquire and profit from real estate investments, why would some management teams elect to sell properties? Like most good businesses, it is advisable for REITs to periodically review its property portfolio and decide which assets are likely to generate less-than-average cash flows in future years. The proceeds from the sale of these properties can be reinvested in opportunities with higher prospects or used to strengthen the balance sheet (viz. debt reduction) or increase shareholder wealth through a share repurchase program. Investors must realize the primary goal of any successful corporation should be to increase shareholder wealth, not just mindlessly keep on doing business.

    Using REITs for Diversification and Asset Allocation Programs

    Real estate investing offers an attractive alternative to common stock, bond, and mutual fund investing. Those investors with an eye on diversification, however, must remember that it is not simply enough to buy a few REITs and call your portfolio diversified. Instead, the investor must make certain that the REITs he acquires represents a geographically and sector diverse group of properties. For the defensive investor, it is far safer to own several apartment, office, industrial, storage, and health REITs from New York to California under different management teams than it would be to buy only a Pennsylvania-based self-storage company.

    Mortgage REITs

    A mortgage REIT is a company that specializes in underwriting, acquiring and holding debt obligations guaranteed by real estate properties. Mortgage REITs are essentially loan portfolios as opposed to ownership of the asset, as is the case with their equity counterparts.

    Hybrid REITs

    A REIT is referred to as a hybrid when it has both equity and mortgage components. Although not as heavily favored by investment advisors as pure equity REITs, they are still attractive investment alternatives.

    Summary: Advantages of Real Estate Investing through REITs

    • Double taxation avoided, allowing more of the investor's capital to compound.
    • Professional, dedicated management team responsible for the day-to-day operation of the business, providing the investor with expertise beyond his or her own knowledge base.
    • Unlike real estate directly held by the investor, REITs are a liquid asset that can be sold fairly quickly to raise cash or take advantage of other investment opportunities.
    • Using REITs, investors with only a few thousand dollars available can diversify their holdings between various geographic areas and property specializations. In the case of direct property ownership, this would not be feasible financially unless the investor took on excessive leverage or business partners.
    • REITs can tap the debt and equity markets and raise funds to take advantage of opportunities when they arise.
    • REITs have a lower correlation to equities than many other asset classes, providing portfolio stability for those with an active asset allocation strategy.
    • High cash dividends relative to the market tend to establish phantom bottoms to REIT share prices, often keeping them from falling as far as common stock in bear markets.

    A Final Caveat on REITs

    The investor must always remember that REITs do not just represent a pile of real estate assets. They are in and of themselves a going-concern business and must be evaluated and analyzed as such.