Basics of real estate investment trusts
Continuing our occasional series on the basics of investment securities, we focus today on Real Estate Investment Trusts, commonly referred to as REITs. This once-obscure and specialized security has entered the mainstream and warrants consideration, especially for investors seeking current income.
Before 1960, real estate investing was the exclusive province of the well-heeled, given the significant capital ante required to buy a seat at the table. As a parting gift to smaller investors, President Eisenhower signed a law creating a new type of pooled investment trust that provided for fractional ownership of real estate assets with relatively small capital investments. The benefits were twofold: providing opportunity for retail investors to diversify into a new asset class, and serving as a new source of capital fueling real estate development during the post-war suburban boom.
The Cigar Tax Extension Act of 1960 was a 13-page bill containing a variety of unrelated tax provisions, including the creation of Real Estate Investments Trusts. (By contrast, the Tax Reform Act of 2017 ran more than 500 pages with an additional 600-page conference report explaining the 500-page bill). By the beginning of the 1970s, about 30 REITs had sprung up, with a value of $1.5 billion. Today, more than 225 are traded publicly, 32 of which are members of the S&P 500. Public REITs today now claim $1.3 trillion in market value.
REITs belong to a class referred to as “pass-through” securities. In general, receipts such as rents and mortgage payments are collected from properties or loans held within the pool of assets and are then passed through to shareholders in the form of dividends or distributions. In order to maintain their tax-favored status (REITs pay no corporate income taxes), at least 90 percent of earned income must be paid out to shareholders. For this reason, pass-through securities and REITs in particular tend to have significantly higher dividend yields than most common stocks, which retain large portions of their earnings for future investment. For this reason, they tend to be favored by retirement investors seeking diversification as well as income.
An advantage of real estate investment trusts over some other pass-throughs such as master limited partnerships (MLPs) is that they do not issue partnership returns, or K-1s. REITs issue 1099s at the end of the year for tax reporting.
Those securities fall into one of two broad classifications. Equity REITs own physical properties such as office buildings, warehouses, shopping malls, apartments and even timberland. Mortgage REITs or mREITs hold pools of mortgage loans, and often employ leverage to boost the dividend payout rate. These should be considered somewhat riskier than their equity brethren.
Due to their relatively high payout compared with common stocks, they tend to react more acutely to changes in interest rates and inflation. Somewhat like Treasury bonds, REIT prices often fall during the initial stages of rising interest rate cycles. However, unlike bonds, REITs are able to increase dividend payouts as fundamental economic conditions improve. Rising rates generally imply a growing economy that translates into higher rents to tenants. These improved profits are passed along to REIT holders. Over an entire cycle, REIT securities often appreciate in value as fundamental economic metrics gain momentum. In fact, they have outperformed the S&P 500 in more than half of all post-war rising rate cycles.
As with any investment, research is essential. Not all REITs are worthy investments. One way to ease into the asset class is to find a good mutual fund or ETF that specializes in REITs.
Ever wish to be a landlord without the hassle of replacing a water heater at midnight? REITs may be just the ticket.
Christopher A. Hopkins, CFA, is a vice president of portfolio manager for Barnett & Co. in Chattanooga.