| For stock market investors, REITs serve as a form of diversification, spreading the risk inherent in the management of a particular REIT among the broad pool of its shareholders. Investors appreciate the diversity of REIT investments, since each REIT typically owns multiple properties. Also, an investment in several different REITs is closely equivalent to the purchase of fractional ownership interests in numerous different properties, all under different management.But what exactly is an REIT, and how does it differ from other forms of syndication better known to the real estate market, such as the limited liability company (LLC)? REITs are essentially property owning corporations. Unlike publicly-held corporations, however, they avoid paying income taxes through a tax loophole by passing a minimum of 90% of their earnings on to investors, in the form of dividends, not passive real estate income. In both REITs and LLCs, income, profits and losses are passed through to the individual members according to their share in the ownership of the entity. For real estate syndication purposes, the REIT resembles an LLC. Both are unincorporated organizations formed for the purpose of group investment primarily in real estate. Additionally, both provide limited liability for investors and pass-through of income for state and federal tax reporting by the investor avoiding the double taxation of distributed corporate earnings – but with very different tax results which favor the stock market vehicle of the REIT; these entities are not LLCs. [Calif. Corporations Code §23000; IRC §856]To qualify for federal tax reporting as a real estate investment trust, the REIT must have at least 100 shareholders, and 75% of the REIT’s business activities must be restricted to investments in real estate, trust deed notes, cash or government securities. No such restrictions apply to the LLC. Another difference: a REIT soliciting investors in California must always first qualify its investment program by obtaining a permit issued by the California Department of Corporations (DOC). [IRC §856(c)(4); Corp C §23000(b)]Of crucial importance to real estate brokers and agents, REITs resemble a Chapter S Corporation, in that they report profits while passing income tax liability on to shareholders. Brokers are thus barred from taking a commission from the sale or purchase of REIT shares (unlike an LLC, which is treated as a limited partnership under California state law). [Business and Professions Code §10131.3]The end result for REITs is a greatly restricted ability for management to receive compensation for just about anything involving fund raising, representations, management fees or allocation of assets and cash reserves. In search of alternative income for their REIT involvement, members of REIT management often work as real estate brokers to take the big front-end fees paid when their REIT purchases or sells large assets—risky behavior that may be good for management, but has negative long-term ramifications for REIT investors. Problems of asset value arise when REITs buy property at prices that deliver low annual returns. While low annual returns are acceptable to stock market investors, they are not acceptable to real estate investors. Stock investors are accustomed to buying and selling business shares at price-to-earnings (PE) ratios (multipliers) that would never be acceptable to prudent investors in the real estate marketplace. Unlike businesses, which are all comparable to one another, parcels of real estate are unique, and their value cannot easily or quickly be judged by comparison or pre-set formulas. After all, businesses can logically grow and remain profitable for centuries, since they are not destined for eventual obsolescence as property improvements are.
Further, businesses are generally not subject to the demographic forces that influence the value of each and every parcel of real estate. Due to the immobility of a property’s location, pricing of that property fluctuates over time with the relocation and shifting age or other mix of the location’s population. Unlike a business marketing a product, a parcel of real estate cannot move to follow the users and buyers. When REIT managers fail to consider these uncertainties, they make purchases at unrealistically inflated prices.
REIT investors may applaud a purchase at what seems like a good rate of return for an investment in the stock market, but while informed property investors will sell at these inflated prices, they refuse to participate as buyers. Put simply real estate values differ when viewed solely through the stock market’s “window of opportunity” rather than through experience in the real estate market’s actual process of evaluation.
Methods of ownership
The multiplier of the PE ratios (its reciprocal) used in the stock market to price many investments in REITs can be traced back to the operating structure and method of ownership in these entities. The participants who invest in REITs are called shareowners. The shareowners hold transferable shares, which have tremendous liquidity since they can be sold publicly on stock market exchanges.
As shareowners, individual investors are not liable for the debts and obligations of the REIT, closely comparable to membership interests in an LLC. The REIT is managed by officers called trustees who also are not liable for the debts and obligations of the REIT – a role comparable to the manager position in an LLC.
REITs are unique among real estate investment vehicles, since participation in them by investors is subject to the benefits and drawbacks of stock in a publicly-traded corporation. REIT investors are thus affected by stock market issues like short-term interest rates and spurts of inflation. Worse, they are simultaneously subject to the capitalization issues of the real estate market that affect the setting of property values. It is a trade-off that many stock-market investors are happy to make, thanks to the convenience of owning stock, especially when that stock can be spread over many REITs.
Of foremost importance to shareowners is a simple trade-off: in exchange for taking on the risks that come from the lack of control in REIT ownership, shareowners can diversify their real estate-based investments. The investor thus avoids the need to conduct a due diligence investigation into the value of the underlying real estate. Investors are also freed from worrying over the income and operating costs of owning a property. Such factors, while of primary importance to a real estate investor owning and operating a property, do not concern investors in REITs.
No formulas, rules of thumb or guidance exist for REIT investors to use to make a quick analysis of value and pricing of share interests in REITs. Investors thus tend to apply the PE ratios commonly used to evaluate stock issued by corporate enterprises and sold through the stock exchange.
Investment fundamentals
Are REITs a good investment? They can be, for portfolio stock market investors willing to do their research. However, as indicated by the indexed values in the above chart, REITs have only recently begun to regain shareholder value after a steep drop in all stock prices at the end of the Millennium Boom, and occasionally still show negative returns.
As part of the recent rise in the stock market, the gain in REIT share values is fueled by ambitious speculators, but lacks support from underlying earnings and property values, which have a long way to go before recovering past value – unlike the present situation in stock market pricing. [For more on the state of the stock market, see first tuesday’s Market Chart: Stock Pricing vs. % Earnings.]
The strength of the REIT market as a whole can be gauged in part by the strength of the commercial real estate market: publicly traded REITs currently hold a full 10% of the nation’s commercial real estate. For the present, however, the commercial real estate market has only begun to recover from a recession that rivaled the pain of the residential sector in intensity. The optimistic stock market investors who choose to invest in REITs under the expectation of a quick real estate recovery will likely be unpleasantly surprised by the results in the next few years.
This is not to say that REITs will remain unable to eventually produce a full recovery for their shareholders. While commercial property is in dire straits, some REITs used the recent recession to acquire additional cash by issuing more certificates of participation (stock, by a different name) with the intention of using the cash generated to purchase property at reduced market prices. [For more on REIT efforts to recapitalize, see the June 2009 first tuesday article, REITs recover from losses by entering the stock market.]
This means the capitalization rates of the share pricing for REIT investors will be nearly back to the real estate market norm of 9-10% (after dropping as low as 5% in the 2005 REIT purchasing frenzy). Those who invested in REITs involved in the California, Nevada, and Florida markets during that frenzy now own certificates worth two thirds or less of what they paid. The rents collected in those locales remain stagnant or worse, and show little sign of increasing anytime soon.
Those who invest directly in real estate ownership today may experience a better fate. first tuesday does not anticipate any sort of bottom in the commercial real estate market until beyond 2012. Readers who follow the movement in the number of jobs existing, returning and newly created in California have already come to the same conclusion. [For more on California employment, see the first tuesday Market Chart, Jobs Move Real Estate.]
By early 2011, REIT shares had more than doubled from their low point in March of 2008, in spite of the fact that commercial real estate values continued to drop anomalously throughout this period. REIT operating income did not increase in this time – it actually fell – but investors felt optimistic about their ability to turn a profit in the stock market’s eventual recovery.
REIT share pricing depends in part on the stock market’s perception of the type of property held by the REIT. REIT share pricing thus tends to be strangely ephemeral, since it is not directly affected by the market value of the underlying real estate owned by the REIT, capitalization rates, the REIT’s actual operating success or any of the other factors that play a role in traditional real estate ownership.
Further research
Cautious and uninformed investors prefer to purchase bundled shares of assorted REITs, mirroring the market as a whole instead of trying to pick individual winners. This approach requires less research, and by its diversification reduces the cumbersome due diligence investigation associated with purchasing any individual REIT. These investors may benefit from the historical information and timely reports available from the National Association of REITs (including the market data depicted on the chart above).
More dedicated investors must put in a greater amount of time and effort asking detailed questions about any individual REIT before purchasing shares. Does the REIT deal in hotels or self-storage units (considered riskier property) or in apartments (less risky)? When undertaking this research, the two most important factors to consider are:
1. The REIT’s management. Management must have a history of operating property responsibly, not just buying and selling for the sake of short term gains. Purchases must be accomplished without losing cash capital to fees loaded on the front end of deals, and property management must be accomplished in an effective and efficient manner. If possible, the investor should analyze the REIT’s income reports to get a feel for its historic use of cash and property.
2.The location and type of property owned by the REIT. This information can be had on the REIT’s operating statements. Perhaps most useful, for those willing to do the research, are the REIT’s annual reports made to the United States Securities and Exchange Commission (SEC). The SEC requires all REITs to report the number of properties they own, the number under construction, the amount invested and details about the property’s type, as well as other information about the REIT’s activities and objectives. The report, which may run over fifty pages, lists potential risks to the REIT and its investors, details the trust’s level of insurance and provides a broad picture of the trust’s position in the market.
Other questions to consider: How has the REIT performed historically? Is it currently burdened with property that has lost value in the recession but not been “marked to market,” or does it have piles of cash to make new investments in the upcoming years? If there is one thing that buyers have learned from the end of the residential and commercial bubbles, it is that there are no sure bets in real estate. The best insurance against a mistake is always knowledge of the market and the individual properties involved. This is true of home ownership (for which there is no ability to diversify), it is true of direct ownership of income property, and it is equally true of indirect ownership through an REIT.
For recent news on REITs, see the June 2009 first tuesday article, REITs may be an opportunity for investors. |
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