Meet REITs — Real Estate Investment Trusts

By Mike Trovato
Analyst, mPower

In this article: Real estate industry boom What is a REIT? Why buy REITs? REIT story not all roses Is now the time to buy REITs?

Real estate industry boom

Have you ever dreamt of being a real estate magnate like Donald Trump? Imagine amassing a portfolio of worldwide property, such as shopping malls in Boston, waterfront property in San Francisco, beachside hotels in Florida and even skyscrapers in New York and Hong Kong! The massive net worth of Trump's real estate assets may be tough to beat, but the structure and vastness of his property portfolio is attainable through Real Estate Investment Trusts (REITs).

REITs (pronounced "reets") have stepped into the limelight over the last five years as their aggregate market capitalization has grown from a boutique-like $44 billion in 1994 to $122 billion today, making them a major segment of the real estate market. The National Association of Real Estate Investment Trusts Index (NAREIT) recorded a remarkable 92.9% industry return from 1995 through 1997. During this period, investment bankers trampled one another to get a piece of the action. From the beginning of 1997 through mid-1998, REITs raised a whopping $49 billion in new equity, driving a 54% increase in the market capitalization of the REIT industry.

What is a REIT?

REITs were created in 1960 by the Real Estate Investment Trust Act to enable small investors to make investments in large-scale, income-producing real estate. Drawing in part from the example of mutual funds, Congress decided that the only way for the average investor to access investments in commercial property was through pooling arrangements. As a result, REITs were formed as closed-end investment companies into which investors could buy and sell just as they would stocks. (Although they contain a mutual fund-like portfolio of assets, they do not trade at NAV, but as shares of common stock on the listed markets -- NYSE and AMEX.)

Among the largest benefits of the REIT structure is that REITs generally do not pay corporate income tax to the Internal Revenue Service (and in most cases they are state-exempt as well). Unlike a real estate limited partnership, a REIT cannot pass its tax losses on to investors. However, according to the Internal Revenue Code, REITs must meet several provisions, most notably:

• at least 75% of their assets must be composed of real estate and held for the long term (four years)
• at least 75% of their income must be derived from real estate
• they must pay out at least 95 % of their taxable income to shareholders

For a REIT to grow, capital must come from money raised in the investment marketplace as well as money generated internally. This capital is used to purchase apartments, shopping centers, offices, warehouses, and even golf courses and racetracks. Like other stocks, REITs are carefully monitored by the SEC, independent directors and auditors, and the business and financial media.

Types of REITs

There are three basic types of REITs:

1. Equity REITs, the most common form, which invest in properties
2. Mortgage REITs, which make construction and mortgage loans to developers
3. Hybrid REITs, which are a combination of equity and mortgage REITs

Copyright 2000, National Association of Real Estate Investment Trusts. Reprinted with permission.
For the NAREIT home page, log onto http://www.nareit.com

"The REIT story is an economic success story. REITs are doing exactly what the Congress intended when it created them in 1960. They have made accessibility to income-producing commercial real estate a reality for all investors. And their liquidity enables investors to buy or sell shares of diversified portfolios of properties - from shopping malls to apartment complexes." - U.S. Representative Ben Cardin (D-MD).

Why buy REITs?

REITs provide investors with many opportunities not otherwise available in the real estate marketplace:
Diversification - The diversification represented by a REIT portfolio would be difficult, if not impossible, for most investors to achieve on their own in the property markets.
Management - Investors can own real estate assets without management responsibility.
Taxation - Unlike most corporate dividends, which are exposed to double taxation, the income passed on to REIT shareholders is not taxed at the corporate level.
Liquidity - REITs have helped turn real estate into a liquid asset. Via the public marketplace of over 200 REITs to choose from, investors can easily buy and sell property interests.

REIT story not all roses

REITs have suffered tremendously since the industry reached a peak in late 1997. The sector has since experienced tremendous selling, hammering stock prices back down to late 1996 levels. The Morgan Stanley REIT Index (the most accepted of the REIT indices) lost 16.9% by the end of 1998 and was down 6.0% in 1999. The below chart compares performance of the Morgan Stanley REIT Index (the dark line) with that of the Russell 2000.

Source: www.BigCharts.com

What happened? There are several negative factors:

REITs are value, yield and small-cap stocks all wrapped up in one. As you are probably well aware, value, yield, and small-cap stocks haven't done well recently. "Why should I care about a REIT with a 9% dividend, when I can get that from my Yahoo stock in one day?" you might ask. Many investors have asked this question, as many non-tech stocks have suffered from recent lackluster performance. Small-caps have been pummeled by large-caps, value stocks have been smoked by growth stocks, and interest rates have steadily risen, making REIT yields less attractive.

REITs have experienced heavy selling from institutional investors. Through November 1999, REIT mutual funds redeemed $1.21 billion of REIT shares, compared to $924 million in 1998. In addition, the market will see even more selling from unit investment trusts (UITs). Wall Street took advantage of huge demand and formed 13 REIT UITs between late 1997 and mid-1998, with a total market value of $4 billion. These unmanaged baskets of real estate stocks were created as a cheap way for retail investors to invest in a mix of REIT stocks. Unfortunately, these UITs were created at the market top and investors have since only seen losses. Even worse, 5 of the 13 trusts are due to expire March 2000, meaning that they will meet their fixed termination date and be forced to liquidate their holdings. Although the market value of these 5 UITs is only $650 million, the smaller, less liquid REITs may take an additional thumping.

REITs have suffered from accounting controversy. Many institutional investors feel that the accounting standards used by REITs are inadequate. REITs do not report traditional net income as calculated under generally accepted accounting principles (GAAP) like nearly all other publicly traded companies. Since depreciation expense heavily affects net income figures, REITs use a measure called "funds from operations," or FFO. FFO takes net income, adds back depreciation, and then subtracts capital gains and losses from REIT property transactions in order to be a "truer" measure of operating performance. As a result, a huge gray area has emerged as REITs have found that they can manipulate "capitalization vs. expense" figures on their financial statements. NAREIT has been pressured to develop a better accounting standard for REITs, but has yet to come up with a solution.

The Internet has posed a threat to REITs. Many investors question the future of the "brick-and-mortar" marketplace, as the Internet allows customers to buy their Pokemon paraphernalia in cyberspace instead of trekking to the local mall. As a result, investors have stayed away from REITs with a concentration of retail property. Likewise, investors feel the Internet may reduce the demand for office property, as a larger percentage of the workforce may "log-on" from home.

Office REITs are far more popular as real estate investments and make up a much larger piece of the REIT market than healthcare and lodging REITs. The office/industrial sector (they are often mixed) makes up nearly 30% of the market cap of all REITs, as opposed to only 5% each for the healthcare and lodging sectors. Although office REITs are up for the year, they would be down about 4% if not for their high dividends.

1999 REIT Sector Returns   Year To Date Dividend Year Heath Care -26.68% 13.18% Self Storage -8.05% 5.88% Industrial 3.62% 7.24% Office 3.09% 7.63% Residential 8.11% 7.52% Retail -12.08% 9.42% Lodging/Resorts -16.01% 12.70%

Is now the time to buy REITs?

Many experts agree that the massive run in Internet and technology stocks has created the potential of a bubble about to burst. If this should happen, REITs could be poised for a comeback. Due to their high yields, REITs are often viewed as defensive stocks, meaning they provide investors with downside protection if the market turns highly volatile or bearish. This theory however, has been rarely tested during the last 17-year bull run of the stock market!

There are reasons to believe REITs may have currently hit rock bottom. A look at the underlying fundamentals shows that the industry is at its healthiest since before it crashed in the late 1980s. Vacancies in office buildings and hotels are near their lowest levels of the decade. Rents are higher thanks to a strong economy and stock market, combined with the technology boom. FFO growth has slowed, but is still good by historical standards, and is estimated by SNL Securities to be 8.5% in 2000.

REITs are also currently cheap. According to Green Street Advisors, a highly regarded real estate research firm in Los Angeles, REIT price-to-FFO ratios have never been lower, when compared to broad market P/E ratios.

A possible return to value and/or small-cap stocks could do nothing but give REITs a much-needed shot in the arm. And if NAREIT can keep its promise to adopt a better accounting standard, the big-hitting institutions will probably pay attention again. Also keep in mind that the average REIT dividend yield is 8.94%. So if the market goes sideways next year, you could still earn nearly 9%. Not a bad return in a flat market. 

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.

Meet REITs — Real Estate Investment Trusts

By Mike Trovato
Analyst, mPower

In this article: Real estate industry boom What is a REIT? Why buy REITs? REIT story not all roses Is now the time to buy REITs?

Real estate industry boom

Have you ever dreamt of being a real estate magnate like Donald Trump? Imagine amassing a portfolio of worldwide property, such as shopping malls in Boston, waterfront property in San Francisco, beachside hotels in Florida and even skyscrapers in New York and Hong Kong! The massive net worth of Trump's real estate assets may be tough to beat, but the structure and vastness of his property portfolio is attainable through Real Estate Investment Trusts (REITs).

REITs (pronounced "reets") have stepped into the limelight over the last five years as their aggregate market capitalization has grown from a boutique-like $44 billion in 1994 to $122 billion today, making them a major segment of the real estate market. The National Association of Real Estate Investment Trusts Index (NAREIT) recorded a remarkable 92.9% industry return from 1995 through 1997. During this period, investment bankers trampled one another to get a piece of the action. From the beginning of 1997 through mid-1998, REITs raised a whopping $49 billion in new equity, driving a 54% increase in the market capitalization of the REIT industry.

What is a REIT?

REITs were created in 1960 by the Real Estate Investment Trust Act to enable small investors to make investments in large-scale, income-producing real estate. Drawing in part from the example of mutual funds, Congress decided that the only way for the average investor to access investments in commercial property was through pooling arrangements. As a result, REITs were formed as closed-end investment companies into which investors could buy and sell just as they would stocks. (Although they contain a mutual fund-like portfolio of assets, they do not trade at NAV, but as shares of common stock on the listed markets -- NYSE and AMEX.)

Among the largest benefits of the REIT structure is that REITs generally do not pay corporate income tax to the Internal Revenue Service (and in most cases they are state-exempt as well). Unlike a real estate limited partnership, a REIT cannot pass its tax losses on to investors. However, according to the Internal Revenue Code, REITs must meet several provisions, most notably:

• at least 75% of their assets must be composed of real estate and held for the long term (four years)
• at least 75% of their income must be derived from real estate
• they must pay out at least 95 % of their taxable income to shareholders

For a REIT to grow, capital must come from money raised in the investment marketplace as well as money generated internally. This capital is used to purchase apartments, shopping centers, offices, warehouses, and even golf courses and racetracks. Like other stocks, REITs are carefully monitored by the SEC, independent directors and auditors, and the business and financial media.

Types of REITs

There are three basic types of REITs:

1. Equity REITs, the most common form, which invest in properties
2. Mortgage REITs, which make construction and mortgage loans to developers
3. Hybrid REITs, which are a combination of equity and mortgage REITs

Copyright 2000, National Association of Real Estate Investment Trusts. Reprinted with permission.
For the NAREIT home page, log onto http://www.nareit.com

"The REIT story is an economic success story. REITs are doing exactly what the Congress intended when it created them in 1960. They have made accessibility to income-producing commercial real estate a reality for all investors. And their liquidity enables investors to buy or sell shares of diversified portfolios of properties - from shopping malls to apartment complexes." - U.S. Representative Ben Cardin (D-MD).

Why buy REITs?

REITs provide investors with many opportunities not otherwise available in the real estate marketplace:
Diversification - The diversification represented by a REIT portfolio would be difficult, if not impossible, for most investors to achieve on their own in the property markets.
Management - Investors can own real estate assets without management responsibility.
Taxation - Unlike most corporate dividends, which are exposed to double taxation, the income passed on to REIT shareholders is not taxed at the corporate level.
Liquidity - REITs have helped turn real estate into a liquid asset. Via the public marketplace of over 200 REITs to choose from, investors can easily buy and sell property interests.

REIT story not all roses

REITs have suffered tremendously since the industry reached a peak in late 1997. The sector has since experienced tremendous selling, hammering stock prices back down to late 1996 levels. The Morgan Stanley REIT Index (the most accepted of the REIT indices) lost 16.9% by the end of 1998 and was down 6.0% in 1999. The below chart compares performance of the Morgan Stanley REIT Index (the dark line) with that of the Russell 2000.

Source: www.BigCharts.com

What happened? There are several negative factors:

REITs are value, yield and small-cap stocks all wrapped up in one. As you are probably well aware, value, yield, and small-cap stocks haven't done well recently. "Why should I care about a REIT with a 9% dividend, when I can get that from my Yahoo stock in one day?" you might ask. Many investors have asked this question, as many non-tech stocks have suffered from recent lackluster performance. Small-caps have been pummeled by large-caps, value stocks have been smoked by growth stocks, and interest rates have steadily risen, making REIT yields less attractive.

REITs have experienced heavy selling from institutional investors. Through November 1999, REIT mutual funds redeemed $1.21 billion of REIT shares, compared to $924 million in 1998. In addition, the market will see even more selling from unit investment trusts (UITs). Wall Street took advantage of huge demand and formed 13 REIT UITs between late 1997 and mid-1998, with a total market value of $4 billion. These unmanaged baskets of real estate stocks were created as a cheap way for retail investors to invest in a mix of REIT stocks. Unfortunately, these UITs were created at the market top and investors have since only seen losses. Even worse, 5 of the 13 trusts are due to expire March 2000, meaning that they will meet their fixed termination date and be forced to liquidate their holdings. Although the market value of these 5 UITs is only $650 million, the smaller, less liquid REITs may take an additional thumping.

REITs have suffered from accounting controversy. Many institutional investors feel that the accounting standards used by REITs are inadequate. REITs do not report traditional net income as calculated under generally accepted accounting principles (GAAP) like nearly all other publicly traded companies. Since depreciation expense heavily affects net income figures, REITs use a measure called "funds from operations," or FFO. FFO takes net income, adds back depreciation, and then subtracts capital gains and losses from REIT property transactions in order to be a "truer" measure of operating performance. As a result, a huge gray area has emerged as REITs have found that they can manipulate "capitalization vs. expense" figures on their financial statements. NAREIT has been pressured to develop a better accounting standard for REITs, but has yet to come up with a solution.

The Internet has posed a threat to REITs. Many investors question the future of the "brick-and-mortar" marketplace, as the Internet allows customers to buy their Pokemon paraphernalia in cyberspace instead of trekking to the local mall. As a result, investors have stayed away from REITs with a concentration of retail property. Likewise, investors feel the Internet may reduce the demand for office property, as a larger percentage of the workforce may "log-on" from home.

Office REITs are far more popular as real estate investments and make up a much larger piece of the REIT market than healthcare and lodging REITs. The office/industrial sector (they are often mixed) makes up nearly 30% of the market cap of all REITs, as opposed to only 5% each for the healthcare and lodging sectors. Although office REITs are up for the year, they would be down about 4% if not for their high dividends.

1999 REIT Sector Returns   Year To Date Dividend Year Heath Care -26.68% 13.18% Self Storage -8.05% 5.88% Industrial 3.62% 7.24% Office 3.09% 7.63% Residential 8.11% 7.52% Retail -12.08% 9.42% Lodging/Resorts -16.01% 12.70%

Is now the time to buy REITs?

Many experts agree that the massive run in Internet and technology stocks has created the potential of a bubble about to burst. If this should happen, REITs could be poised for a comeback. Due to their high yields, REITs are often viewed as defensive stocks, meaning they provide investors with downside protection if the market turns highly volatile or bearish. This theory however, has been rarely tested during the last 17-year bull run of the stock market!

There are reasons to believe REITs may have currently hit rock bottom. A look at the underlying fundamentals shows that the industry is at its healthiest since before it crashed in the late 1980s. Vacancies in office buildings and hotels are near their lowest levels of the decade. Rents are higher thanks to a strong economy and stock market, combined with the technology boom. FFO growth has slowed, but is still good by historical standards, and is estimated by SNL Securities to be 8.5% in 2000.

REITs are also currently cheap. According to Green Street Advisors, a highly regarded real estate research firm in Los Angeles, REIT price-to-FFO ratios have never been lower, when compared to broad market P/E ratios.

A possible return to value and/or small-cap stocks could do nothing but give REITs a much-needed shot in the arm. And if NAREIT can keep its promise to adopt a better accounting standard, the big-hitting institutions will probably pay attention again. Also keep in mind that the average REIT dividend yield is 8.94%. So if the market goes sideways next year, you could still earn nearly 9%. Not a bad return in a flat market. 

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.