Exchange-traded Landlords Now A Mature Investment Option But Knowledge Needed
Why A REIT
In this piece, we take an in-depth look at investment in REITs – real estate investment trusts – as an alternative to a direct investment in a property. As we’ll shortly see, the raison d’etre of a REIT is to provide a means for exposure to the real estate sector for mainstream investors who either cannot or do not want to make the size of financial commitment required to acquire a particular type of real estate (or who don’t want in any event to become landlords as such). We’ll also see that, whilst Real Estate Funds (REITs) started life in the United States, they’re now established investment options in the UK real estate sector and in a number of other countries.
The Birth Of the Real Estate Investment Fund
Just over two years ago, on 14 September 2010, the lower house of the United States Congress took time out from its busy schedule – 20 minutes to be precise – to speak to a resolution recognising the contribution made by REITs – real estate investment trusts – to the well-being of middle America. The significance of the date was that it was 50 years to the day since then president Eisenhower had signed into law – curiously as part of the Cigar Excise Tax Extension – legislative rules for the creation of an investment vehicle for real estate funds which in concept and form would mirror the long-established mutual funds for stocks and bonds.
Speaking to the 50th anniversary resolution as its co-sponsor from the Republican party, Congressman Dave Camp explained the relevance of REITs in these terms –
Prior to the 1960 legislation, only the very wealthiest individuals and corporations had the accumulated capital required to invest in commercial real estate. Thanks to REITs and the unique financial incentives they offer to their shareholders, more middle class Americans can save and invest, whether it is for a college education, a new home, or a secure retirement.
That observation fairly neatly encapsulates the ‘populist’ point of a vehicle for real estate funds. Investors in real estate don’t any more need to be wealthy; ordinary folk can buy a piece of the action.
And Their Spread – Across America And The Globe
From its modest beginnings a half-century ago, the real estate investment fund has – at least in the United States – become a fixture in the publicly-traded investments scene. According to data published by the National Association of REITs on its website reit.com, at the end of 2011 some 160 exchange-traded US-REITs had a market capitalisation of $450 billion, with real estate holdings estimated in value terms as some 10-15 percent of institutionally-owned property in the United States. In a separate assessment, Ernst & Young – in their ‘2012 REIT Report – Global Perspectives’ – put the market cap of all US-REITs as of 30 June 2012 at $632 billion. Since the first listing in 1965, the great bulk of US-REITs have listed and trade on the New York Stock Exchange.
And whereas real estate funds in their early days focused on mainstream commercial property – offices and warehouses – today there’s a wide variety of REIT-owned real estate affording investor choice across a range of economic sectors, from timber yards to medical and dental clinics, shopping malls to self-storage units, family homes to forests.Like other bright business ideas which started life in America, the REIT real estate investment fund investment model has taken root in other parts of the world. Over 20 countries now have REIT-enabling legislation and functioning REIT markets, with governments in others actively thinking about their introduction. Australia was an early enthusiast, with a first A-REIT listing in 1971. They are popular investments in several Asian countries – Japan and Singapore in particular. By contrast, the United Kingdom is a relative Johnny-come-lately, not legislating for the establishment of REITs until 2006. Germany was even later, with enabling legislation finally – after years of debate – passing in 2007, just in time for the global financial crisis and its decimating effect on international real estate markets.
Essential Criteria For REIT Status
There is no international standard for REIT status but there are certain essential criteria which in all participating countries distinguish REITs from ordinary companies which invest subscribed capital,being criteria which must be complied with, either on formation or during their tenure as REITs, for this special status of a given real estate investment fund to be maintained.
These criteria are very much related to the key feature of REITs, which is their tax treatment. REITs are ‘pass-through’ entities, meaning that under the enabling legislation the income they earn from authorised activity is tax-free in the entity’s hands and is taxed only on distribution to stakeholders – investors – and then at the individual investor’s tax rate. In this key respect, REITs differ fundamentally from mainstream corporates, whose income is taxed both on receipt by the company and again when distributed as dividend to shareholders. REITs are thus attractive income generators for certain funds which enjoy tax-free status as well as individual investors on low tax bands.
But to maintain this privileged tax position, REITs are obliged to distribute a high proportion of their income – again from authorised activity – annually. Typically, this is set at 90 percent.
A further hallmark of REITs, as just noted, is the restriction placed on the type of business they may engage in. In essence, inaugural and ongoing REIT status for real estate funds requires a minimum proportion of total business – 75 percent in asset value and turnover is typical – to be in the acquisition and holding of real property for income-generating purposes, ie, for rent. In the US, and some other REIT countries, an alternative category is permitted – mortgage-backed lending, as are ‘hybrids’, being REITs which are both landlords and property financiers. What is not permitted as part of the core business is the purchase or development of property for resale.
In the United States, non-listed and closed-end REITs are permitted. Not so in the UK and some other countries, where REIT status requires the entity to list on a recognised stock exchange, with no restrictions on the transfer of its securities (except as may be imposed under trading rules). Until this year, UK-REITs were obliged to list on primary exchanges, which essentially meant the London Stock Exchange’s main board. But in recognition of the regulatory – and fiscal – obstacle this posed to potential REIT start-ups, the UK rules have been relaxed to allow for listing on secondary exchanges, such as the LSE’s AIM. The expectation is that the less stringent listing requirements and lower cost will encourage privately-held real estate funds to ‘go REIT’ and further expand the modest UK market (estimated by Ernst & Young at just six percent in market cap terms of the US market).
REIT Investment Funds
A potential downside – risk factor – in a real estate investment fund is that the entity proves to be operating in the wrong type of real estate, or the right type but at the wrong time. Of course, larger REITs have diversified holdings – perhaps a mix of office and retail, say, or retail and residential, but the risk to the investor of too many eggs in the one basket can remain.
To counter that risk, the investor may consider a stake not in a specific REIT but in an exchange-traded fund (ETF) which specialises in REIT investment. Or in a fund which invests in a REIT index. In the US, the major player in REIT indices is the FTSE NAREIT US Real Estate Index Series, which tracks the performance of exchange-traded REITs in several specialised types of real estate. Several ETFs exist which invest, either actively or passively (with attendant differences in cost to the investor), in these and other real estate indices both in the US and globally.
Correlation With Other Exchange-Traded Investment Products
An abiding issue with investment in REITs is the extent of correlation with other exchange-traded investment products, especially equity and debt. The opposing schools of thought have it, on the one hand, that a real estate investment fund makes an ideal diversification product in an investment portfolio otherwise consisting of exposures to stocks and bonds, because of low correlation of real estate and industrial markets. And, on the other, that because REITs are exchange-traded they are highly correlated to sentiment shift in capital and debt markets.
The position taken on this issue is likely to be strongly impacted by the view of a REIT investment as either a short or long-term holding. It’s tolerably clear that, viewed in the short-term, a stake in a REIT – or for that matter in a REIT index fund – will ordinarily behave as if an equity position. Which is to say, REIT securities are unlikely to be immune to market-wide shifts in sentiment, driven by external factors impacting the market – such as, for example, quarterly unemployment figures which turn out to be worse (or better) than the market had anticipated.
And during the global financial crisis of 2007-09, exchange traded real estate funds were savaged as much as the mainstream capital markets, indeed more so given the origins and primary impact of that crisis – massive defaults in securitised American housing debt leading to a widespread collapse in real estate values across the globe. According to NAREIT data, in 2005 there were 197 US-REITs, an historical high, with a market capitalisation in 2006 of $438 billion. Just two years later, some 60 REITs had either folded or been absorbed and market cap had shrunk by 56 percent, down to $191.6 billion, more than either equity or debt markets in the first two years of the crisis.In the longer term though, REIT real estate funds correlate much less obviously with equities or with debt securities. NAREIT asserts that over the 40-year period 1971 to 2010, compounded annual returns for publicly traded US-REITs were 12.01 percent – compared with 6.8 percent for Dow Jones Industrials, 8.4 percent for the NASDAQ Composite and 10.04 percent for the S&P 500.
And there’s no doubting that, compared with many other parts of the wider economies of REIT countries, real estate as an investment class has made an impressive rebound since the dark days of 2008-09. In Singapore, for example, the Business Times reported in September 2012 that since the start of the year, the FTSE ST Real Estate Investment Trust index, which tracks the performance of the S-REIT market, had appreciated by 23 percent against 16 percent for the benchmark Straits Times Index.
Valuing Individual REITs
With equity stocks, the traditional means of valuing the investment is by the application of two ratios – price to earnings (PE) and earnings per share (EPS). The higher the PE, or lower the EPS, the less valuable is the stock relative to others of its type. But with real estate investment fund securities, a somewhat different approach is typically advocated – the ‘funds from operations’ (FFO) technique, and its refinement, ‘adjusted funds from operations’ (AFFO).
The principal difference from traditional stock valuation lies in the treatment of depreciation. In essence, FFO is net income + the REIT’s annual depreciation charge. This approach, pretty much standard with REIT accounting, reflects the non-cash nature of depreciation as an expense and the historical likelihood that a REIT’s real estate holdings – its raison d’etre – won’t have depreciated at anything like the straight line used in conventional company accounting.But that add-back of annual property depreciation to produce a real estate investment fund’s FFO assumes that its property inventory is being maintained to optimal standards for rental purposes. Capital maintenance is a significant expense for real estate funds so their valuations typically provide an ‘adjusted’ FFO – or AFFO – which is a best attempt at calculating an annualised maintenance charge.
Beyond those peculiarities, REITs are rated by the market much like ordinary equities and debt securities. Both internal factors – the trust’s growth strategy, for example, or its management charges as a percentage of rental income – and external factors such as the prospects for the applicable property sector, be it malls, retirement homes or bowling alleys are factored into a REIT’s market pricing. The pricing of REIT securities, as with ordinary company shares, is a combination of income generation and capital appreciation.
The US, UK and Global REIT Markets
With over five decades of development under its belt, the United States REIT market offers both an enormous and a mature range of options for domestic and international investors seeking American property exposure. The sheer number of individual exchange-traded real estate funds – with 155 listed on the NY Stock Exchange – and REIT investment funds makes for a difficult – even bewildering – selection process. Then there are the various property sectors and sub-sectors in which US-REITs operate.
According to NAREIT data, the largest grouping – some 62 trusts, comprising nearly half of the 129 constituents in the FTSE NAREIT All Equity Index – are landlords either in commercial (industrial and retail) or residential property. And as of October 2012 nearly 28 percent – $136.4 billion – of the total market capitalisation of listed REITs was held by shopping mall operators, making this segment by far the largest investment category.
But within this one category can be found both the largest and the smallest of listed US-REITs. Towering above all its peers, with a market cap going into 2013 of $48.5 billion and a share price of around $157, is Simon Property Group (NYSE: SPG), which modestly describes itself on its website as ‘the largest real estate company in the world’.
Whether that’s the case or not, its 270 or so retail properties across the United States and an interest in a further 60-odd in Europe and Asia make Simon a primary option for investors seeking both US and international retail exposure. Yet the conglomerate gets the thumbs down in a post-Christmas note on barron.com, entitled ‘Time To Vacate Mall-REIT Stocks’. The author opines that, with a price currently more than eight times the book value of its assets, versus a 10-year average of 5.7, and a dividend yield down to 2.8 percent (10-year average of 3.9%), Simon has gotten too expensive.
At the other end of the retail US-REIT scale, with a market cap of just $372 million making it the smallest of all REITs in the S&P Equities Indices, is Cedar Realty Trust (NYSE: CDR). Based in Port Washington, NY, Cedar owns all or part of some 70 suburban strip-malls and retail shops along the eastern seaboard states. Its current share price of a shade over $5 represents a yield of 3.88 percent.In Britain, with its relatively juvenile REIT market, there’s nothing to hold a candle to Simon Property Group. The UK’s largest real estate investment fund – Land Securities Group (LON: LAND) – with a market cap of £6.41 billion ($10.3 billion) would rank it only at 13th of the 16 US-REITs in the S&P 500. With holdings across the British commercial and retail sectors, Land Securities’ current price of around 820 pence is yielding 2.87 percent.
At the other end of the UK-REIT spectrum may be found The Local Shopping REIT plc (LON: LSR), which listed on the LSE in 2007 and with its current price of around 24.5 pence giving it a market cap of just £20.3 million ($32.7 million). Though, with a very healthy yield currently of a shade over 10 percent. According to its website, Local Shopping seeks to exploit pricing weaknesses in Britain’s fragmented market for local – read ‘suburban’ – retail property.
Investors looking for an international flavouring of their real estate exposure can choose between country-specific REITs – and as noted earlier, Singapore’s REIT market is generating a lot of heat at present – or a global fund. Investment guide morningstar.com lists some 200 global real estate funds, mostly listed on the NYSE, which invest in REIT stocks both in the US and around the world.
REITs – Outlook for 2013
In the United States and further afield, pundits are primarily bullish about REIT performance in the year just under way. Typical is a piece just uploaded to the news section of reit.com, entitled ‘Expectations Remain High for REITs In 2013’, which quotes a range of industry players and observers pointing to the combination of stable income flow and liquidity which listed REITs offer, being factors likely to remain attractive for many investors during 2013.
You’d expect the industry’s US mouthpiece to be positive but actually it’s hard to find bearish sentiment amongst independent observers of US and global real estate markets. Growing signs of recovery in the American housing market, the just-avoided US ‘fiscal cliff’, continuing growth in Asian real estate markets, and a growing sentiment that, while the global economy may still be bumping along the bottom, the only way is up – these and other factors are identified as portents of another strong year for real estate funds going into 2013.
Based on performance since 2009, REITs with solid, sought-after portfolios, ready access to funding and competent management look well-placed to perform strongly in the year ahead. The task for the prospective investor is to find them.