Real Estate

What Is a REIT? Real Estate Investment Trusts Explained (Pros, Cons, Alternatives)

For investors who want to invest into Real Estate, a popular option can be a Real Estate Investment Trust (REIT).

REITs are companies that own and/or operate commercial real estate. The REIT structure provides access to real estate, via a security, for investors to collectively participate in a larger portfolio of assets.

The most commonly used REITs are publicly traded REITs where investors can buy or sell shares on the secondary market and hold them in their brokerage accounts. Other REITs are “non-traded,” meaning an investor purchases shares directly from the issuer and agrees to hold them for a fixed period of time, without any opportunity for secondary market trading.

The benefits of owning shares of a REIT are:

1. Distributions: REITs are structured so that they must distribute at least 90% of the income generated from the real estate assets to the shareholders of the REIT.

2. Professional RE management teams: REITs are typically managed by established real estate teams and companies.  These RE firms have long track records and can be analyzed by investors.

3. Diversification: REITs typically invest in, and own several buildings thus providing diversification across several buildings in different areas and regions. Many REITs will diversify over different CRE asset types like: Office, Multi-family, Retail, Industrial/Logistics, Digital/Data Centers.

4. Liquidity: Investors can buy and sell the shares of the publicly traded REIT when they wish to exit their position.

5. Tax Benefits: REITs are not taxed at the corporate level. Unlike REITs, corporations are taxed at the corporate level, and then any dividends paid to investors are taxed at the investor level as well. REIT distributions and dividends are typically paid to the shareholders of the REIT on a regular basis, usually quarterly.

6. Participation in underlying potential real estate gains: Shareholders of a REIT can benefit in gains in value of the underlying real estate assets as markets strengthen and higher rents can be realized.

Some disadvantages of REITs are:

1. Volatility of REIT shares: Publicly traded REITs typically have a high correlation to the broader equity and debt markets. The volatility in the publicly traded REIT shares may cause REIT shares to significantly fluctuate regardless of any changes to the fundamentals of the underlying properties owned by the REIT. The table below shows how the 10 largest REITs performed relative to the S&P500 over the last 5 years.

Source: GreenStreet REIT Research

2. REIT shares can trade at a discount to Net Asset Value (NAV): REIT shares are traded on exchanges and thus will fluctuate based on the dynamics of buyers and sellers of the REIT shares. The table below shows the amount of time each of the 10 largest REITs traded at a discount or a premium to their net asset value over the last 2 years. 

Source: GreenStreet REIT Research

3. Interest rate exposure: REITs can be highly sensitive to interest rate fluctuations. Investors typically purchase shares of REITs for the cash distribution and yield. So, if interest rates rise, distribution rates become less attractive to investors compared to other fixed income instruments available to investors.  Fixed income and yield oriented instruments will most likely adjust lower to bring the yields into line with the market.  The chart below shows the degree to which movements in the share price of the top 10 REITs correlate to movements in interest rates over the last 5 years.  

Source: Federal Reserve Economic Data (FRED), GreenStreet REIT Research

4. Taxation of dividend income:  While REITs are not subject to double taxation (taxation at both the entity and shareholder levels), REIT dividends do not qualify as capital distributions, so they are taxed as ordinary income to shareholders, and REIT shareholders do not receive additional deductions for depreciation. Direct investment in real estate through an LP or LLC, by contrast, allows the investor to treat dividends as capital gains (taxed at a lower rate) and allows investors to receive enhanced tax deductions for depreciation, also while avoiding entity level taxation. Publicly traded REITs are typically more liquid than direct investments in real estate.

5. Expense ratio of the REIT: REIT operating expenses and fees may run higher for transaction fees, for property management fees, for acquisition fees, when compared to direct ownership of real estate assets.  Also, there are additional costs required of a publicly traded REIT to maintain regulatory compliance with the SEC and other regulatory agencies.

6. Alignment of interest between REIT shareholders and REIT management: There is much less alignment of interest between REIT Shareholders and the REIT’s management because typically the REIT’s size and AUM is very large and thus REIT management does not hold a significant amount of the shares. The REIT management is managing the REIT assets for a management fee and does not suffer nearly as much as REIT shareholders if the REIT does not perform well and the REIT stock price declines. As shown in the table below, with the exceptions of REITs that started as family investment firms and are still closely held (Tamara Gustavson at PSA, David Simon at SPG, and Sam Zell at EQR), management teams of REITs own very small minority stakes (<1%).  Even at firms with ‘large’ family ownership, it is uncommon to see individual or group ownership >10% of the shares.

Source: Public filings (most recent 14A for each REIT)

LEX Markets does not provide tax, legal or accounting advice. Potential investors are encouraged to consult with professional tax, legal, and financial advisors before making any investment into a securities offering. This investment may not be suitable for all investors. Distributions and liquidity not guaranteed. Property performance and performance of property tenants not guaranteed. Diversification does not eliminate the risk of experiencing investment loss.

November 15, 2022

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