REITs can be managed to exclusively hold real estate investment properties. These REITs are designated equity REITs. REITs can also hold commercial real estate mortgages. These securities are designated mortgage REITs. Hybrid REITs hold both real estate properties and mortgages.
- The maturation of the U.S. REIT market
- Types of equity REITs
- Investment characteristics
- Returns and volatility
- Investment considerations
- Tax considerations
The maturation of the U.S. REIT market
The development of the U.S. REIT market has been marked by both market performance and legislative changes in tax law and regulations.
By the early 1970’s the REIT marketplace consisted of mortgage REITs and hybrid REITs comprising approximately two-thirds of all REIT securities and holding approximately three-fourths of REIT market capitalization. The debt that these REITs issued was predominately building loans to commercial property building contractors. Many of these contractors defaulted on loans during the severe 1973 – 1974 recession. The result was carnage in the mortgage REIT market; the NAREIT Mortgage REIT index declined -36.26% in 1973 and fell -45.32% in 1974.
An additional factor in the slow growth of equity REITS during the 1970’s through 1987 was the favorable tax treatment for investment real estate property held in limited partnerships rather than REITs. The Tax Reform Act of 1986 (TRA), eliminated the tax benefits of real estate limited partnerships and launched the modern era of equity REITS. An additional boost to the growth of the equity REIT marketplace came with the IRS private letter ruling on the Taubman Centers Inc. initial public offering (IPO) in 1992, which allowed for the tax free exchange of partnership real property to a REIT.
The growing size of the equity REIT marketplace made it practical for mutual fund companies to establish U.S. REIT mutual funds. Vanguard created an equity REIT index fund in 1994.
At the close of 2013 REITS owned over 40,000 investment properties distributed across the United States. The equity REIT marketplace consisted of 161 REITs with a market capitalization of 608,276.6 million dollars. This comprises approximately 2.5% of the total U.S. stock market capitalization.
In 2014 S&P announced that they would be moving equity REITS out of the S&P financials sector to be given a separate sector listing, Equity Real Estate Investment Trusts, with implementation expected after market close on August 31, 2016.
Types of equity REITs
There are two venues for acquiring equity REITs in the United States.
- Equity REITs: own physical real estate and are traded on a public stock exchange.
- Private REITs: Private (non-traded) REITs are not traded on a public stock exchange, and are very illiquid. These are often sold by financial advisors who receive large commissions. Prudence suggests that investors should stick with exchange-traded equity REITs.
- Diversified REITs: own a diverse group of properties not tied to any specific sector or industry.
- Industrial REITs: own industrial real estate, ie. used for industry manufacturing.
- Office REITs: REITs that own office buildings or other similar property.
- Residential REITs: REITs that invest in residential real estate, such as apartment complexes.
- Retail REITs: REITs that invest primarily in retail properties such as shopping malls.
- Specialized REITs: own property that is specialized in a single use (such as lodging or storage).
While few will doubt that commercial real estate is a distinct asset class, there is debate among academics, practitioners, and individual investors as to whether REIT stocks serve as a suitable proxy for direct investment in commercial real estate.
REITs are marked to market each day in the stock market, and as such, are subject to numerous market forces. Physical real estate properties are illiquid and do not trade on liquid markets. Those who argue that REITs capture real estate returns point out that the relationship requires long holding periods.
Returns and volatility
The NAREIT Equity Index provides a long-term record of U.S equity REIT investment performance, with data starting in 1972.
Over this time frame, equity REIT annual returns ranged from a high of 47.59% in 1976 to a low of -37.73% in 2008. Over the entire 1972 -2013 period, the index provided a compound annual return of 11.83% with a standard deviation of 18.35%.
Returns and volatility will vary according to varying time frames. Rolling returns and volatility can be found in the spreadsheet link, accessible in the chart below. A table of annual returns is including in this accompanying page.
Keep in mind that past performance does not forecast future performance.
Equity REITs have historically proven to be not exactly correlated with the total U.S. stock market. Note that correlations tend to shift over time, and tend to rise during recessions and bear markets.
For investors who value the simplicity of total market investing, it is important to realize that equity REITs are included in total stock market index funds, where they represent approximately 2.5% of the market capitalization.
Investors who accept equity REITs as a proxy for the U.S. commercial property market return may want to dedicate a higher portfolio allocation to equity REITs in order to more accurately reflect the higher weighting of commercial real estate in the nation’s total stock of capital assets.
Model portfolios that include allocations to equity REITs are suggested by Rick Ferri in his Core Four portfolios and by Yale endowment manager David Swensen in his portfolio from Unconventional Success. Both authors stress the use of low-cost REIT index funds as fund selections.
Equity REITs are generally considered to be high-yielding securities that are best held in tax deferred accounts. Equity REITs distribute three types of distributions.
- Dividend distributions– To qualify as an equity REIT, management must distribute at least 90% of income to shareholders. As a result, equity REITs tend to generate high dividend distributions. These dividends do not generally meet the requirements for lower taxed qualified dividends because REITs do not pay corporate income tax on earnings; the income is only taxed at the individual level, where it is taxed at marginal tax rates.
- Capital gains distributions- Equity REITs are required to distribute any net gains realized from selling investment properties.
- Return of Capital distributions– Equity REITs distribute income from funds of operation, which do not include depreciation of investment property. The part of the dividend distribution attributable to the depreciation allowance is usually deemed a return of capital.
For taxable investors, return of capital distributions are not taxable. The investor is required to reduce the tax basis of the investment by the amount of the distribution. The eventual tax on the distribution is deferred until the shares are sold by the investor. If the result of the sale is a long-term capital gain, the return of capital distribution is taxed at the investor’s long-term capital gains tax rate.