One of the least appreciated economic developments of the past decade of recovery from the 2008 financial collapse is the dramatic upswing in value of both commercial and residential real estate.
According to the U.S. Census Bureau’s monthly home sales report, the average home price at the apex of the mid-2000s real estate bubble was $317,000. In June 2018 it was $363,000, which is still nearly $40k shy of its peak average in December 2017.
Additionally, the average price for commercial real estate has grown steadily from 2013 to early 2018, according to data from the National Association Of Realtors. In short: real estate is going at a premium again.
The resurgence of real estate prices has also meant the resurgence of a special kind of securities, shares of corporations that own real estate properties and lease them to corporations, stores and individuals. These are called REITs, or Real Estate Investment Trusts.
A place in many portfolios, REITs have long been known for paying healthy dividends. In June, the average annualized yield for REITs trading in the U.S. was 4.3%, with a comparatively low correlation to other investment assets. This isn’t anything new. The average REIT yield has been higher than 3.7% nearly 90% of the time since 1972.
REITs, a different asset class?
First introduced in 1960, REITs were created to provide regular cash flow and income to investors thanks to timely (monthly) payments generated from lease contracts on residential and commercial properties. Much like mutual funds, REITs will allow investors to have a direct stake in a portfolio of related real estate properties bought, sold and managed by the REIT. Unlike mutual funds, REITs are individual companies, and investors buy and sell shares of the company itself. This means investors can trade publicly-listed REITs on the stock market, although some REITs are private businesses, while others are public, but not listed on the major U.S. exchanges.
REITs can contain a variety of underlying assets, from retail to residential, shopping malls to data centers. For the most part, each REIT has a particular asset specialization, like Simon Property Group, which mainly owns shopping malls, or AvalonBay Communities, which manages only apartments. There are also some REITs whose portfolio is a deliberate asset mix intended to diversify real estate risks for investors.
Equity REITs vs. Mortgage REITs
At this stage, it’s important to distinguish two types of REITs: Equity REITs and Mortgage REITs.
The assets in Equity REITs (eREITs) are real properties, and each property asset is owned by the REITs itself. This is not the case for Mortgage REITs (mREITs).
Assets in mREITs are exclusively financial assets, and the property those assets represent are held in pools to minimize default risk. Investors don’t own the mortgages, but instead hold pass-through certificates issued by government mortgage pools like Fannie Mae or, in the case of Commercial and Residential Mortgage-Backed Securities (CMBS, RMBS), private mortgage pools. Income in these REITs is generated by the regular “coupon” or “interest” payments of the mortgage securities they own.
Because these two types of REITs have fundamentally different underlying assets, they also differ in their risk profile and risk expectations. For these reasons, mREITs can be quite volatile and dangerous for individual investors, since they can carry significant interest rates and credit risks. If you are not familiar with those types of risks, make sure not to put your money into a mREIT. Read carefully the prospectus to find out if a REIT is fully invested in financial assets and is a Mortgage REIT. Below is a list of pros and cons of mREITs.
Pros and Cons of mREITs
- Pay very high dividends, some annual yield are as much as 23% per year
- mREITs can have volatile share price (as much as 60% annual volatility, with possibly 20% down overnight) since mREITs Book Value per Share will vary greatly with the market prices of mortgage securities. This means that a mREIT Net Asset Value (or NAV) can drop as much as 30% from one quarter to the next if it holds very risky mortgage securities
- Annual Income or Funds from Operations (FFO) of mREITs can also vary greatly, sometimes decreasing by as much as 50% from one fiscal year to the next, hence impacting the next dividend payment to shareholders (cut by more than 50%)
- mREITs might be highly leveraged when buying mortgage securities through their prime broker, hence increasing the price risk of the underlying mortgage securities they own if markets are down or underperforming.
For these reasons, individual investors looking for the diversification value of REITs should focus primarily on eREITs, not mREITs.
Special Tax Treatment
However, just because a company owns a mall or has purchased a few mortgages, that doesn’t mean it’s a REIT. In order to be classified and do business as a REIT, per SEC rule, a company must invest three-fourths of its total assets into real estate or mortgage pass through securities and subsequently receive three-fourths of its gross income from real property or mortgage holdings.
Finally, one of the most notable features of a REIT is that it is a pass-through business, meaning it must pay out 90 percent of its gross income to investors in the form of dividends. While this may seem like an easy way for investors to turn a quick buck, the reality is there is a number of accounting loopholes REITs use to skirt giving investors the lion’s share of their profits. Nevertheless, REITs do pay out quarterly dividends and are given preferential tax treatment, which make them a popular choice for income investors.
Again, REITs come in a variety of shapes and sizes. Investors should research each REIT, as well as some of their property holdings, and consult with a fiduciary or financial manager before investing.
Of course, advisors and their clients should never solely focus on taxes when choosing an asset. But if they’d like to gain tax-advantaged income and real estate exposure in their investment portfolios, it may be a good time to take a look at REITs.