- Studies indicate RE comprises 40-50% of the total wealth of the U.S. However, REITs represent only ~10% of total institutional quality RE assets in the U.S. (and in the world).
- Mortgage REITs: >75% of holdings in financial assets (e.g. mortgages) and short-term loans; equity REITs: >75% of holdings in real property.
- The REIT structure is not designed for growth—have to keep a majority of assets in property or mortgages at all times, and pay out 90% of taxable income. REITs do not pay corporate income taxes, so do not have a tax shield benefit, and therefore have less incentive to use debt. Firms wishing to add dividend and investment flexibility and growth may switch from a REIT to a corporate structure.
- MLPs are structured similar to REITs but have higher administrative costs. They benefit mostly high income tax-bracket investors. Empirical evidence suggests REITs outperform MLPs (and REOCs) and are a better structure to hold real property. REOCs are not pass-through structures and are actively managed.
- UPREIT: umbrella partnership REIT; a more flexible REIT that is also a partnership.
- REIT size economies of scale are parabolic: they increase up to a certain size then decrease, because RE is largely a localized business (it can never get too large). REIT’s are mostly small-cap companies. However, there is no empirical size premium—small cap REITs do not outperform large-cap REITs.
- Reputation effect: a REIT sponsored by a well-known institutional investor (e.g. pension fund) tends to perform better. It may get better analyst coverage. Institutional participation in REIT’s has expanded substantially so that the average REIT now has higher institutional ownership than the average stock.
- Externally advised REITs underperform internally advised REITs due to agency costs (self-dealing, improper revenue allocation, etc). Captive REITs (created to serve needs of the sponsor) perform the worst. Finite-life REITs (FREITs) underperform infinite-life REITs (market favors some growth).
- REITs with high debt or hard to value properties may tend to diversify to lower chance of bankruptcy. However, REIT’s that focus can leverage informational efficiencies. REITs became more concentrated after 1990. Smaller REITs tend to be geographically concentrated.
- REIT returns are attributable more to sector (property type) than to geography.
- REITs are normally not constrained by the 90% taxable income distribution, since cash flows are a lot higher than income due to property depreciation deductions. A bit puzzling that actual distributions are high: ~120% of taxable income, yet REITs raise capital and debt to grow. Equity REITs with more depreciation and highly leveraged REITs over-distribute to because they have more cash flow. High growth and high performing REITs under-distribute to use the cash; more volatile REIT’s under-distribute for fear of ever having to cut its dividend.
- REITs have lower debt than investors in the RE property market (up to 80% loan-to-value) but higher debt than industrial firms, despite no benefit from a tax shield. Arguments against debt: RE highly cyclical and have high operational fixed costs. Arguments for debt: RE assets are viewed to have high debt capacity, leverage improves returns; small firms easier to issue debt than equity.
- Don’t buy REIT IPO’s. Like closed-end fund IPO’s, they are sold to unsophisticated individual investors (institutions participate in the larger deals by more prestigious underwriters). REIT IPO’s are overpriced and return 0.2% on the first day vs. industrial IPO’s are underpriced and return 18.5% on the first day.
- No consensus in research literature on whether the REIT market and the RE property market are well integrated. Integration are higher during some sub-periods than others, as REITs behave more like small stocks sometimes and like RE property other times. There is some evidence unsecuritized RE lags REITs by about 1-2 years, due to the instantaneous market vs. periodic appraisal valuation methods. Over the long run, there are basic underlying economic drivers that affect both (interest rates, cap rates, underlying real property).
- REITs exhibit varying factor relationships with RE property, stocks, and bonds. In addition, REITs are exposed to small-cap and value (P/B) factors. Equity REITs are more exposed to stock market factor, mortgage REITs are more exposed to bond market (interest rate) factor.
- REIT interest rate sensitivity has decreased due to ARM’s and shorter leases.
- Equity REITs consistently outperform mortgage and hybrid REITs. REITs are affected by RE cycles and can perform differently than the stock market. Over time, REIT risk-adjusted returns are no greater than stocks.
- REITs offer poor inflation hedge in the short-term, and questionable hedge over the long-term. It may weakly hedge actual and expected (but not unexpected) inflation.
- REITs are good portfolio diversifier, but it cannot substitute for RE property. Optimal allocation in almost all portfolios is less than ~10%. Timing the allocation (chasing momentum) might make sense—REITs exhibit lower (higher) correlation with stock and bonds in strong (weak) performing periods.
- REITs are income stocks—high, stable dividends (mortgages, leases), but investors prefer some growth element. REITs perform well when interest rates are low (yield advantage) or when stock markets are volatile (stable income return).
- REIT Modernization Act (1999): allowed REITs to own subsidiaries that provide operational services without unfavorable tax treatment of income. Essentially allows REITs to act more like operating companies.
- REIT markets may be less efficient because 1) small-caps—less analyst coverage, less institutional interest; 2) difficult to value so many RE properties in a portfolio. However, like all stocks momentum and contrarian strategies may not outperform after transaction costs.
- REITs will continue to evolve and operationally will converge towards REOCs. More countries are adopting the securitized structure.
Finished: 13-Aug-2008