What is a REIT?

REIT stands for Real Estate Investment Trust, and is a company that buys, develops, manages and sells real estate assets.  REITs allow participants to invest in a professionally-managed portfolio of real estate properties.  REITs qualify as pass-through entities, companies who are able distribute the majority of income cash flows to investors without taxation at the corporate level (providing that certain conditions are met).  As pass-through entities, whose main function is to pass profits on to investors, a REIT's business activities are generally restricted to generation of property rental income.  Another major advantage of REIT investment is its liquidity (ease of liquidation of assets into cash), as compared to traditional private real estate ownership which are not very easy to liquidate.  One reason for the liquid nature of REIT investments is that its shares are primarily traded on major exchanges, making it easier to buy and sell REIT assets/shares than to buy and sell properties in private markets

INTRODUCTION

Public real estate investment trusts (REITs) are tax-advantaged corporations which own real estate properties or invest in loans which are secured by such properties. These organizations are tax-exempt provided that they satisfy certain provisions of the Internal Revenue Service Tax Code. The most significant of these requirements are 1) at least 95% of net taxable income must be paid to shareholders as dividends; 2) at least 75% of total assets must be related to real estate property; and 3) at least 75% of gross income must be derived from property rents or mortgage interest.

Public REITs are generally classified into three categories: equity, mortgage and hybrid. Equity REITs, which represent more than 90% of the total market capitalization of the REIT universe, invest directly in real estate properties. Mortgage REITs invest in real estate mortgages and construction loans, while hybrid REITs own both equity and debt. Within these broad categories, REITs will typically focus their investments on a single property sector. The table below represents, by percentage of total market capitalization, the major property sectors of the publicly traded REIT universe:

*Includes diversified, self storage, specialty and mortgage REITs.

Back To Top

MARKET GROWTH

The REIT market continued its rapid development in 1997. The ongoing emergence of REITs as an asset class is apparent in their increasing number (198 to 210), their expanding market capitalization ($88 billion to $141 billion) and their improving liquidity ($182 million to $232 million traded per day). The number of real estate mutual fund offerings increased from 44 to 69 over the past year, and more than 40 REITs now boast a market capitalization in excess of $1 billion.

Following a record return of 36.4% in 1996, REITs posted an average gain of 18.8% last year. This continued strength was the result of a number of factors, including the booming stock market, an improving real estate market, and a glacial shift away from private real estate ownership by corporations and investors. While the early adopters of securitized real estate were primarily individuals, recent activity in REITs has attracted the attention of a greater number of institutional investors. These larger entities placed almost $3.5 billion of new money in REIT separate accounts last year, and market watchers are expecting an even greater windfall in 1998.

Back To Top

WHY INVEST?

Though not for everyone, there are a number of compelling arguments, both short- and long-term, why an investor might consider an allocation to REITs as part of a multi-asset portfolio:

Competitive Performance

Historically, REITs have provided investors with returns which are superior to those of fixed income securities but less volatile than those of traditional small capitalization equities. The annualized return and standard deviation of REITs over various periods are quite competitive versus other asset classes:

Greater Diversification

Correlations between REITs and other major asset classes have dropped precipitously in recent years, presenting an even greater opportunity to diversify a portfolio by adding REIT exposure. A sample of trailing five-year correlation coefficients is listed below:

Improving Real Estate Fundamentals

The enduring strength of the U.S. economy has driven a steady recovery in the domestic real estate market. Fundamentals are improving across almost all property types and geographic regions as exhibited by lower vacancy levels, climbing rents and increased property values. Furthermore, it will be a few years before the new construction pipeline has a meaningful impact on the balance of supply and demand in the market.

Room to Expand

Despite their recent activity, REITs still represent only a fraction (4%) of the total U.S. real estate market. Like many other industries, however, the highly-fragmented real estate industry is undergoing a consolidation which will be largely financed through the issuance of public securities. Within the major property sectors, the potential for further securitization of real estate assets is apparent:

Attractive Versus Other Securities

Given their defensive characteristics, REITs are an attractive subset of the U.S. equity market which, by many measures, appears richly valued. Historically, the low beta and substantial yield of REITs have protected value in falling markets, while in the near term, the domestic focus and underlying leasing structures of REITs should provide investors with superior earnings visibility. We have also seen investment managers use REITs as an alternative to some fixed income securities. While the average yield of REITs (5.7%) was on par with that of the 10-Year Treasury at year end, REIT dividends are expected to grow between 6% and 8% in 1998.

Back To Top

RISK/ISSUES

While the growth and performance of REITs have been impressive, there are a number of risks and other issues associated with the asset class that an investor should consider:

Equity Market Risk

Given that they are publicly traded securities, REITs will always possess some element of stock market risk. This is an even greater issue in the current environment where the overall U.S. equity market is trading at historically high valuation levels. In quarters when the S&P 500 or Russell 2000 have posted negative returns, REITs have also declined, though not as severely:

Real Estate Market Risk

The primary driver of REIT cash flows is the performance of the underlying portfolio of real estate properties. Though currently on an upswing, real estate is still a cyclical industry and, when supply for space surpasses demand, REITs will likely suffer. In 1989, the real estate market began to show signs of overcapacity and the public REIT market reacted decisively. The NAREIT index fell almost 21% from the fourth quarter of 1989 through the third quarter of 1990.

Transaction Premiums

Consolidation in the real estate industry has produced economies of scale and increased cash flows for many REITs. This "bigger is better" mentality, however, has also pushed some REITs to pay inflated premiums over net asset value for existing properties. While spiking rent levels and climbing property values have glossed over even the largest premiums, it will become more difficult for REITs to justify such deals to shareholders as the current real estate recovery slows.

Duplication in Portfolio

Before electing to fund a dedicated REIT portfolio, investors should evaluate the use of REITs by their traditional U.S. equity managers. More money managers, particularly those who specialize in small capitalization value stocks, are now comfortable investing opportunistically in REITs. These discretionary investments may, when combined with a pure REIT mandate, result in unintended duplication and overexposure to the asset class.

Changes in Legislation

President Clinton�s fiscal 1999 budget includes a number of proposed changes to the tax treatment of REITs. The primary target of these proposals is a handful of "paired-share" REITs which are allowed to own real estate operating companies while shielding the majority of these companies� profits from corporate taxes. Because of the potential for abuse of this tax loophole, Congress abolished the paired-share format in 1984 but allowed existing paired-share REITs to continue using this structure. Now, a few of these REITs are pushing into the gaming industry and the notion of these REITs generating tax-free profits from gambling has touched a nerve in Washington. While Clinton�s proposals are only the beginning of a lengthy political process, we expect to see some form of legislation which closes the final paired-share REIT loophole.

Back To Top

CONCLUSIONS

• We believe REITs are a sound investment alternative which, over longer horizons, should provide attractive risk-adjusted performance as part of a multi-asset portfolio.
  
• The near-term economic environment is generally positive for REITs and there are secular changes (ie: consolidation, securitization) occurring in the real estate industry which could serve as the catalysts for continued growth over the next few years.
  
• Like the S&P 500, the trailing three-year return of the NAREIT Index is an all-time record. As the U.S. stock market slows and/or the current real estate cycle runs its course, we expect some degree of reversion to the mean where dividends account for almost two-thirds of the total annual return of REITs.
  
• Diversified portfolios of REIT stocks are the most attractive vehicles for institutional investors to gain exposure to the asset class. In this way, an investor can own shares of REITs across a variety of property sectors and geographic regions.
  
• While there is obviously a strong relationship between the two, we still view REITs as a complement to, rather than a replacement for, private real estate. As long as it is financially feasible, they are better utilized as a part of an overall allocation related to real estate investments rather than as a stand-alone play in the real estate market.
  
• EAI now tracks more than 40 investment management firms that offer specialized REIT and/or global real estate securities products.