Cutting Edge Insights
with Dr. Lee

Why get my hands dirty with real estate?  Isn’t it easier to invest in a REIT?

REIT stands for Real Estate Investment Trust.  Investing in a REIT is a way to own a share of a fund which in turn owns many pieces of real estate across different asset classes and geographic markets.

Sounds easy, right?  A few clicks and you can own a share of any publicly traded REIT (some REITS are not publicly traded).

The answer is yes – it is easier.  Investing in a REIT is the essence of “passive” investing, once the shares are purchased.

Isn’t all real estate investing supposed to be passive?  I mean, I don’t punch a time clock for my real estate investing activities…

The answer to that question depends on whether one refers to the activity or the tax consequences of the activity:

Buying a rental house and self-managing it is definitely an “active” activity, even though the income is likely to be taxed passively (disclaimer: I am not a CPA so I do not give tax advice).

Buying a share of a REIT involves some minimal initial activity such as deciding on the specific REIT and transferring funds to the broker, after it becomes entirely passive.  Meaning you have zero control.

Q:  But is there a happy medium?

A:  Yes – a real estate syndication is a way to invest in a real estate project for passive returns while others – whose track record and credentials have been thoroughly vetted – manage the project.  A sort of passive way to actively invest, if you will.  And no tenants, toilets, or termites to deal with.

In my opinion, real estate syndications are unequivocally better investments than REITs for the following reasons:

Tax Consequences: The dividends paid by a REIT are taxed as ordinary income, on which you would pay your prevailing marginal tax rate.  This is not any different than the income from a real estate syndication – that income is also taxed as ordinary.  However, law requires 90% of a REIT’s income to be passed through to shareholders rather than having the discretion to decide what is in the best interest of the fund.  So, distributions are taxed as income when they could otherwise have been classified as capital gains and taxed at a lower rate.

Degree of Control:  If you own a real estate investment, you are in control of that property.  If you are a passive investor in a syndication, you are only 1 degree of control away from the investment – should you dislike the management style, you can make your opinion known, or simply withdraw your capital at the first opportunity and move on.  In a REIT, you are 3 steps away (Property →→→  REIT fund manager →→→ REIT →→→ you) from controlling the property, and if you don’t like a particular property, your share of the REIT owns a fraction of it nonetheless.

The illusion of diversification:  It is well understood that owning multiple investments within an asset class decreases the risk of portfolio loss from any one particular investment.  This is true regardless of asset class.  However, there is a point of optimization beyond which additional investments have minimal effect on reducing risk.  In fact, more investments beyond this point may actually decrease a fund’s ability to outperform market indexes.  Generally, for securities, that level is thought to be 20 individual stocks.  It is not uncommon for a REIT to own hundreds, or even thousands, of properties.

Stability:  An individual real estate property or investment, such as an apartment complex, derives its value from three different metrics:  First, and most importantly, it is valued at some multiple of gross income.  There is also a hard asset value or replacement cost that is applicable.  Finally, there are comparable sales values which indicate what an investor would be willing to pay for a similar piece of property.  The value of real estate pertaining to its ability to generate income is not subject to massive fluctuation even in a recession, pandemic, or other black swan event.  However, your share of a REIT is only worth what the next investor is willing to pay for it.  One REIT, for example, lost 50% of its value between 2007 and 2008.

Returns: There have been certain periods of time during which REITs have returned in excess of the S&P 500.  That sounds favorable…until you learn that U.S. large cap stocks beat REITs by a percentage point or two.

Q:  What level of return are you referring to?

A:  About 14% yearly from a period of 1975 through 2014.

Q:  That is a great return!  Should we expect better than that from real estate?

A:  Absolutely.  When investing in real estate directly or through a syndication, total returns in excess of 40% are not uncommon.

Total return comes from 5 areas:

1) Leveraged appreciation – conservatively 30%

2) Cash flow – income in excess of expenses (perhaps 5%)

3) Amortization (loan paydown) of 3-5% per year

4) Tax deductions – the IRS allows depreciation as a non-cash expense (say 5%)

5) Using debt to short the dollar – in other words, you are paying back yesterday’s debt with today’s dollars – say 2-3%

(We will do a deeper dive into each of these areas in future blog posts.) 

All told, your annual return from a thoroughly underwritten, well-managed real estate investment could be 45-48% or greater.

Q:  Can’t a REIT do that for me?  It’s real estate too, right?

A:  Yes, REITs own real estate, and REITs absolutely make their returns in the same manner.  But remember, the fund managers need to be paid and there are other expenses.  The returns cited above are all “baked into” a return from a REIT and your return is simply what is left over – historically around 11%.

Q:  I want to model my investing after Warren Buffet.  Does he own REITs?

A:  As of Q4 2020, Warren Buffet’s company, Berkshire Hathaway, had approximately 0.25% (one quarter of one percent) of its holdings in REITs – specifically one single REIT – STORE Capital {NYSE:STOR}.

Further, Buffet personally owned one REIT – Seritage Capital Properties {NYSE:SRG} whose 2020 return to date was negative 70%.

As you think about this, keep in mind that how you invest in a given asset class can be more important than which asset class you invest in.

We invite your questions and comments.

Until next time,

Dr. Lee Newton

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