FAQ | Real Estate Investment Trust
FAQ | Real Estate Investment Trust
By Jan Brzeski
Managing Director and Chief Investment Officer, Arixa Capital
Basics of Real Estate Investment Trusts
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A Real Estate Investment Trust, or REIT, is a special type of company set up specifically to hold a portfolio of investments in properties or in some cases mortgages secured by property. There are a number of very professional FAQs about REITs available on the Internet. In this FAQ, we will reference those other FAQs, and also add in our own perspective on REITs–the investor’s perspective. Our approach is to de-mystify REITs but also to point out some of the risks and pitfalls that investors should be aware of, when evaluating a REIT investment.
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The first distinction is between publicly-traded REITs and non-traded REITs (also known as “private REITs” or “non-exchange traded REITs). Public company REITs can be bought and sold on a stock exchange like other stocks. Private REITs are harder to sell and take longer to sell. There are advantages and disadvantages of both types of REITs, some of which will be covered in this FAQ. In addition to the public-private distinction, many REITs identify themselves by what kinds of real estate investments they hold. For example, Equity Residential only owns apartment properties, especially larger properties. Other REITs may own only shopping centers while still others own bonds backed by single family home mortgages.
Public Company Real Estate Investment Trusts
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Advantages of public REITs, from the investor’s perspective, include the following:
Liquidity. Investors can sell their investment easily through any broker including many low-cost online brokerage firms. Having the ability to sell if an unexpected need arises is valuable and accounts for the premium paid by investors for liquid investments.
Transparency. Public companies generally are required to disclose quite a bit of information about their holdings, executive compensation and other aspects of their business.
Scale. Most of the largest REITs are public. These firms may enjoy some economies of scale, better diversification and will generally attract more professional management.
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Rich Valuations. Many public REITs carry a premium valuation. For example, Equity Residential (ticker symbol EQR), which is one of the largest apartment REITs, pays a dividend of about 3.5% as of April 2013. In most parts of the country, direct ownership of apartments (either personally or by participating in a syndication as a passive investor) can generate cash flow of 5% or more.
Volatility. Like all public stocks, REIT shares do not necessarily reflect underlying value but rather a the market price which can be impacted by emotions and market sentiment. For example, suppose you owned Equity Residential and had to sell soon after the financial crisis. The value of EQR’s stock dropped by more than 50% in a 12 month period spanning 2008-2009 as shown on the chart below. reit graph for apartments 1
Figure 1 – Equity Residential apartment REIT–10 year price history.
An even more extreme example of public REIT volatility is Aimco, also one of the largest apartment REITs:
Aimco apartment REIT
Figure 2 – AIMCO apartment REIT – 10 year price history.
Capital structure can create complexity and risk. Some public REITs use leverage to enhance their returns, just as real estate investors might take out a bank loan to purchase an investment property. In a small number of cases, the way public REITs use leverage can create risk. I have written on this topic on SeekingAlpha.com; please reference the following article for more information: http://seekingalpha.com/article/291768-how-risky-is-annaly-capital.
Private Real Estate Investment Trusts
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Private REITs have become a popular investment option for many individuals; however we believe many private REITs have disadvantages that may not be fully appreciated by the typical REIT investor. Some of these issues are outlined below, and are also highlighted by the SEC in their FAQ on REITs.
High up-front fees. According to an FAQ from an industry association of private REITs, the typical up-front fee for non-traded REITs is 10%. This large fee is paid to brokers who sell the REIT shares the individual investors who make up the great majority of private REIT investors. In our opinion, this fee is so unfavorable as to almost overwhelm all the other details of the investment, explaining why experienced real estate investors avoid such offerings.The trade association points out that public REITs incur fees also. However, there are important differences. In the private REITs, the 10% fee applies across all the money raised by the REIT. If a public company raises capital, it incurs a fee but the broker fees for follow-on equity offerings are much less than 10%. Let’s also conduct a thought experiment to explore the fee issue more closely. Suppose a private REIT raises $100 million from investors, with $10 million of fees going to brokers who sell the shares or units, for net proceeds of $90 million. The REIT then borrows $100 million and proceeds to buy apartment buildings or office properties using the $190 million. What are these buildings worth the moment after the transaction closes? They are worth $190 million on a gross basis, but because real estate brokers charge a fee of, say 3% on transactions of this size, the REIT’s net proceeds in a sale would be 97% of $190 million, namely, about $184 million. The first $100 million of proceeds goes to the lender, leaving $84 million of proceeds. If the REIT then liquidates and returns proceeds to the investors who put up the original $100 million of equity, they would get 84 cents for each dollar invested—an immediate loss of 16%. This example might be a little unfair because the REIT does not intend to sell the properties it bought right away. They might argue that by the time they do sell, the value of the properties will have risen more than enough to overcome the transaction costs. Still, there is no denying the negative impact on investors of a high up-front load that goes to brokers who sell private REIT units and shares—brokers who have no long-term interest in the results of the underlying investment.
Lack of liquidity. Private REITs cannot be sold easily. If an investor is forced to sell, he or she can expect to take a significant loss.History of Poor Transparency. As outlined in the SEC’s FAQ, private REITs have a checkered history of transparency and disclosure to their investors. For example, even though an investor’s account is worth less than 100 cents on the dollar right after he or she invests (because of the high up-front fees described earlier), most REITs show the account as still being worth 100 cents on the dollar, to prevent alarm on the part of investors. Also, some private REITs promise an appealing-sounding annual yield, but in order to make these yield targets, they may borrow money or return some of the investors’ original capital. This creates an illusion of an investment with higher yield than what is actually achievable, based on the underlying investments.It is techniques like these that have given private REITs a bad reputation among many sophisticated investors.
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If a private REIT were to studiously avoid the issues described in the prior section, it could potentially offer a number of advantages to investors. Such a “model private REIT” would need to figure out a way to reduce the up-front costs of raising capital from investors. Advantages of a “model private REIT” might include the following:
Yield. In theory, private REITs have the ability to provide higher yield than public REITs (because public REIT investors pay a liquidity premium).
Less perceived volatility. For investors who cringe watching their stock portfolio’s value jump up and down, owning a private REIT may be better than owning a public REIT. With no daily share price to be alarmed about, some investors might sleep easier and have less temptation to sell at the worst time.
Access to non-institutional properties. Public REITs have a tendency to purchase the best properties in the largest markets. These “Class A” properties are pricey and tend to offer lower yields as many other REITs, pension funds and even sovereign wealth funds aim to purchase only these “trophy” properties. In contrast, private REITs have historically purchased “Class B” properties in secondary markets. To the extent that there is less competition for these properties, they can offer higher yields and could give investors exposure to a different type of property than public REITs generally provide.
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A REIT must have at least 100 investors. Typically REITs own more than one property. A fund is similar but need not have 100 investors. An individual property syndication gives the investor the chance to see the actual property in which he or she is investing, but also hitches the investor’s results to that single property, which could be a negative. For example, I know more than one investor who purchased an interest in a single apartment building in Phoenix in 2007 and ended up losing their entire investment. In both cases, if they could have recovered much of their loss if they had the ability and/or patience to hold the property for the following 7-8 years, however many investors are not able or willing to do so.
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For those professionals considering setting up their own REIT, check out this FAQ from Morrison Foerster which is one of the top American law firms: http://www.mofo.com/files/uploads/images/faq_reit.pdf For an even-handed an exhaustive look at REITs through the lens of the REIT industry’s official association, navigate to: http://www.reit.com/investing/reit-basics/frequently-asked-questions-about-reits. Since association dues are paid disproportionately by the largest REITs, which tend to be public companies, this FAQ will have more of a focus on public REIT investing. Finally, the U.S. Securities and Exchange Commission has a useful FAQ that highlights risks that investors should be aware of: https://www.investor.gov/investing-basics/investment-products/real-estate-investment-trusts-reits#