As of April 30, 2019, the market capitalization of publicly traded equity REITs was over $1 trillion and they comprised 94% of the entire REIT universe (the other 6% was comprised of mortgage REITs). They owned over $1.5 trillion of income-producing properties in over 15 different property types, and the three largest are Infrastructure (mostly cell towers and data centers), Retail, and Residential. Virtually all real estate owned is located in the US adding to the defensive characteristic of this asset class. No longer can investors generalize about REITs given that the fundamental drivers for every property sector vary significantly. Importantly, 31 REITs are in the S&P 500, and 70% of the market capitalization is represented by 67 equity REITs that are classified as investment grade by the major ratings agencies. REITs should be attractive to all investors as they are designed to produce a growing stream of dividends and, in recent years, dividends have accounted for roughly 50% of total returns.
In 1960, REITs were given relief from federal income taxes for the first time. It was the intent of Congress to give individual investors access to commercial real estate. But, by the end of the decade, only 12 equity REITs were publicly traded with total assets of only $300 million. In contrast, mortgage REITs exploded in both number and with assets peaking at over $20 billion; however, their ‘‘time in the sun’ was short lived as real estate became overbuilt, problem loans dominated portfolios, and most would not survive under the weight of too much leverage and high external advisory fees. Out of over 100 mortgage REITs in 1972, none survive today. Meanwhile, equity REITs put up consistent numbers through the 1970’s but gained little traction as a player in commercial real estate.
The 1980’s saw several REIT IPOs (Initial Public Offerings), but REITs still played a back seat to syndicators that were able to raise tax sheltered equity for developers. Coupled with lax lending standards, this incentivized capital to be irrationally allocated, allowing even mediocre operators to survive and prosper. That is, until 1986, when the real estate world changed forever with the Tax Reform Act of 1986 that lessened the attraction of most tax shelters. Real estate was grossly overbuilt, many banks and savings and loan associations collapsed, and the capital markets were effectively shut for real estate forcing the US government to form the Resolution Trust Corporation to help save financial institutions and deal with foreclosed properties and non earning loans. Without tax shelters, syndicators were essentially out of business leaving a huge hole in the capital market for real estate.
Thus, the stage was finally set for Wall Street to securitize real estate on a scale few could imagine as we entered the 1990’s. The modern REIT era began with the IPO of Kimco Realty (NYSE: KIM) in late 1991. At the time, the market capitalization of all equity REITs stood at less than $10 billion. In only five years, the number of equity REITs doubled to 166 and the market capitalization stood at $80 billion by the end of 1996. Some of the best real estate companies in the US entered the public market. In addition to investor’s appetite for yield, the rapid rise of Equity REITs was aided immensely by the introduction of the UPREIT. Simply put, the publicly traded REIT is the sole general partner and owns the largest interest in the OP (or Operating Partnership) that owns the income-producing portfolio. Many private real estate companies would have had little to no equity if they had been forced to pay taxes upon formation using a traditional legal structure. Today, most REITs are structured as such, and may use this format to acquire properties by issuing OP units to sellers with a similarly low tax basis. Units can be converted to common stock of the REIT on a one-for-one basis at any time and earn the same dividend.
Equity REITs have learned important lessons since the Modern REIT era began almost 30 years ago (see Figure 1). We believe the most important benefit is the transparency that is the result of almost 200 REITs producing quarterly and annual reporting to shareholders, the comprehensive analytical coverage by Wall Street firms, and the essential work by rating agencies. This has helped institutionalize commercial real estate as more and more participants demand a return on investment. The industry is considerably less risky relative to the past. Cycles, once characterized by overbuilding and then the inevitable bust, now essentially remain in equilibrium and offer investors a more predictable return profile. We are currently in year 10 of a cycle than began in 2009 and, as we have said over and over in previous Outlooks, this cycle is one for the record books and it shows no signs of ending.
High quality commercial real estate is one of the oldest industries, and has long been an essential asset class for the most sophisticated institutions, including pension funds, insurance companies, sovereign wealth funds, endowments, and ultra high net worth investors, among others. Presumably, such institutions were attracted to the annual income stream, diversification benefits from a lack of correlation to equities and fixed income, and inflation protection. However, due to the lack of quality options in the public market, most gravitated to direct ownership of real estate or investing through private equity funds. Thanks to the evolution of the public REIT through the Modern REIT Era, that is no longer the case today. While many of these institutions have embraced REITs for at least some portion of their allocation, we believe there still is much work to be done to break some of the myths and historical biases that continue to influence some investors to favor the private market over public REITs.
Similarly, individuals were able to participate, usually through partnerships and ‘retail–oriented’ (non-institutional) funds, in commercial real estate prior to the Modern REIT Era. However, with so many high quality options available today on the public market, we remain shocked at the lack of REIT ownership among individuals. As mentioned earlier, the REIT structure was created for the sole purpose of allowing an individual investor to own high quality real estate on par with the largest institutions. We believe we can address several roadblocks that we’ve heard along the way.
First, a primary residence does not qualify as an investment in commercial real estate. There is very little correlation between residential and commercial real estate. In addition, it provides very little diversification benefit as it is one property in one city; in contrast, a portfolio of REITs provides ownership of thousands of properties in the best cities in America. Finally, a home is more of a lifestyle choice; in fact, instead of providing a growing cash flow stream, it consumes capital annually. The average home costs about 5-10% per year, depending on local property taxes. Notwithstanding, the total returns are much better in commercial real estate when compared to the Case-Schiller home price index, which does not even include annual property taxes and maintenance costs.
Second, in spite of the recent success of the public REIT, they own only about 20% of the high quality commercial real estate in the country. As a result of their small market capitalization relative to all securities, REITs represent only 3% of the S&P 500 as of May 31, 2019. Valuation metrics are different for commercial real estate which has hampered stock investors from understanding the benefits of this asset class. Not surprisingly, the average equity mutual fund was 67% underweight to REITs as of December 31, 2018. Therefore, in a traditional 60/40 stock and bond portfolio with mutual funds for the equity portion, the average investor would have only 0.6% exposure to high quality commercial real estate. In contrast, commercial real estate represents 15% of the US economy, as shown in Figure 2. Excluding residential homes, commercial real estate is over 17% of the US economy. Therefore, adding a commercial real estate allocation beyond a generalist equity fund is essential to building a properly diversified portfolio.
To address this gap, the ‘REIT-dedicated’ community was created for investors that wanted to add to their commercial real estate exposure. As a result, dedicated real estate funds comprise 17% of the market capitalization of REITs, the highest sector-dedicated ownership by a factor of four.
Third, many studies have proven that adding a 5% to 20% allocation to commercial real estate increases portfolio return and maintains similar risk. Due to its low correlation with equities and fixed income, commercial real estate tends to balance a portfolio when one of the other two asset classes is underperforming, as shown in Figure 3.
While many investors can point to positive experiences with private real estate investments, we believe that they could have experienced a risk-adjusted return as good or better over the same period with equity REITs, while also avoiding the lack of liquidity and high fees.
In particular, we can only laugh at the argument that private vehicles present lower risk than public due to lower volatility. While volatility is one way to measure risk, it only works on an apples-to-apples basis. For example, comparing the daily volatility of one stock versus the monthly volatility of another does not prove anything. However, because public REIT prices are available on a second by second basis, some investors try to compare REIT volatility to private real estate prices that may only report estimates on a quarterly or annual basis (and are not subject to much scrutiny). Ultimately, if a public REIT and a private fund own similar assets, the risk should be the same.
However, we believe owning that same real estate in a private fund presents higher risks than owning public REITs. First, private funds tend to employ much higher leverage than public REITs. As of April 30, 2019, the average REIT debt to total market capitalization was only 31%, which compares to private real estate leverage that normally resides in the 50% to 80% range!
Second, there is little to no transparency in private funds, particularly for those targeted at high net worth investors. While public REITs are subject to SEC regulations, quarterly conference calls, institutional sell side coverage, and shareholder activism, private fund investors have few rights and little access to both property level data and management teams.
Third, REITs employ much lower payout ratios, which provides significantly lower risk in the form of higher financial flexibility, more predicable dividend growth, and the comfort of internally-sourced equity than can be used for redevelopment, development, acquisitions, debt paydown, or stock buybacks. As of March 31, 2019, the average REIT payout as a percent of adjusted funds from operations (or AFFO) was 74%. In comparison, the average private REIT had a payout ratio of 192%, according to FactRight as of 2Q2017. Not surprisingly, data such as this on private REITs is difficult to find. As a result, many investors are surprised when their cost basis is much lower at the end of a private REIT fund’s life, meaning they were being paid back with their own principal in the form of the ‘annual yield’, and could end up paying taxes on ‘gains’ even when the final price is lower than the initial investment price!
Finally, private fund fees are notoriously high, and historically opaque. Initial investments are typically associated with fees to the broker of 5% to 15%, meaning only $0.85-$0.95 of every dollar invested is actually going to real estate. In addition, annual investment management fees, asset management fees, transaction fees, and other expenses can total 2% or higher! In contrast, the average REIT General and Administrative (or G&A) expenses equate to 0.4% of the historical cost of assets (even less on market value) and the same brokerage fees as buying any other stock, such as Exxon (NYSE: XOM). For comparison, the annual G&A and ‘other expenses’ of Exxon amounted to 0.2% of its market value in 2018.
In addition, it would be extremely difficult to replicate the diversification of public REITs in the private market without making investments in 10-20 funds focusing on 15 property types and all of the top US cities. Some property types are not even available to the average private fund investor, particularly class A malls and cell towers, which are 75% owned by public REITs.
Furthermore, the lack of liquidity in the private funds market doesn’t allow investors to rebalance or ‘actively manage’ exposure to the desired markets or property types. While we at Chilton can avoid elevated risk in a particular property type or geographic by reducing exposure to a particular REIT (typically trades are done in one day), private fund investors would be stuck with limited redemption options, potentially with additional fees and staged over several quarters or even years.
Due to the many benefits listed above, public REITs should be included in all diversified investment portfolios in all parts of the cycle. There are certainly times when it can be higher weights than others, but a minimum allocation should be 5%. We understand that there are other vehicles that may offer similar benefits to check the real estate allocation box. However, we believe public REITs should comprise at least 50% of the real estate allocation to provide proper diversification by property type and geography, while also giving the investor the liquidity to increase or decrease the total real estate allocation depending on the comparative pricing between public and private real estate. In particular, the lower risk nature of public equity REITs can provide the ‘core’ real estate exposure, while the riskier private equity portion can serve as the ‘opportunistic’ real estate exposure for an investor that is interested in both. Furthermore, the favorable tax status of public equity REITs is extremely valuable to tax-deferred or tax-exempt investors due to the lack of taxes at the REIT level. Not to be left out, taxable REIT investors recently had their tax status improved due to the Tax Cut and Jobs Act, which significantly lowered (~1,000 basis points) the tax rate on the ‘ordinary income’ portion of the REIT dividend.
Matthew R. Werner, CFA
Bruce G. Garrison, CFA
RMS: 2220 (5.31.2019) vs 1909 (12.31.2018) vs 346 (3.6.2009) and 1330 (2.7.2007)
Previous editions of the Chilton Capital REIT Outlook are available at www.chiltonreit.com/category/library/reit-outlook/.
An investment cannot be made directly in an index. The funds consist of securities which vary significantly from those in the benchmark indexes listed above and performance calculation methods may not be entirely comparable. Accordingly, comparing results shown to those of such indexes may be of limited use.
The information contained herein should be considered to be current only as of the date indicated, and we do not undertake any obligation to update the information contained herein in light of later circumstances or events. This publication may contain forward looking statements and projections that are based on the current beliefs and assumptions of Chilton Capital Management and on information currently available that we believe to be reasonable, however, such statements necessarily involve risks, uncertainties and assumptions, and prospective investors may not put undue reliance on any of these statements. This communication is provided for informational purposes only and does not constitute an offer or a solicitation to buy, hold, or sell an interest in any Chilton investment or any other security.
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