The 1990s witnessed tremendous growth in the REIT industry, which helped to bring transparency to real estate markets through public disclosure. This development has restrained the excesses that have historically characterized the real estate market in the United States.
As a way of making real estate investment more widely available to small investors, Congress in 1960 passed tax legislation allowing the creation of real estate investment trusts, or REITs. A REIT is a corporation or business trust that invests in real estate, mortgages or real estate-related securities. There are over 200 REITs traded publicly on major stock exchange. To qualify as a REIT, a corporation or trust must pay out at least 90% of its taxable income as dividends to its shareholders. As long as this dividend requirement is met, the REIT does not pay federal taxes on its income and avoids the double taxation of regular corporations. By taxing income only at the shareholder level, REITs mimic one characteristic of direct property ownership.
Other legislated requirements are that the REIT invest at least 75% of its total assets in real estate assets and derive at least 75% of its gross income from real estate rents or interest on mortgages on real property. To promote stability, REITs may derive no more than 30% of their gross income from the sale of real property held for less than four years or securities held for less than one year. To ensure that they fulfill their purpose in broadening real estate ownership, REITs are required to have at least 100 shareholders and they may have no more than 50% of their shares held by five or fewer individuals during the second half of each taxable year.
Equity REITs buy, build, own and manage properties. Revenues come principally from their properties' rents. Different property types include:
Mortgage REITs deal in investment and ownership of property mortgages. These REITs loan money for mortgages to owners of real estate, or invest in (purchase) existing mortgages or mortgage backed securities. Their revenues are generated primarily by the interest that they earn on the mortgage loans.
Hybrid REITs combine the investment strategies of Equity REITs and Mortgage REITs by investing in both properties and mortgages.
Investors have learned that a firm's accountng decisions can be quite subjective, and arnings numbers reported to shareholders are sometimes different than the actual cash, if any, generated by underlying business. By their nature, however, REITs are different. REITs must distribute at least 90% of their earnings to shareholders, and that requires cash. No amount of accounting gimmickry can substitute for actual cash that goes to shareholders. Either the REIT has the cash to pay the dividends, or it doesn't, and if there is not enough cash to make the dividend, at least the shareholders have tangible assets, the properties, rather than something in cyberspace.
Investors typically invest in REITs for their high dividend yields and stable cash flows. Because REITs derive their income from rents, they are often considered to be a hedge against inflation.
Another major advantage of REIT investment is the liquidity (ease of converting assets into cash), as compared to traditional private real estate ownership which is difficult to liquidate. REIT shares are primarily traded on major exchanges, making it considerably easier to buy and sell REIT shares than to buy and sell properties in private markets.
Investors should keep in mind that, just like other stocks, REITs are monitored on a regular basis by independent directors of the REIT, analysts, auditors, and the business and financial media and thereby often have very sound fundamentals.
In recent years, there has been widespread recognition of REITs and real estate investing. Examples of this recognition include:
REITs are now included in Forbes magazine's report card on the financial performance of America's biggest corporations. REITs now comprise a significant portion the magazine's list of 500 on the basis of sales, profits, assets or market rank.
REITs are part of the S&P 500 and the S&P Smallcap 600.
Additional investor attention could drive REIT prices higher. Investor interest has sparked REIT growth in recent years and the group's relatively attractive dividend yield and low volatility continue to attract shareholders.
Leading stock market authorities expect a 7% annual return for the stock market in this decade. Compare that expected return with the average REIT yield of approximately 5%, and REITs look very attractive. Furthermore, with an expanding economy it is likely that many REITs will raise their dividends consistently over the next few years. We believe REITs are an excellent way to match or beat the stock market's expected return, yet with lower risk than the typical stock.
Since their inception, REITs have provided competitive investment performance. According to Frank Russell Co., over the last 30 years, REITs have provided a better average annual return than Large Stocks, Bonds, and International Stocks, and have provided an average return nearly equal to that of Small Stocks. Furthermore, REITs have had less risk (as measured by the standard deviation of returns) than Large Stocks, Small Stocks, and International Stocks. Studies have shown that, historically, including REITs in a portfolio increases the average return and lowers risk.