Case 35: REITs

REITs have been in existence since 1960. However, it wasn't until around 1992 that they became popular. A REIT is a securitized form of owning real estate. Before REITs, the only way to experience the risk and return associated with commercial real estate was to own it directly through property pools, commingled real estate funds (CREFs), syndications, or separate accounts. Today, you can buy a REIT, which represents ownership in a company that holds real estate as their primary assets. REITs are real estate stocks and are traded on the NASDAQ, AMEX, and NYSE. As such, they are exposed to market noise like any other stocks, but are also similar to their underlying assets, real estate. This makes the capital gains component of their returns very attractive as a hedge against inflation, a characteristic much desired by investors.

Moreover, since a minimum of 95% of a REIT's taxable income must be paid out in the form of a dividend, investors liken the income stream to utility stocks that also pay a high percentage in dividends. Finally, REITs have a low correlation with other stocks, bonds, etc. and therefore have been found to warrant inclusion in mixed-asset portfolios. But, even with their steady returns and low volatility, REITs have received little attention from the investment community.

One of the reasons why REITs are given little attention is because there are only around 200 in existence today. While this is three times greater than the number just ten years ago, the total market capitalization of all REITs is still less than that of Microsoft. As such, analysts have not considered them worth the time to monitor and evaluate.

That being said, REITs are being used by several real estate portfolio managers as a way to rebalance their portfolios over time. Why? Unsecuritized real estate, such as a $50 million dollar office building in downtown Chicago, is an illiquid and lumpy asset. That is, if you want to sell $1 million dollars of it, it would not be possible. You would have to be able to sell off just one or two floors of the building. Since this is not possible, institutional investors might instead sell off $1 million worth of an office REIT.

Whether or not REITs gain widespread acceptance and continue to perform well remains to be seen. Still, at present, REITs do offer an attractive risk-return tradeoff.

Questions

1. Why would you suspect real estate is a good hedge against inflation?

2. Which types of investors are more likely to own REITs?

3. REITs have had a lower correlation recently than in the past. Explain why and justify whether or not you think this trend will continue.

4. Does the fact that the total market capitalization of all REITs sums to less than that of MicroSoft present a problem for real estate portfolio investors who are trying to use REITs to rebalance their large portfolios? Explain why or why not.