The quest for consistently high risk-adjusted return is an arduous, never-ending journey. In the current investment terrain, key elements for success include viable capital preservation and/or appreciation, positive yields, adequate liquidity, and low transaction costs. Diversification is another prominent consideration, especially over the longer haul, as investors find themselves transitioning into changing financial landscapes. This outline introduces the basics of Real Estate Investment Trusts (REITs). That REITs can serve as a useful portfolio diversifier can easily be made apparent. The next issue becomes “which type of REIT?” The emphasis of this write-up is on identifying the different types of REITs. Outfitted with this information, investors can make better REIT choices, aiding portfolio diversification now and into the future.

What are REITs?

Real Estate Investment Trusts are corporations or trust arrangements that use the pooled capital of many investors to purchase and manage portfolios of income-generating real estate property (equity REITs) or mortgage loans (mortgage REITs). REITs that own both real estate and mortgages are known as “hybrid REITs.” Real Estate Investment Trusts were developed largely after the Real Estate Investment Trust Act of 1960 and are designed to serve as vehicles that allow for wider participation of investors in real estate markets.

The main impetus behind the creation of REITs is to minimize, via favorable tax law provisions, the double taxation faced by pooled investment activities in real estate, prior to the 1960 Act. Double taxation stems from tax liabilities from income generated at the corporate level and then accruing to the individual level. In exchange for the preferential tax treatment, REITs must abide by certain operating provisions concerning structure of governance, concentration of ownership, and sources and uses of income, to list a few.

One specific requirement that stands out is that REITs must pay dividends of at least 90% of the trust’s taxable income. This requirement highlights the ability of REITs to stand out as a source of investment income among the various asset classes. Because REITs represent a specific type of asset, real estate, (and the income flows derived thereof) REIT performance may move in a different direction compared to other investments in a given time frame. In line with this, investors sometimes seek out REITs for positive yields when other asset classes have disappointed.        

 

 

 

Different Types of REITs

The National Association of Real Estate Investment Trusts classifies REITs into three different types: Publicly Traded, Public Non-Listed, and Private. This listing reflects, in descending order, the degree to which each REIT is subjected to scrutiny by the public at large and regulatory requirements in general. Thus, Publicly Traded REITs (sometimes referred to as Listed or simply as Public REITs) are the most visible; whereas Private REITs are less obvious, with fewer publicly disclosed features to research.

Publicly Traded REITS, as their name suggests, offer ownership shares for ongoing trade on major stock exchanges, such as the New York Stock Exchange (NYSE). This is unique among the three types of REITs and affords Publicly Traded REITs the ability to offer liquidity that is unmatched by the other two types. Liquidity, the ability to convert an asset to cash quickly, and with preservation of capital, is made available due to the ease and low cost of buying and selling shares. In this way, Publicly Traded REITs allow investors to enter and exit positions with the timeliness that facilitates preservation of capital as well as appreciation of capital. Contributing to this liquidity, as little as one share of a Publicly Traded REIT can be exchanged at brokerage costs that are the same or very similar to that of buying or selling any other publicly traded security.

Because their shares are publicly exchanged, Publicly Traded REITs allow for performance tracking and comparison to numerous independent benchmarks. In this way, more information (e.g. dividends) regarding the REIT is generated and distributed, so that overall transparency is enhanced. Publicly Traded REITs are required to regularly file audited financial updates with the Securities and Exchange Commission (SEC). They differ from the other two types of REITs in that they are subject to specific rules on corporate governance as dictated by the major exchange they are listed on. Publicly Traded REITs are summarized below.

              Publicly Traded REITs

• Pay dividends, normally have a perpetual life
• Publicly traded on national exchanges
• Offer higher liquidity than the other two types of REITs
• Offer convenience and low cost in acquisition and disposition
• Allow for ease in performance tracking and benchmark comparison
• Generate the most information and transparency of all REIT types
• File with the SEC and are subject to major exchange listing requirements

 

 

Public Non-Listed REITs are registered with the SEC and file quarterly and yearly financial reports with that regulatory body. The major difference compared to their Publicly Traded counterparts is that Public Non-Listed REITs are not traded on major exchanges (thus, they are not listed on the exchange). Because they are not openly traded, Public Non-Listed REITs cannot match the level of liquidity provided by Publicly Traded REITs. Additionally, Public Non-Listed REITs are not as competitive in terms of convenience and low cost. Minimum initial investment amounts of $1,000 - $2,500 are typical. Distribution fees and front-end costs, as well as on-going management and back-end fees, may be charged and are more likely when compared to Publicly Traded REITs.

Due to Public Non-Listed REITs not being traded on major exchanges, the opportunities available for performance tracking and benchmark comparison are limited. Without true exchange market performance, not as much information is generated and disseminated, resulting in less overall transparency. However, because these REITs report to the SEC and are subject to state and North American Securities Administrators Association (NASAA) regulations, some independent performance analysis is available.

Public Non-Listed REITs normally have a limited expected life. Typically, after 10-12 years, a liquidation event occurs that allows investors to cash out. These events may take the form of an initial public offering (IPO), merger, outright sale of assets, etc. The liquidation goal of investors is for capital preservation. Sometimes back-end fees (or surrender charges for redemptions or early individual liquidation) exist that work contrary to this goal. The recap for Public Non-Listed REITs is provided below.

Public Non-Listed REITs   

• Pay dividends, normally have a limited life, tend to have back-end fees
• Are not traded on national exchanges
• Less liquid when compared to Publicly Traded REITs
• Less convenience and more costs compared to Publicly Traded REITs
• Less performance comparison capability than Publicly Traded REITs
• Less information and transparency relative to Publicly Traded REITs
• File with the SEC and are subject to state and NASAA regulations

 

 

Private REITs are not registered with the SEC and are not regulated securities. Ownership shares are not traded on major exchanges. Because Private REITs are not regulated or traded, they represent the REITs with the least amount of liquidity and transparency. Like all REITs, however, they pay dividends. Compared to Publicly Traded REITs, they typically offer less convenience and higher costs. Minimum initial investment amounts of $10,000 - $100,000 are common, as these REITs tend to target institutional investors.

Private REITs do not report to the SEC or state or NASAA regulatory authorities. No public performance tracking and benchmark comparison are available and other information is provided at the discretion of the REIT management and board. Very little overall transparency exists. For these reasons, we view Private REITs as the riskiest type of REIT. Although many Private REITs claim very attractive dividends, we find many examples of how high fees and costs diminish this shine.

Private REITs also have a limited expected life and expected liquidation event similar to Public Non-Listed REITs.  They are likely to possess distribution fees, front-end costs, and ongoing management fees, etc. These costs and fees, when levied, are typically the highest of all types of REITs. Back-end fees, surrender charges for redemptions, and penalties for early individual liquidation often exist for Private REITs. A fair number of roadblocks exist that can hamper a Private REIT exit strategy for investors. Cautionary examples of Private REITs gone wrong are not hard to find in the financial news media. A summary of Private REITs follows below.

Private REITs   

• Pay dividends, normally have a limited life, tend to have back-end fees
• Are not traded on national exchanges
• Less liquid when compared to Publicly Traded REITs
• Less convenience and more costs compared to Publicly Traded REITs
• Less performance comparison capability than Publicly Traded REITs
• Least information and transparency overall
• Do not file with the SEC and are not regulated by states or NASAA

 

REITs and Diversification Goals

The above outline presents a great deal of information to process. Despite this, we feel a clear-cut choice emerges. It’s our view that most investors are best served by the option offering flexibility along with the greatest number of positive attributes - Publicly Traded REITs. A prudent, risk-minded approach to investing guides our thinking in this matter.

Besides direct ownership of REIT shares, we point out that investors can also gain exposure to REITs through mutual funds. Mutual funds, like individuals, are able to purchase shares of REITs. When choosing this investment avenue, we encourage carrying out a thorough due diligence of the fund. This effort would include inquiry into the type and characteristics of REITs held in the mutual fund portfolio. Again, we feel Publicly Traded REITs exposure, in general, is the most advantageous to pursue over time and over the varied financial terrain one is likely to encounter.

Note that dividend yield opportunity has promising characteristics but is not guaranteed.

National Association of Real Estate Investment Trusts website, www.REIT.com; this source is used extensively in this paper.

 

This information is not intended to serve as investment advice; it is for educational purposes only.

The opinions expressed are those of Peter Hardy, CFA and are no guarantee of the future performance of any American Century Investments portfolio.

Diversification does not assure a profit nor does it protect against loss of principal.

Understanding inherent risks such as interest rate fluctuation, credit risk and economic conditions are important when considering an investment in real estate.  

 

 

 

 

(c) American Century Investments

www.AmericanCentury.com

 

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