REITS take flight
When Charles Lindbergh became the first to make a solo, non-stop transatlantic flight from New York to Paris in 1927, his journey captivated the world and established one of aviation’s most important milestones.
With less fanfare, the real estate investment trust (REIT) model has in recent years migrated from the US to the rest of the Americas, Asia and Europe. Viewed from the perspective of the world’s commercial property sector, the tax-transparent, real estate securitisation trend may be just as significant as Lindbergh’s flight over the Atlantic.
With government policy-makers across the world, especially in Europe, now looking at adoption of a REIT-like structure, it may be useful to reflect on the American experience that began with the creation of REITs by the US Congress in 1960. The lawmakers goal was: to make investment in large-scale, income-producing real estate accessible to investors from all walks of life. They decided that average investors could invest in large-scale commercial properties in the same way as they did in other industries – by buying equity. REITs offer distinct advantages for investors: diversification through investing in a portfolio of properties rather than a single building and management by experienced real estate professionals.
For a company to qualify as a REIT, it must comply with provisions of the US Internal Revenue Code. These include: investing at least 75% of its total assets in real estate; deriving at least 75% of its gross income from rents from real estate property or interest on mortgages on real property; and distributing at least 90% of its taxable income to shareholders in the form of dividends. By complying with these requirements, a REIT deducts from its taxable income dividends paid to its shareholders. The net result is that REIT shareholders pay tax on distributions, but the REIT generally pays no corporate-level tax.
Importantly, US public markets have rewarded companies meeting certain criteria not incorporated in the tax code. For example, almost all listed equity (property-owning) REITs are managed by REIT employees rather than by outside advisers, and industry-wide leverage has generally been around 50%.
With a very diverse profile, the US REIT industry offers investors many alternatives across a broad range of specific real estate sectors (see figure). Regardless of the specific business line, REITs most often acquire or develop their properties primarily to manage and operate them as income-producing businesses. And one significant segment of the US REIT industry has a real estate finance, mortgage-focused investment strategy.
Although still solidly anchored in the ownership or financing of commercial properties, legislative improvements have enabled REITs to keep pace with the changing marketplace. Congress has adopted various enhancements to the REIT rules through the years. Most recently, the REIT Modernisation Act of 1999 contained several provisions designed to allow REITs to remain competitive, in part by permitting them to own fully taxable subsidiaries that provide personalised services to tenants and other customers.
The industry’s evolution has been accompanied by rapid growth. In 1974, there were only 53 publicly traded REITs, with a combined equity market capitalisation of just $712m (e519m). Today, there are 173, with collective equity market capitalisation at $239bn.
US REITs are typically structured in one of three ways: traditional, UPREIT and DownREIT. A traditional REIT is one that owns its assets directly rather than through an operating partnership. An UPREIT is a structure under which the REIT is a general partner in a partnership with individuals who contributed property to the partnership; the REIT’s sole asset is its general partnership interest in the ‘operating partnership’. A DownREIT is structured much like an UPREIT, but the REIT also owns and operates properties other than its interest in the operating partnership. Both the UPREIT and DownREIT allow investors to contribute property on a tax-deferred basis in exchange for a partnership interest in a diversified partnership managed by a REIT. The contributor can later exchange his or her partnership interest for REIT stock in a taxable transaction.
Like other public companies, the corporate officers and professionals that manage REITs are accountable to their boards of directors as well as their shareholders and creditors. Most US REITs became public companies within the past 10 years, often transforming to public ownership what previously had been private enterprises. In many cases, the majority owners of these private enterprises became the senior officers of the REIT and rolled their ownership positions into shares of the new public companies. Thus, the senior management teams of many REITs today own a significant portion of the company’s stock, which helps to align the economic interests of management with shareholders.
The inclusion of REITs in 2001 in the Standard & Poor’s 500 Index - the most widely followed investment performance benchmark for the US equity markets - speaks to the increasingly widespread recognition of the importance in the US of the real estate sector in public capital markets. REITs, alongside other mainstream industries, are now widely acknowledged for the integral role they play, both in the economy and in diversified investment portfolios.
The performance of real estate stocks speaks for itself. Whether over three years or three decades, US REITs have outpaced most other market measures (including the S&P 500, Dow Jones Industrial Average and NASDAQ), and with significantly less volatility (see table). And because US REITs are required to distribute most of their taxable income to shareholders, the yields generally have produced a steady stream of income through all market conditions.
The National Association of Real Estate Investment Trusts (NAREIT) tracks the returns of real estate stocks – at home and abroad. Our partnership with the European Public Real Estate Association (EPRA) and Euronext resulted in the creation of the EPRA-NAREIT Global Real Estate Index in 1999. Comprised of three distinct series - North America, Asia and Europe - the index has become an increasingly useful tool for investors throughout the world.
Like Lindbergh’s flight, ours has been a successful ocean crossing; one that is already helping the world’s property markets, and their investors, soar to even greater heights. Oh, and by the way, New York’s Roosevelt Field - where Lindbergh took off - is now the site of a shopping mall. And yes, it’s owned by a REIT.
Steven A Wechsler is president and chief executive officer of the National Association of Real Estate Investment Trusts (NAREIT) in Washington, DC