Because of hefty down payments, commercial real estate investing was out of reach for most investors. So fifty years ago, the U.S. Congress encouraged investors to purchase a diversified portfolio of income-producing real estate by the creation of Real Estate Investment Trusts (REITs) corporate-tax exempt status.
High average yield, a focused real estate exposure, and above-average liquidity appealed to both retail and institutional investors. REITs provide a higher yield return compared to other asset classes because they are required to distribute 90 percent of profits to earn a corporate tax exemption. Because REITs shares trade on an exchange, transaction costs are miniscule. But the benefits come with costs.
High volatility, positive correlation to the market value of other asset classes, and a lack of control adversely affect investors. With the advent of purchasing REITs on a margin, capital calls risk mushroomed. Real estate valuation developed a dependency on the valuation of other asset classes. And because the investor implicitly takes a passive ownership interest, management skills became a source of risk uncertainty.
Types of Real Estate Investment Trusts
Just as Real estate properties differ in risk and return, so do REITs. One distinguishing factor is their asset type; another is their management core strategy, which may range between value-add acquisitions to inflation hedging. Within the asset class itself, REITs tend to specialize in a subset. Within residential REITS, for example, there are REITs who focus on student housing while others focus on apartment buildings or residential homes.
Retail REITs acquire, develop, manage, and operate retail buildings. The retail sector is dependent on consumer sentiment, economic growth, and technological advances. With an average lease term of five to ten years, investing in retail tends to attract institutional investors because of a longer investing time horizon.
Office REITs are engaged in the acquisition, development, ownership, leasing and management of office buildings. Corporate profits, employment growth, and business outlook are major economic drivers. Leases are typically five to ten years, but executive suites may have a shorter lease term. In an article for Barron’s, a financial magazine, Amey Stone notes how economic drivers affect Office REITs valuations.
Mortgage REITs finance the acquisition of real estate by their clients, or purchase loans originated by others. The balance sheets of these entities resemble those of a bank. Instead of borrowing from depositors, these entities fund their operations via capital markets. Balance sheet interest rate sensitivity, leverage, and asset-liability management are key factors in the valuation of mortgage REITS.