Why (and Why Not) to Invest in REITs

This is chapter two of a guide
to REIT stocks. Begin here.

This is chapter three of a guide on REITs. Begin here.

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Five reasons not to invest in REITs

You have no control

As an apartment building owner, you have the right to select the tenants and to replace management. But not so in buying the stock of a REIT.

As a minority shareholder, except for casting your vote once a year on the election of the board of directors and other trivial matters, there is little that you can do to change the current or future operations of the business. Investing in REITs, in other words, requires a leap of faith.

Misaligned interests

The REIT asset managers compensation is directly related to the size of the REIT itself. Thus the asset managers spend their time looking for ways to grow the size of the fund. Yet raising capital in the secondary market - and diluting the ownership of current investors - is never in the best interest of the current common shareholder.

In addition, the REIT's management often has little to no ownership stake in the company. And this lack of "skin in the game" creates a culture of risk-taking at the expense of the common shareholder.

Perhaps because it is impossible to quantify this agency risk in numbers, that the REIT community hardly speaks enough that the nature of the REIT structure is full of misaligned interests.

No tax benefits

The Internal Revenue System (IRS) recognizes both the interest expense and the depreciation charge to be deductible from taxable income for the individual investors, but not for the REIT investor.  

If you sell a property real estate and exchange it for a similar property, you are not taxed for the capital gains. (Known as 1031 Exchange.)

Yet none of these tax benefits apply to the REIT investor. The dividends you receive are fully taxed as ordinary income, and any difference between the cost of the REIT stock and the price you sell it for is immediately taxed as either ordinary income or at the capital gains level.

The ups and downs of the stock market

The value of a REIT stock is not strictly dependent on the value or the condition of the real estate properties. Buying a REIT stock exposes you to market risks that are hardly seen on the property level.

When you own an apartment building next to a university, your rental income is not affected by changes in the U.S. administration or by the GDP growth expectations. But these factors will influence the price of your REIT stock.

The addiction to debt

The value of a REIT stock is highly dependent on the lending environment. If debt markets freeze and consequently REIT companies lose access to raise equity or borrow debt, future growth becomes questionable. And it is this lack of future growth prospects that penalizes the stock price in the present.

In addition, the cost of debt changes in time. In the late 1980s the WSJ Prime rate was as high as 20% while today it is 6%. And the higher the interest rate level is, the less appealing real estate appears.

Four reasons to invest in REITs

Liquidity

As owners of commercial real estate know, it takes at least a few months to sell a commercial property. First you must stage the property; perhaps, replace the roof and repaint some walls. Then you must list the property with a broker and negotiate terms with potential buyers. Then you wait in escrow for the lender to seal the deal.

By investing in REITs, however, you can sell your interest quickly, usually within less than 24 hours.

Investment requirements

The great value investor Walter Scholls once said that you never know a stock until you own it. The same applies to the understanding of commercial real estate. If it were not for the advent of REITs, we would not understand the mechanics behind commercial real estate ownership.

By buying a few shares in a REIT, you can understand the margins of the business; how commercial real estate works; and the real estate outlook. To enter that knowledge base, you don’t need more than a brokerage account and a few dollars.

Investing in the industry, not the management

Managers of private real estate partnerships tell the story of their unique expertise that will ultimately result in fatter pockets for you. But it is hard to tell between bad and excellent management. The unique feature of investing in REITs is that it allows the investor to take a position on a specific segment in the industry and not necessarily in its management.

In Warren Buffet's words:

“Our conclusion is that, with few exceptions, when a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact.”

Diversification of the real estate asset classes

The REIT investor can take a position in an asset class and can allocate to that asset class a small portion of the portfolio. This is a unique feature. Most of us cannot afford to own hotels, shopping centers, offices, retail and apartment buildings as investments. They are simply too much to manage and too expensive to own.

But as REIT companies focus on a specific sector of real estate, allocation among the many real estate asset classes is as easy as clicking on a few buttons.

A rule of thumb in investing (and in life, for that matter) is that the more dependent you are on one thing, the more risk you take. If you invest your savings in buying and renting a condo, you risk that one tenant may destroy your entire investment.

However, the typical REIT company owns over 50 different properties. And if a negative development occurs in a specific property - for example, a major tenant vacates the property - the REIT’s cash flow is hardly tarnished due to the diversification of income.