REITs & Investment Property

Having examined the pros-and-cons of buying a home for investment purposes, let's compare the ins-and-outs of buying income property directly (that is, with the help of a lender, a title company and a real estate agent) versus buying it passively through Real Estate Investment Trusts, or REITs.

Chances are, you live near one or more of the following: a hospital, apartment building, industrial site, office complex, shopping center, hotel or bank. Unless these places are visited for the purpose of running errands, this type of property is seldom given much thought. These venues are just sort of there; and so, are easily taken for granted. When you think about it, this is a bit strange considering that, nationwide, there's a staggering abundance of commercial real estate. Whether you’re surrounded by skyscrapers in a bustling metropolis, strolling the air conditioned confines of a shopping mall, heading into town to grab a cup-o-joe or are running to the nearest bank, much of the property surrounding you is zoned strictly for commercial use. Nonetheless, many Americans are only peripherally aware of how this enormous segment of the real estate industry works. Which raises an obvious but generally unasked question: who owns commercial real estate? Well, it so happens that this vast and extremely valuable category of property is often owned and managed by companies that lease it to a broad spectrum of businesses in every sector of our economy.  

Mention the word tenant and most people automatically think of a person. Well, tenants aren’t always people; often times, they're businesses. Although residential and commercial real estate are identical in that both relate to land and whatever buildings or improvements are on it, there are important distinctions between these two vastly different categories of property. Fortunately, they're easily distinguished because residential real estate satisfies the property needs of citizens whereas commercial real estate accommodates the property needs of businesses. Believe-it-or-not, knowing a thing or two about commercial property can be quite lucrative—especially if you know how to put this knowledge to work. Going back to the 1960s, dramatic changes were made to real estate laws that opened up whole new vistas of economic opportunity for ordinary people looking to add commercial real estate to their investment portfolios. As you might guess, before real estate laws were amended to allow this, this type of investment property was out of reach for all but the wealthiest and most sophisticated industry players. Nowadays, however, anyone with a few measly bucks and a brokerage account can snap up an impressive portfolio of commercial property. How is this possible? Interested in the answer? Read on.

Many people are understandably perplexed by commercial real estate’s dual status as both an indispensable factor of production in the business world and a stubbornly illiquid form of wealth in the real world. To be sure, this industry has huge barriers to entry. If the daunting prospect of scraping together enough money for a 10% down payment on a house sounds intimidating, imagine the horrifying prospect of having to come up with a 10% down payment for a run-of-the-mill commercial property like, say, a shopping mall or office building. that sports a hefty $10 million dollar price tag. What's more, money isn't the only obstacle preventing the average person from entering into such a high level transaction. Negotiating and ultimately closing such a deal would require a rare blend of specialized industry and legal expertise. Essentially, you'd need to have all of these things simultaneously to become a serious player in commercial real estate. And yet, based on your extensive experience as a consumer, you've probably seen commercial venues change business tenants with the speed and ease of a runway model swapping glamorous outfits. If you've seen a Sears or K-Mart close its doors only to reopen months later as a Home Depot or Best Buy? If so, then you've witnessed this extraordinary phenomenon first hand. And yet, for reasons that have been discussed, this sort of thing happens shouldn't happen since these extremely valuable properties can't easily or quickly change ownership. This peculiar phenomenon underscores a need for the property management business model. Were it not for property management companies and the essential role they play in the marketplace, commercial spaces couldn't change business tenants as frequently as they do. This flexibility gives our economy the additional wiggle room it needs to quickly adapt to changing market conditions. You see, our economy resembles a beating heart, as it rhythmically expands and contracts, businesses open or close and employment rises or falls. And all of this happens with the passage of each economic cycle. Though it's true that some businesses actually do own the properties they occupy to serve their customers, given commercial real estate's prohibitive price tag and the fact that a company's Chief Financial Officer can usually deploy an organization's operating capital more productively elsewhere by either investing it or plowing it back into the business that generated it in the first place, it's often in a company's best interest to pay property managers rent instead. The same basic economic considerations apply to those who decide whether to buy a home or rent.

Curiously, although home values attract nationwide attention and are frequently discussed in the news, most people don’t regard their homes as a steady source of cash; and rightly so. For starters, a house can’t be easily bought or sold. Real estate agents, closing costs and the nettlesome prospect of having to deal with bankers and complete lots of legal forms tends to discourage people from attempting to squeeze money from their homes on a regular basis. Fortunately, such procedural obstacles are mere speed-bumps insofar as the well-heeled world of commercial real estate is concerned. From an investment standpoint, is commercial real estate as desirable as residential real estate? You bet, perhaps even more so. For most aspiring capitalists, the prospect of owning a portfolio of income generating commercial properties in a variety of essential industries would be a dream-come true… Think back to your favorite real estate board game; you know, the one you played as a kid. To jog your memory, here's a hint: it’s got a colorful foldout board; lots of pretend money and tiny player icons in the shape of a destroyer, a thimble, a beat-up old shoe and a banker’s top hat. No-doubt, owning a portfolio of income producing commercial real esate would be like owning the most coveted color coded properties on the Monopoly board. Imagine how it might feel to rattle off Fortune 500 companies as personal tenants. No-doubt, if you found yourself in such an enviable position, you’d be well positioned to collect obscenely large rent checks on a regular basis. Better yet, were you to find yourself in such a circumstance, you’d also have the wherewithal to hire a team of professionals to help you manage and maintain all of the properties in question. As the “silent partner” in this happy little arrangment, your most pressing obligation would be to saunter on over to the mailbox every now and then to collect and deposit your portion of the rental income. Suppose there were a way for you to make this dream scenario a reality? Would the prospect of doing so interest you?

Before we get too far afield, however, I should warn that there are many important differences between how the economics of real estate work in the game of Monopoly versus the real world. For starters, the financial benefits of owning investment property aren’t limited to the collection of rental income. As ardent Monopoly fans will probably recall, the amount of money that changes hands when someone lands on someone else’s property is fixed. To keep the rules of this game simple and accelerate flow of play, rent prices are permanently fixed. For a board-game, that’s all well and good. In the real world, however, we all know that landlords tend to raise tenant rents anywhere from three-to-five percent a year. Meanwhile, by financing the bulk of a property's purchase price with a 30 year loan that has a low fixed interest rate, inflation will slowly reduce the "real-dollar" economic burden of an astronomical amount of debt. Chances are, whatever money is borrowed to finance a commercial property's purchase will, in a good 20 or 30 years, be repaid with depreciated dollars. Also, whoever bags the deed to Park Place in the real world will almost surely enjoy years of future appreciation as the value of the property itself—and a generous helping of tax breaks thrown in by Uncle Sam to help smooth the ride. Tax breaks on real-estate? You bet, and for investment property owners there are oodles of them. Though homeowners often crow about the mortgage interest and property tax deductions they receive, investment property owners are treated to a far more expansive range of such taxpayer subsidized treats. In addition to the tax perks that a residential homeowner gets, property owners can deduct the full value of the building or structure that's been erected on their property, a nice little value-add that's parceled-out in equal installments over a period of twenty seven and a half years. Periodic outlays for property maintenance expenses--which includes outlays for a new roof, upgraded fixtures and necessary improvements--also reduce an investment property owner's end-of-year tax liability. But wait, there's more. The slowly thickening cushion of equity that investment property owners accrue is mostly subsidized by various business tenants that dutifully pay rent. In theory (and often in practice) it’s a handsomely profitable arrangement for commercial real estate owners.

If you're looking for the biggest bang on your investment buck, you could do a lot worse than own commercial real estate. Problem is, this type of property is difficult to acquire. The average shopping mall, for instance, is out of reach for most hobbyist investors. Moreover, there's the tedious follow-up hassle of having to collect rents from business tenants and the expenditure of additional time and energy to make sure that one's commercial facilities are continuously up to code, properly cleaned and well maintained. Individual investors are understandably put-off by the dreary prospect of having to tend to these irksome responsibilities, but does this mean that you should abandon all hope of owning commercial property? Absolutely not. Fortunately, commercial properties of various descriptions are lumped into large pools and divvied up into millions of tiny slivers so that investors, university endowments, pension funds, foreign central banks and institutional money managers can easily buy them.

Thanks to the growing popularity of the REIT (Real Estate Investment Trust) ownership structure, commercial real estate has gradually become just another highly liquid and easily tradable form of capital. Every day, billions of dollars worth of commercial properties are passed between buyers and sellers on the floors of the world’s stock exchanges—just like stocks. REITs shrink vast portfolios of commercial property into something that can be quickly and easily bought and sold. The main difference between REITs and stocks, however, lies in the nature of the underlying asset. In the case of a stock, an investor buys a single business enterprise, which, in turn, exposes that investor to all of the risks and rewards of owning a company. When an investor buys a REIT, however, instead of owning a fractional share of a business entity's current and future profits, a portfolio of income producing commercial properties is bought instead. When you buy one share of a REIT, vast acreages of commercial property, the structures erected on it, the rent paying business tenants occupying it, and a team of qualified professionals who're responsible for managing the whole kit-n-caboodle is neatly shrink-wrapped into something that can be bought or sold by anyone with a few bucks and a brokerage account. An investor who purchases REIT shares will receive a fractional interest in its funds from operations, or free cash flow, which, in turn, comes from tenant rents and, from time-to-time, capital gains resulting from the strategic sale of commercial properties that are held in a REIT's diversified portfolio of real estate holdings.

Incidentally, the REIT ownership structure is rapidly being adopted in other parts of the world. China has been in the news lately because of its growing economic clout. To put China’s gargantuan size and future economic growth prospects in proper perspective, Ted Fishman, author of China, Inc., estimates that China currently has anywhere from 100 to 160 cities with populations of a million or more people; the U.S., meanwhile, has only 9 while Eastern and Western Europe combined have 36. Does the prospect of owning commercial real estate in China’s most vibrant metropolitan markets sound like a feasible long-term wealth building strategy? Since China has joined the World Trade Organization and its’ economy is rapidly modernizing and opening to the West, owning commercial real estate in the middle kingdom by acquiring international REITs may be a smart way to capitalize on this and other country's luminous future growth prospects.

Last time I checked, the Standard & Poor’s 500 Index (a well-known index dominated by large U.S. companies) sported a skimpy dividend yield of 1.6%. In other words, for every hundred dollars an investor plows into the S&P 500, they’d get $1.60 a year in income. REITs, however, offer a heftier payout--typically on the order of 4% to 7% of a REIT’s share price. Higher REIT yields owe to the fact that commercial real estate generates huge cash-flows from business tenant rents. To qualify as a REIT, which allows management to avoid paying corporate taxes, REITs are required by law to distribute at least 90% of their operating profits (a.k.a funds from operations) directly to their shareholders. Unlike qualified stock dividends (which are subject to a skimpy 15% tax rate), REIT shareholders must pay regular income tax on the income they receive from their commercial real estate holdings. And, much like stocks, REIT financials are carefully audited by outside accounting firms. The remaining 10% of REIT income that shareholders don’t receive is used by management to build an operational cash-cushion, cover administrative costs and pay for maintenance expenses. It’s worth emphasizing, however, that REITs offer an additional benefit as well: “pass-through” depreciation. In other words, the tax breaks that REIT properties generate is automatically factored into the payouts that REIT shareholders receive. Another worthwhile advantage of REIT income is that it’s generally thought to be a safer form of investment income because a REIT's cash flows are advantageously placed on the economic totem pole. Why? Because, by law, corporations are required to pay operating expenses like rent before they pay interest to bond holders or dividends to stockholders. Consequently, should a business tenant unexpectedly fall on hard economic times, REIT shareholders are first-in-line to be paid.

Considering the diversification benefits that REITs offer; the fact that qualified professionals are tasked with managing the properties in question; the significant tax benefits that commercial properties generate; the likelihood of future appreciation in the underlying value of REIT shares; and the fact that all of these benefits can be enjoyed passively—and at a much lower incremental cost than buying real estate directly—I’d say that REITs are an elegant way to cash in on real estate. By all means, those who insist on singing the praises of real-estate should continue humming along; only, they'd do well to include the word “REIT” in the lyrical high-notes.