REITs & Investment Property

Having examined the pros-and-cons of buying a home as an investment, let’s take a closer look at the ins-and-outs of buying income producing real estate directly (with the aid of a lender, title company, escrow service and real estate agent) versus acquiring 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, high rise office complex, assisted living facility, mobile home park, shopping center, hotel or bank. Unless these places are deliberately sough out for the purpose of running errands, such properties are seldom given much conscious thought. For many, these varying generic properties are just sort of there and are often ignored. When you think about it, this is downright peculiar given that, nationwide, there’s a staggering abundance of commercial real estate. It’s literally everywhere. What’s more, its dense global footprint is even visible from space at night. Whether you’re surrounded by skyscrapers in a bustling metropolis, strolling the cozy temperature controlled confines of a shopping mall, heading into town to grab a quick cup-o-joe or are running to the nearest bank, much of the property surrounding you is zoned for commercial use. Nonetheless, it seems that many Americans are only peripherally aware of how this vast segment of the real estate industry works. Of course, this raises an obvious but generally unasked question: who owns commercial real estate? Well, it’s generally owned and managed by private and publicly traded companies that, in turn, lease it to businesses operating in every sector of our economy.

Mention the word tenant, and most people think of a person. It so happens that tenants aren’t always people; often times, they’re businesses. Although residential and commercial real estate are identical in the broad sense that both relate to land and whatever buildings or improvements stand on it, there are important distinctions between these two dissimilar categories of property. Luckily, it’s easy to tell them apart. Basically, 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—particularly if you know how to put this knowledge to work. In the 1960s, sweeping changes were made to real estate laws that opened up whole new vistas of economic opportunity for small investors looking to add commercial real estate to their investment portfolios. Before legislation allowed for the creation of real estate investment trusts, ownership of commercial properties was off limits to all but the wealthiest and most sophisticated industry elites. Nowadays, anyone with a few measly bucks and a brokerage account can amass an impressive and broadly diversified portfolio of income producing commercial real estate. 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 an illiquid (that is, hard to monetize) form of financial capital in the real world. Commercial real estate has enormous and mostly impenetrable barriers to entry. If the idea of scraping together enough money for a 10% down payment on a single family home sounds intimidating, imagine having to accumulate enough cash to come up with a 10% down payment on something as pricey as a mid-size shopping mall or office building that’s attractively priced at, say, $75 – 100 million. Alas, money isn’t the only barrier preventing a casual individual investor from pulling off such a lofty acquisition. Engaging in multiple rounds of intense buyer-seller negotiation and eventually consummating such a mammoth purchase requires a rare blend of industry expertise and costly legal representation. Pulling off such a high-level purchase requires a rare blend of resources and talent. Needless to say, one can’t easily become a serious player in the well-heeled world commercial real estate. And yet, strangely, based on your day-to-day experience as a consumer, you’ve probably seen commercial venues in your neighborhood swap business tenants with the speed and ease of runway models wiggling into and out of glamorous outfits. Case in point: if you’ve seen a Sears or K-Mart permanently close its doors and reopen months later as a Home Depot or Best Buy, then you’ve witnessed this extraordinary phenomena first hand. Interestingly, despite the many legal and financial barriers that tend to prevent commercial properties from quickly or easily changing ownership, such spaces frequently change business tenants. Conveniently, this seemingly irreconcilable dilemma is neatly resolved by the property management business model. Simply put, were it not for the existence of property management companies and the essential role they play in the marketplace matching business tenants with needed commercial spaces, our economy would lack the resilience and flexibility it needs to quickly adapt to changing market conditions. You see, our economy is like a beating heart. As it rhythmically expands and contracts, businesses open or close and national employment levels alternately rise and fall. What’s more, regardless of the overall economic climate, this frantic activity occurs simultaneously and is broadly influenced by what phase the economic cycle is in. While it’s certainly true that some businesses own the properties they occupy to serve their customers, given commercial real estate’s hefty price tag and the fact that a company’s Chief Financial Officer can usually deploy its capital more productively elsewhere by re-investing it or plowing it back into the business that generated it in the first place, it’s often in a company’s best financial interest to sign a lease and pay property management companies rent instead of purchasing real estate outright. Of course, this allows companies to devote more of their precious time and energy to improving their own operation. Similar considerations apply to individuals who must decide whether to buy or rent their primary residence.

Curiously, although home values attract nationwide attention and are breathlessly discussed, people seldom regard their homes as a steady and reliable source of cash; and rightly so. For starters, a house isn’t easily bought or sold. Real estate agents, closing costs and the nettlesome prospect of having to deal with bankers and wade through reams of complex legal documents tends to discourage people from trying to squeeze money out of their homes. Fortunately, such procedural obstacles are mere speed-bumps when applied to the well-heeled world of commercial real estate. From an investment standpoint, is commercial real estate as desirable as residential real estate? You bet, perhaps even more so. For aspiring capitalists, the idea of owning a geographically diversified portfolio of income producing commercial properties in a variety of 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 help jog your memory, it’s got a colorful foldout board, lots of pretend money and an assortment of die-cast player icons in the shape of a destroyer, thimble, wheelbarrow, a beat-up old shoe and a banker’s top hat. No-doubt, owning a vast portfolio of income producing commercial real estate would be like owning the most desirable properties on the Monopoly board. Imagine how it’d feel to rattle off a long list of prestigious Fortune 500 companies as personal tenants. No-doubt, if you found yourself in such an enviable position, you’d be primed to collect obscenely large rent checks on a regular basis. Better yet, were you to find yourself in such a lucrative circumstance, you’d probably also have oodles of spare cash to hire a team of industry professionals to help you manage and maintain your properties. As the “silent partner” in this happy little arrangement, 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 ahead of ourselves, however, I should emphasize that there are many subtle differences between how the economics of real estate operate 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 Monopoly fans will readily acknowledge, the amount of money that changes hands when someone lands on someone else’s property is fixed. To ease flow of play and keep the rules of the game simple, rental rates never change. For a board-game, that’s convenient. In the real world, landlords generally raise rents over time at a rate of anywhere from three-to-five percent a year. The idea is that property managers want to compensate for inflation and maintain the purchasing power of the money they collect from tenants. Meanwhile, by financing the bulk of a property’s purchase price with a fixed interest rate loan, inflation will slowly reduce the “real-dollar” cost associated with carrying an astronomical amount of debt in the form of a mortgage. After all, it’s a very safe bet that borrowed money will, 20 or 30 years hence, be repaid with depreciated dollars. Also, whoever succeeds in obtaining the deed to Park Place in the real world will surely enjoy years of future appreciation as the value of the underlying commercial property appreciates. To further encourage entrepreneurial risk-taking and stimulate investment, commercial property owners enjoy an expansive range of tax breaks, courtesy of Uncle Sam. Tax breaks on real-estate? You betcha, and for investment property owners there are oodles of them. Though homeowners occasionally crow about the mortgage interest and property tax deductions they receive, investment property owners are treated to a far more expansive range of taxpayer subsidized goodies. In addition to the tax perks that a residential homeowner gets, property owners get to deduct the full value of the building or structure that’s erected on their property. This nice little value-add is parceled-out in equal installments over twenty seven and a half years. Moreover, property maintenance expenses–which includes outlays for a new roof, upgraded fixtures and necessary improvements–also lower an investment property owner’s tax liability. But wait, there’s more. That growing cushion of equity that investment property owners gradually accumulate is heavily subsidized by 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. Such real estate is out of reach for most hobbyist investors. Even if the price tag weren’t an impediment to breaking into this industry, there’s the tedious prospect of dealing with tenants, collecting rents, accounting for expenses, maintaining facilities, and, from time-to-time, renovating properties. Individuals are understandably reluctant to tend to these burdensome and ongoing operational responsibilities. To be sure, nobody could do this on a part time basis. But does this mean you should abandon all hope of owning commercial property? Absolutely not. Fortunately, such properties are lumped into large pools that are divvied up into millions of tiny pieces so that ordinary individuals, university endowments, pension funds, foreign central banks and institutional money managers can acquire them.

Thanks to the growing popularity of the REIT (Real Estate Investment Trust) ownership structure, commercial real estate has morphed into just another 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 acreages of commercial real estate 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 business entity, which, in turn, exposes that investor to the risks and rewards of owning a company. When an investor buys a REIT, however, instead of owning a fractional interest in a company’s current and future profits, an income producing roster of commercial properties is purchased instead. When you buy one share of a REIT, you get your fair share of the rents that business tenants pay to occupy it and, of course, a team of qualified professionals who’re responsible for managing the whole kit-n-caboodle. All of this is readily available to any investor with a few bucks and a brokerage account. Not only do REIT shareholders receive ongoing cash distributions from operational activities and rent paying tenants, it so happens that capital gains are occasionally reaped from the strategic sale of commercial properties that are held in a REIT portfolio.

Encouragingly, the REIT ownership structure is spreading to other parts of the world. China has been in the news lately because of its growing economic clout. To put China’s largeness and future economic growth potential in proper perspective, Ted Fishman, author of China, Inc., estimates that it has anywhere from 100 to 160 cities with a population of at least one million 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 recently joined the World Trade Organization and its economy is rapidly modernizing and opening to the West, owning commercial real estate in this and other up-and-coming developing countries through international REITs may be a smart way to capitalize on this and other emerging market’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 annual payout–typically on the order of 4% to 7% of a REIT’s share price. Higher REIT yields stem from the fact that commercial properties regularly generate huge cash-flows from business tenants who pay big money for the facilities they occupy to manufacture goods and serve their customers. To qualify as a REIT, which exempts management from having to pay corporate taxes, REITs must, by law, derive at least 75% of its revenues from rents and distribute at least 90% of its operating profits (also known as its funds from operations) directly to its shareholders. Unlike qualified dividends (which are subject to a skimpy 15% tax rate), REIT shareholders must pay regular income tax on whatever “income” they receive from commercial real estate holdings. And, much like stocks, REIT financials are carefully scrutinized and audited by large and respected accounting firms. The 10% of REIT income that shareholders don’t receive goes to management to support ongoing business operations, pay administrative overhead and cover essential maintenance expenses. It’s worth noting, 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 widely considered to be a safer form of investment income. And this is because REIT cash flows are advantageously placed on the economic totem pole since, by law, corporations must pay operating expenses like rent before they can dig into their pockets to pay interest to bond holders or dividends to stockholders. Consequently, should business tenants abruptly 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 considerable 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 a better 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.

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