Economic Analysis Suggests That REIT Investment Characteristics Are Not as Advertised
Graff, Richard A., Journal of Real Estate Portfolio Management
This article is the winner of the Innovative Thinking "Thinking Out of the Box" manuscript prize (sponsored by the Homer Hoyt Advanced Studies Institute) presented at the 2000 American Real Estate Society Annual Meeting.
Executive Summary. Commercial real estate is a cyclical asset with partial inflation-hedging characteristics. The inflation-hedging characteristics can account for the observed long-term appreciation in institutional-grade real estate value over the last two decades. Investment characteristics of regulated investment companies are shaped by two sets of economic attributes: investment portfolio characteristics and legal constraints on the companies. Both sets of real estate investment trust (REIT) attributes differ from corresponding attributes of regulated funds that invest in corporate securities. Analysis of the REIT attributes suggests that REIT investment performance since industry inception has been more or less as could have been anticipated. Despite imminent regulatory changes, it also suggests that future REIT investment performance should be similar to performance in the recent past.
Real estate investment trusts (REITs) are the resuit of a mid-twentieth century attempt by the United States Congress to extend the investment company concept beyond securities such as stocks and bonds to more exotic asset classes.
REITs were authorized by the Real Estate Investment Trust Act of 1960. The statute was enacted in response to pressure from Wall Street investment banks, which were searching for highly profitable new investment products to satisfy growing consumer demand for financial assets during one of the greatest bull markets in U.S. history.1
The benefit bestowed on REITs by the authorizing legislation was an exemption of shareholder dividends from the double taxation that applies to dividends of conventional operating companies. The legislation included constraints on REIT business activities to ensure that the tax exemption applied only to real estate investment companies that exhibited the same type of passive investor behavior as regulated stock and bond investment companies already exempt from double taxation.2 Foremost among the constraints was a prohibition against REITs managing their own real estate.3 The prohibition applied to both direct management activities and indirect self-management through economically related entities.
The 1960 REIT legislation was not passed as a stand-alone bill, but rather as a rider attached to an unrelated piece of tax legislation.4 This suggests that the REIT industry owes its existence more to adept legislative maneuvering by lobbyists and legislative sponsors than to recognition by Congress of the desirability of providing real estate investors and developers with preferential access to the public equity markets. As will be discussed, the REIT industry recognized the implications of this lesson and has applied it over several decades to achieve a step-by-step reduction in constraints imposed on REIT activities by the original legislation.5
Although publicly traded REITs enjoyed an initial period of popularity at the end of the 1960s, they did not develop into a major source of real estate capital during the ensuing market cycle. Imprudent use of debt by REIT managers to boost earnings led to a number of forced REIT dissolutions and asset liquidations during the real estate and corporate equity bear markets of the early 1970s .6 Accordingly, it is not surprising that investor appetites for real estate securities withered by the mid-1970s, both for REIT initial public offerings (IPOs) and for secondary stock offerings by existing REITs.
Most of the surviving REITs continued to operate quietly over the next two decades without significant infusions of equity capital from the public markets. During that period, REIT stocks exhibited investment characteristics associated more closely with small-capitalization stocks than with real estate. …