Photo Stephen Webster

Investors have more ways to buy and sell real estate than ever before

By Allen Kenney

Depending on who you ask, it was either legendary author Mark Twain or famed humorist Will Rogers who once said, “Buy land. They aren’t making any more of it.”

“In a very large market, if you’re not invested in real estate at all, you’re shorting yourself on a significant asset class,” says J.D. Sitton, a J.P. Morgan vice president and manager for public and private clients’ real estate portfolios.

Creative financiers and public policy makers have devised a multitude of ways to invest in real estate, including REITs, commingled funds and mutual funds, among others. Yet, more options also bring more decisions, which may be daunting for some investors.

Of course, the main reason for this wide variety of choices is that different types of investors bring different types of needs to the table. It helps to know which forms of investment are right for you.

"Investors must match their form of real estate investing to their goals by asking, 'What are you in it for?'" says David Bailin, president of Bank of America's alternative investments for global wealth and investment management department.

Publicly Traded REITs

Typically, publicly traded REITs own and operate income-producing commercial real estate, including apartments, offices, shopping centers and warehouses. Less frequently, a REIT might engage solely in financing.

To qualify as a REIT, a company is required to meet certain legal obligations. Among them, at least 75 percent of the company’s total assets must be in real estate, and 75 percent of its gross income must be derived from real property rents or real property mortgage interest. In addition, REITs must annually pay out at least 90 percent of their taxable income to shareholders as dividends. Because REITs can deduct their dividends from their taxable income, most opt to distribute the entirety of that amount to shareholders, negating any corporate tax liability.

REITs enable both institutional and retail investors to add commercial real estate exposure to their portfolios without the large capital requirements involved in direct investment, but with the same liquidity of other publicly traded equities. Like any other publicly traded corporation, REIT equity shares trade on a real-time basis on the major stock exchanges.

The Pension Real Estate Association (PREA), a nonprofit trade group that represents major institutional investors, annually surveys its members about their real estate investment holdings and strategies, which are then compiled in the PREA Plan Sponsor Research Report. PREA’s most recent report, published in 2007, details the responses from 2005 and 2006 of approximately 70 of its members who hold nearly $2 trillion in assets altogether, including $150 billion in real estate. The data shows that REITs are far and away the most popular of the public investment strategies with these major investors, as nearly 95 percent of the money in public real estate covered by PREA’s research went into REITs.

“In terms of appeal, the bottom line is that REITs make it easy for anyone and everyone to invest in real estate,” Sitton says.

Real Estate Operating Companies (REOCs)

Like REITs, REOCs are publicly traded real estate companies. However, REOCs, which must face corporate-level tax, do not have a dividend payout requirement. Paul Adornato, a senior analyst in BMO Capital Markets’ Equity Research Group, notes that REOCs tend to be development-focused companies such as Forest City Enterprises Inc. (NYSE: FCE.A), a $10 billion multi-sector REOC. The REOC approach is also popular among businesses that generate a significant portion of their income from services, rather than rents.

“If you’re more focused on capital appreciation but need the liquidity, then REOCs are a better way to go for you,” Sitton says.

For the most part, it looks as though major investors have shied away from REOCs. For example, PREA’s survey found that just 0.3 percent of respondents’ total real estate allocations were dedicated to these operating companies.

Publicly Registered, Non-Traded REITs

Non-traded REITs differ from their publicly traded counterparts primarily in that they don’t trade on stock exchanges. However, they still are required to file financial statements with the Securities and Exchange Commission (SEC).

Most often, non-traded REITs are a finite-life investment. For example, the company would be required to be acquired, go public, or liquidate within a 10-year timeframe.

“For individuals who are most concerned with income and capital preservation, as opposed to capital appreciation, non-traded REITs may be appropriate, provided that management has a favorable track record and the investor’s time horizon coincides with that of the non-traded REIT,” Adornato says.

Editor’s note: for more information on non-traded REITs, turn to “Building Potential.”

Private REITs

Private REITs adhere to the same tax rules as publicly traded REITs, but they don’t file with the SEC. They market themselves primarily to wealthy investors and large, institutional investors, as evidenced by their high minimum investment levels.

Bailin maintains that private REITs present a “more stable form of REIT ownership,” accepting less liquidity in exchange for less volatility. “The private REIT, today, is actually a good spot for the more mature investor,” Bailin says.

Direct Investment

Direct investment in real estate is the favored vehicle of the largest institutional investors, such as insurance companies and pension plans. For instance, PREA’s data shows that direct investment constituted more than 50 percent of the total real estate allocation made by survey respondents with more than $25 billion in assets in 2005. Respondents with less than $25 billion in assets, on the other hand, had dedicated approximately 35 percent of their allocation to direct investment.

“There’s clearly a trend among institutions. As they get larger, they seem to prefer owning properties outright or in small joint venture partnership,” Bailin says.

For large investors, one of the major advantages of direct investment over other approaches is control, according to Adornato. Buying properties directly “allows large institutions to choose specific investments, such as apartments in Los Angeles or industrial properties in Atlanta, and control the investment decision process,” he says.

Direct investment typically appeals to buyers with longer planning horizons for their assets, because the time needed to market and sell properties significantly limits their liquidity. Additionally, most investment properties must be managed, which typically entails hiring an outside property manager. Such complications tend to rule out smaller investors.

Direct investment does seem to appeal to a certain type of individual investor, though. It tends to attract the well-heeled individuals who enjoy managing and developing properties on their own, according to Brad Case, NAREIT’s vice president, research and industry information.

“Many individuals have very poor returns from direct real estate ownership,” he says. “However, they like the feel of having a real asset that they can drive by and even visit.”

Commingled Funds

In a commingled real estate fund, the fund manager pools money from multiple sources. The fund then directly purchases and manages properties with the contributed capital. Subsets of commingled funds include “value-add” and “opportunity” funds that seek out high-yield targets.

Commingled funds have provided smaller institutional investors with some of the opportunities available through direct investment without the large capital requirements. “Commingled funds work best for smaller institutions that want direct property exposure, but may not have the size to efficiently invest directly by themselves,” Adornato says.

PREA’s data bear this out. While larger institutions dedicated just 13 percent of their real estate allocation in 2005 to commingled funds, investors with assets of less than $25 billion put 41 percent of their real estate money into such investments.

“We’ve seen direct ownership take a back seat to commingled funds in recent years,” Sitton says, who speculates that the number of institutional investors in the United States large enough to manage their own direct real estate investments is between 30 and 40.

Limited Partnerships

In a real estate limited partnership, the general partner buys, sells, and operates properties on behalf of the limited partners, whose legal and financial exposure is limited to their initial investment. Income and capital gains from the properties flow through the partnership to its members.

According to Case, limited partnerships are typically sold primarily to high-net-worth investors because of their high minimum investment, generally in the tens of thousands of dollars.

Case also argues that real estate investors should tread lightly when it comes to partnerships. They generally lack transparency, he says, making it difficult to judge their performance relative to alternatives. Also, investors who want to withdraw their funds from partnerships face stiff penalties, severely reducing their liquidity.

“Limited partnerships are illiquid investments, even relative to direct property holding: it is generally costly and difficult, if not impossible, to exit a real estate limited partnership, and it can be difficult even to borrow against the equity in the investment,” Case says.

Limited partnerships’ holdings are typically concentrated around a small group of assets, according to Bailin. This makes them best suited for investors who already have diversified real estate exposure in their portfolios, he says.

Open-End Mutual Funds

In real estate, open-end mutual funds refer to REIT stock portfolios under professional management. Like other equity mutual funds, investors buy shares in these pools of stocks, rather than purchasing the stocks themselves.

“This is a great convenience for many individual investors, who may not have the tools, knowledge or desire to closely manage their investments,” Adornato says.

Open-end funds can both issue and redeem their existing shares daily, with share prices determined by the component stocks’ closing prices. As a result, although investors know mutual funds’ share prices with certainty, fund managers are subject to some fluctuation in their portfolios’ assets under management on a daily basis.

Exchange-Traded Funds (ETFs)

ETFs, which are bought and sold like common stocks on major exchanges, are similar in function to index funds.

ETFs are composed of a suite of stocks. Their overall goal is to track a certain real estate index, or even part of an index. For example, Barclays Global Investors offers the iShares FTSE NAREIT Real Estate 50 Index Fund, which is pegged to the 50 largest REITs within the FTSE NAREIT U.S. Real Estate Index. Like index funds, ETFs are popular among investors who prefer investment approaches with lower fees.

ETFs can provide “an important tool for portfolio managers who can use the ETFs to quickly and efficiently gain exposure to the real estate market,” according to Adornato. For example, if portfolio managers have a general idea that they want to increase their real estate exposure but lack specific companies to target, they can invest in ETFs as a stopgap until they identify the stocks they want to populate their real estate allocations. At that point, they can begin to shift their positions from ETFs to the individual stocks.

This scattershot approach does have one significant weakness, Sitton argues. “Within the REIT industry, the ability to generate above-benchmark returns is well documented, and the best managers outperform benchmarks consistently,” Sitton says. “Even though it’s cheap to get into an ETF, there’s no active management component. The excess return potential of active management far outweighs ETF cost savings.”

Closed-End Mutual Funds

Unlike open-end mutual funds, closed-end funds only focus on certain types of stock offerings, such as funds that concentrate on initial public offerings.

Another key difference between open- and closed-end mutual funds is how they are bought and sold. While sales and purchases of open-end funds occur through fund providers and brokers, closed-end funds are traded on the stock exchange. Consequently, the open market determines pricing, rather than the underlying value of the funds’ components.

The closed-end pricing mechanism has two important consequences, according to Adornato. First, it makes the portfolio manager’s job much easier than that of an open-end fund manager. While open-end funds have to account for daily shifts in daily fund inflows and outflows, closed-end managers avoid these disruptions. Second, closed-end funds have the ability to use leverage, which can enhance their returns.

Characteristics of Publicly Traded REITs, Non-Exchange Traded REITs and Private REITs
				Publicly Traded REITs			Non-Exchange Traded REITs			Private REITs
	Overview			REITs that file with the SEC and whose shares trade on national stock exchanges.			REITs that file with the SEC but whose shares do not trade on national stock exchanges.			REITs that are not registered with the SEC and whose shares do not trade on national stock exchanges.
	Liquidity			Shares are listed and traded, like any other publicly-traded stock, on major stock exchanges. Most are NYSE listed.			Shares are not traded on public stock exchanges. Redemption programs for shares vary by company and are limited. Generally a minimum holding period for investment exists. Investor exit strategy generally linked to a required liquidation after some period of time (often 10 years) or, instead, the listing of the stock on a national stock exchange at such time.			Shares are not traded on public stock exchanges. Existence of, and terms of, any redemption programs varies by company and are generally limited in nature.
	Transaction			Brokerage costs the same as for buying or selling any other publicly-traded stock.			Typically, fees of 10–15 percent of the investment are charged for broker-dealer commissions and other up-front costs. Ongoing management fees and expenses also are typical. Back-end fees may be charged.			Varies by company.
	Management			Typically self advised and self managed.			Typically externally advised and managed.			Typically externally advised and managed.
	Minimum Investment			One share			Typically $1,000–$2,500.			Typically $1,000–$25,000; private REITs that are designed for institutional investors require a much higher minimum.
	Independent Directors			Stock exchange rules require a majority of directors to be independent of management. NYSE and NASDAQ rules call for fully independent audit, nominating and compensation committees.			Subject to North American Securities Administrators Association (NASAA) regulations. NASAA rules require that boards consist of a majority of independent directors. NASAA rules also require that a majority of each board committee consist of independent directors.			Not required.
	Investor Control			Investors re-elect directors.			Investors re-elect directors.			Investors re-elect directors.
	Corporate Governance			Specific stock exchange rules on corporate governance.			Subject to state and NASAA regulations.			Not required.
	Disclosure Obligation			Required to make regular financial disclosures to the investment community, including quarterly and yearly audited financial results with accompanying filings to the SEC.			Required to make regular SEC disclosures, including quarterly and yearly financial reports.			Not required.
	Performance Measurement			Numerous independent performance benchmarks available for tracking public REIT industry. Wide range of analyst reports available to the public.			No independent source of performance data available.			No public or independent source of performance data available.

Portfolio Cornerstone When it comes to the numbers, it’s not even close: major institutional investors prefer private, direct investment in real estate to indirectly investing through public markets via REITs. For example, PREA’s 2005 data suggest that institutions are putting almost 90 percent of their real estate allocation into private investment structures, half of which goes to direct investment. Additionally, commingled funds receive 20 percent of the institutions’ total real estate allocations. In contrast, PREA’s findings indicate that just slightly more than 50 percent of its members even owned publicly traded REITs, which received around 13 percent of their total real estate investment. Yet, despite the ongoing popularity of direct investment, sentiment is growing that institutional investors should give greater thought to REITs as a keystone of their portfolios. “REITs deliver better risk-adjusted returns than any real estate investment vehicle known to humankind. I co-started a business more than 20 years ago knowing that to be true,” says Mike Kirby, chairman and co-founder of Green Street Advisors Inc. “To me, the case is so compelling just from a common sense standpoint, and once the REIT industry begins to make it in a passionate manner, it seems like an easy sell.” Since 1977, equity REITs have averaged an almost 15 percent return annually, according to a NAREIT analysis, while returns from direct forms of real estate investment have been closer to 10 percent. Industry experts also note that, as with stocks, investing in REITs entails more than investing in a company’s assets. It’s an investment in management with “specialized capabilities,” Bailin observes. “I think the management of some public REITs is pretty extraordinary,” he says. “They’re some of the best managers in the United States.” If that’s the case, why do some of the world’s biggest investors prefer directly investing in real estate? Industry observers tend to home in on a few different explanations. “The single strongest reason is that direct real estate has lower ‘beta’—or less market risk,” Sitton contends. Many point to the perceived volatility of REITs, which are thought to have a stronger correlation to the everyday ups-and-downs of the general stock market. Hard real estate assets, in contrast, are seen as more stable. “There’s always concern that regulators are going to look askance at high levels of volatility,” says Barden Gale, who recently left his position as managing director and chief investment officer for real estate at ABP Investments, U.S., to serve as vice chairman of real estate for Starwood Capital Group. Gale notes that these “regulators” consist not only of government authorities charged with overseeing investing, but boards of directors as well. Others, though, question whether it’s fair to compare measured REIT volatility with measured volatility of direct property investments. “Are REITs more volatile than direct property? That seems likely,” Case says. “But the truth is that we simply don’t know just how volatile direct real estate is. There’s no question that the available measures are biased downward—that is, direct real estate is more volatile than it looks. But that’s all we know, and until we get better measures, a comparison is meaningless,” he says. Big investors with a long investment horizon may be looking to capture an “illiquidity premium”—a higher return to compensate them for locking their funds into hard-to-sell investments. But they don’t seem to be earning any such premium in practice, according to Case. “The illiquidity premium exists in theory, but there’s no evidence that it exists in the real world,” he says. Gale also points out that direct non-core investment can offer “outsized” returns. REITs are more constrained by tax regulations, investor sensitivity and market opinion than private investment vehicles, he says. For example, non-core investors and value-add or opportunistic fund managers can take more risk, use more leverage and vary their strategies more than REITs. Help Needed Yet, to Gale, most of the pluses of a strategy of direct investment in core real estate are still outweighed by the negatives, leading him to strike a balance in his portfolio of 70 percent REITs and 30 percent private investment. “There just aren’t that many opportunities for outsized returns from investing directly,” he says. “Core assets—by definition—represent the bulk of investment opportunities, and most investors aren’t equipped to take advantage of the higher risk-return strategies, such as development, structured transactions and buy-outs.” Additionally, Gale argues that direct investing can be “highly labor intensive.” As most investors can’t achieve the scale of REITs and are required to invest through intermediaries, costs of direct investing can be very high, he says. Indeed, three independent academic studies, along with data compiled by the National Conference of Real Estate Investment Fiduciaries, suggest that fees and expenses paid by direct real estate investors or investors in core commingled funds are typically at least twice as high as expenses of REIT investing—and expenses for value-add and opportunity funds can be even higher. Some also maintain that armies of personnel working on direct investment within major investors actually help to perpetuate their own existence. “There’s a perception in our world that a lot of the resistance to the REIT vehicle comes from the pension fund staffs themselves. A lot of the bigger pension funds have pretty sizable real estate staffs,” Kirby says. Another big drawback of direct investment relates to one of the key elements of a successful portfolio. “If you own direct assets it is difficult to diversify unless you are an extremely large investor,” Gale says. Under this line of thinking, the large capital requirements for direct investment prohibit investors of any size from achieving the right amount of exposure to all the different kinds of markets available. Still, while REIT fans know that they are in the minority when it comes to weighing the pros and cons for institutional investors, it doesn’t dampen their enthusiasm. “By investing in REITs, large investors get access to the highest-quality, fortress-like core assets, great diversification, high dividends and great management teams,” Gale says.