By Ralph Block

Until fairly recently, the REIT industry has been the province of “small”—although not necessarily “vertically challenged”—investors. They have been able to own commercial real estate without having to manage or lease it, and they could obtain adequate diversification by owning a number of sector-focused REITs. To top it off, total returns have been outstanding. Now, the investor’s choices are many, including stocks, active or passive mutual funds and ETFs.

What is a REIT—stock or real estate? Who would manage the REIT portfolio, equity managers or real estate professionals? Furthermore, until Joe Pagliari and his colleagues published the study “Public vs. Private Real Estate Equities” in 2003, it was thought that REIT stock performance had little to do with that of commercial real estate.

Institutional investors also worried about the track records of REIT executives. For example, could they manage through a down cycle? Disclosure of property information was spotty, and corporate governance was sometimes problematic.

However, those are yesterday’s issues. The publicly traded REIT industry is now larger, deeper and fully liquid; disclosure and governance are vastly improved; and most REIT executives have shown that they can manage through real estate recessions—as well as satisfy investor expectations. Particularly within the past several years, REITs have shown admirable capital allocation skills.

Many have created extra shareholder value through development, joint ventures and related strategies. The REIT industry’s track record of strong total returns with modest risk is now firmly established.

So no more excuses. Even the largest institutional investors must now look at REITs as possibly an alternative, and certainly a complement, to direct real estate investing. However, there are trade-offs.

One principal disadvantage: the assets are owned by the REIT, not the investor. There is no ability to control acquisition, sale and leasing decisions, market focus or debt leverage. Furthermore, the investor must often accept development risk. The 8 percent to 9 percent average annual total returns likely to be garnered by REIT investors may be inadequate if compared to riskier “opportunity” funds.

However, there are, of course, many advantages to owning securitized real estate. Management can be as important as location, and REITs boast proven management teams that have been making sound real estate decisions for years. In sectors where strong tenant relationships provide a competitive advantage, such as retail, REIT executives know the players and their space needs. Because most REITs focus on a specific real estate sector, it’s easy to monitor performance versus the peer group (and NCREIF).

Despite general and administrative expenses, most REITs can manage and lease assets much more efficiently than those not active in the real estate business. Some real estate assets, such as large malls, cannot be easily acquired except through REIT stocks. Elsewhere, where brand names and marketing are important—such as storage properties—REITs have an advantage. Importantly, some of the very best property development teams are found within strong REIT organizations.

In response to the desire of some institutions to take advantage of a REIT’s expertise, while also participating directly in the fortunes of specific assets, many investment joint ventures have been organized. These arrangements can be a “win-win” situation for both the REIT and the investor.

As the REIT industry increasingly continues to win investor respect, more institutions will figure out that they will improve the quality—and, probably, performance—of their real estate portfolios by investing in REITs or, at the least, entering into partnership arrangements with them. This trend is just in its infancy.