Real Estate Investment Trust
Real Estate Investment Trusts (REITs) were created from a law that Congress enacted in 1960 [footnotes 1] to enable small investors to invest in real estate without either the large capital required to purchase single properties, or the responsibilities of property maintenance on a direct realty purchase. When holding shares of an equity REIT, an investor is an actual owner of the underlying real estate.
REITs receive special tax treatment--the deduction of dividend payments on their corporate income taxes-- as long as the primary purpose of the company is to own real estate and it pays out 90% of its dividend income (rental income or mortgage interest) each year to shareholders. The special tax treatment REIT dividends receive means that they are deemed non-qualified dividends for the investor (ie. not subject to the lower "qualified" dividend tax rate granted to firms subject to double taxation). This makes REITs very tax-inefficient, and best held in tax-deferred accounts. [footnotes 2] If an investor has filled up available tax-advantaged space with bonds and wants to invest in REITs, placing them in a low-cost variable annuity or a non-deductible Traditional IRA is usually more tax efficient than holding them in a taxable account. Alternately, an investor can also switch taxable bonds held in tax-advantaged accounts for REIT held in tax-advantaged and adding municipal bonds held in taxable accounts.
Types of REITs
REITs are typically characterized by the nature of the assets the company holds: real estate, mortgages, or a combination of the two.
- Equity REITs: own physical real estate and are traded on a public stock exchange. This makes REITs very liquid unlike owning real estate on your own. Equity REITS make up over 80% of the U.S. REIT market,  and include the following sectors:
- Diversified REITs: own a diverse group of properties not tied to any specific sector or industry.
- Industrial REITs: own industrial real estate, ie. used for industry manufacturing.
- Office REITs: REITs that own office buildings or other similar property.
- Residential REITs: REITs that invest in residential real estate, such as apartment complexes.
- Retail REITs: REITs that invest primarily in retail properties such as shopping malls.
- Specialized REITs: own property that is specialized in a single use (such as lodging or storage).
- Mortgage REITs: Invest primarily in mortgages backed by commercial real estate, and the earnings are from the mortgage loans. [footnotes 3]
- Hybrid REITs: REITs that invest in both property ownership and mortgages.
- Private REITs: Private (non-traded) REITs are not traded on a public stock exchange, and are very illiquid. These are often sold by financial advisors who receive large commissions, an indication that they are not looking out for your best interest, and are designed to be sold and not bought. 
Valuation of REITs
REITs are typically valued using two factors: yield, and premium (discount) to NAV.
A REIT's yield [footnotes 4] is calculated exactly as stocks and is expressed as an amount of dividends (in percent) a REIT will pay investors.
Unlike a bond's Yield-to-Maturity (YTM), there is no presumption that capital, i.e. NAV, will be returned to investors in that equation (the redemption of a bond).
With common stocks, company boards decide how much of Earnings Per Share are to be paid out as Dividends Per Share. This can cover a large range, as many pay no dividends at all, but Dividends Per Share may typically range from 1.5 to 3 times Earnings Per Share.
With REITs, Earnings Per Share are not an accurate measure of a REIT's performance. Investment analysts usually use an adjustment to earnings known as Funds From Operations (FFO) [footnotes 5] as a more accurate measure of an equity REIT's profitability and capacity to pay dividends. 
US tax laws require essentially a payout of 90% of GAAP (Generally Accepted Accounting Principle) taxable income, so "adjusted" Earnings Per Share and Dividends Per Share are closely aligned. Therefore, it is appropriate to value the REIT on a dividend yield basis.
For example: A REIT has a share price of $100. The total dividend for the REIT is expected to be $3.00 over the next 12 months. The REIT is therefore said to be trading at a prospective dividend yield of 3/100 or 3%.
Average premium (discount) to NAV
A REIT's Net Asset Value is calculated as:
Debt is taken deducting any cash that is on the REIT balance sheet. [footnotes 6]
The quoted price of a REIT, which trades like any stock, can differ from NAV. Historically, when the market is bullish about future Commercial Real Estate values, stocks move to a premium to NAV. This is also true if there is a lot of takeover activity in the REIT sector. In essence, investors are expecting NAVs to rise. The discounts are quite analogous to closed end funds, which normally trade at a discount to the value of their underlying investments.
Green Street Advisers publishes graphs showing estimated average premium (discount) to NAV.[footnotes 7] The premium (discount) to NAV has ranged from over 30% premium to 40% discount over time.
Expected returns from REITs
William Bernstein has proposed a simple model for estimating long term returns for equity REITS. The sources of return for a REIT are:
- The current dividend yield, [footnotes 8] ( in our example above $3.00 per share).
- Any future growth in dividends. William Bernstein has shown that these grow by less than GDP.  For REITS, rental income growth is usually assumed to roughly equal the inflation rate.
- The change in valuation of the REITs, or ‘speculative return’.
As an example, if REITs are currently yielding 3% and we expect future dividend growth of 3% per annum (i.e. slightly ahead of inflation), then expected long term returns are = 3% + 3% + change in valuation.
The following example illustrates the role of speculative return in the valuation model.
In our example above, the REIT has a share price of $100 and pays $3.00 dividends per annum. Our assumed yield on REITs (c. 3%) is very low compared to historic ranges. A pessimist might argue REITs will eventually return to say a 6% yield, implying a halving of valuation. If this revaluation took place over 18 years, the expected return of REITs in the formula above = 3% + 3% - 4% = 2% per annum.
In other words, in 18 years, our REIT would have dividends of $5.11 (x 1.03^18), a price of $85.12 (5.11/ 6% yield), but the investor would also have received the dividends paid out in that time period, giving a positive total return despite the fall in valuation.
Note that in this model, because a yield is a per cent rather than a times (‘x’) like PE, a rise in yields is a fall in valuation, while a fall in yields is a rise in valuation.
The most important thing to observe both about premium/ discount to NAV and yield, for REITs, is that it is anything but stable. Even the long term average may not be that helpful, because real estate tends to have long cycles and the reversion to mean from a high or low takes so long. [footnotes 9]
REIT dividends are composed of three different types of yield income, which are taxed at different rates:
- Return of Capital: This is a return of your own investment and is not taxed upon distribution, it reduces your cost basis by the amount of the dividend. [footnotes 10]
- Capital Gain: Results from sale of properties or other assets, taxed at either short or long term capital gains rates.
- Dividend: Income which usually results from rental income of properties, which is non-qualified and taxed at your full marginal tax rate. 
The exact breakdown of the REIT fund dividends are not known until after the calendar year, sometimes as late as late February or early March. Beware of this if you hold REIT in a taxable account. [footnotes 11]
Composition of MSCI REIT index
Below is a table of a percentage breakdown of the different types of REITs in the MSCI REIT Index .
| MSCI REIT Index Composition |
|REIT Type||Percentage of Index|
See also: US Equity REIT Index Returns
The NAREIT Equity Index provides the longest term history of U.S equity REITs, covering the period from 1972 to the present. Over this period, equity REIT's annual return ranged between a high of +47.59% in 1976 and a low of -37.73% in 2008.
The 1973 - 1974 bear market in REIT stocks was predominantly marked by the negative performance of mortgage REITs which made up the majority of REIT issues during this era. These mortgage REITs had a large number of holdings in real estate building and development loans, many of which defaulted in the recessionary economic environment. . The NAREIT Mortgage REIT indexed declined -36.26% in 1973, and dropped -45.32% in 1974. [footnotes 12]
After the 1973 - 1974 bear market equity REITs remained a small portion of the overall equity market. In 1975 the market consisted of 12 equity REITs with a market capitalization of 275.7 million dollars. Tax changes in 1987 and 1992 set the stage for a steady increase in both the number of equity REITs and the market capitalization of the REIT market (in 2012, 139 REITs with a market capitalization of 544,414.9 billion dollars). . In 1994, with the maturation of the equity REIT market, Vanguard introduced an equity REIT index fund, tracking the MSCI US REIT Index.
Most equity REIT market declines have historically preceded or been coincident with economic recessions. The NAREIT Index declined in the 1989 - 1990 recession; ,  declined again in the 1998 - 1999 bear market  in advance of the 2000 - 2002 overall U.S. market decline (during which equity REITs provided positive returns); and declined once again in 2007 - 2008, the beginning stages of the 2008 - 2009 recession. 
Interest rate risk
REIT prices may decline as the interest rate rises.
Equity REITs are one specific sector of the stock market; there are only 97 stocks in the MSCI REIT index. This makes REITs more volatile than broad market index funds. Some suggest that public REITs represent only a small slice of the commercial real estate market, and are best referred to as a separate asset class rather than a sector. [footnotes 13]
Role in a portfolio
Most Bogleheads allocate REITs up to 10% of their total portfolio according to a forum poll. David Swensen, CIO of Yale University and author of Unconventional Success suggests a 20% allocation to equity REITs in his model portfolio for individual investors. REITs should be treated as equity, even though they have income-producing characteristics similar to bonds, due to the risks involved. REITs can act as a portfolio diversifier since they have varying correlation to stocks and bonds (either higher or lower).  REITs are weakly correlated to inflation, due to the hard asset/rental income nature of the investment, however if you are looking specifically for inflation protection, use individual TIPS, held to maturity, instead. For investors using a portfolio of Vanguard market based or style based index funds, one should consider what Percentages of REITs Present in Vanguard Index Funds these funds already own before adding a separate REIT fund.
Indexed portfolios of equity REITs are available as both mutual funds and exchange traded funds. Fidelity and Vanguard offer low cost REIT index mutual funds. Ishares, Schwab, Guggenheim, State Street Global Advisors, and Vanguard offer equity REIT exchange traded funds.
|Fidelity Spartan Real Estate Index Fund||Mutual||FSRVX (link)||FSRVX||0.20%||Dow Jones U.S. Select Real Estate Securities Index|
|iShares Cohen & Steers Realty Majors Index Fund||ETF||ICF (link)||ICF||0.35%||Cohen & Steers Realty Majors Index|
|iShares Dow Jones U.S. Real Estate Index Fund||ETF||IYR (link)||IYR||0.47%||Dow Jones U.S. Real Estate Index|
|iShares FTSE NAREIT Real Estate 50 Fund||ETF||FTY (link)||FTY||0.48%||FTSE NAREIT Real Estate 50 Index|
|Schwab U.S. REIT ETF||ETF||SCHH (link)||SCHH||0.07%||Dow Jones U.S. Select REIT Index|
|SPDR Dow Jones REIT ETF||ETF||RWR (link)||RWR||0.25%||Dow Jones U.S. Select REIT Index|
|Vanguard REIT Index Fund Admiral Shares||Mutual||VGSLX (link)||VGSLX||0.12%||MSCI US REIT Index|
|Vanguard REIT Index Fund ETF Shares||ETF||VNQ (link)||VNQ||0.12%||MSCI US REIT Index|
|Wilshire US REIT ETF||ETF||WREI (link)||WREI||0.32%||Wilshire US REIT index|
- ↑ Additional major legislative changes to REITs since 1960 include the Tax Reform Act of 1986 (TRA), which eliminated the tax benefits of real estate limited partnerships and launched the modern era of equity REITS; the IRS private letter ruling on the Taubman Centers Inc. initial public offering (IPO) in 1992, which allowed for the tax free exchange of partnership real property to a REIT (known as an UPREIT); the Omnibus Budget and Reconciliation Act of 1993 (OBRA), and the REIT Modernization Act of 1999 (RMA). See Feng, Zhilan, Price, S. McKay and Sirmans, C. F., An Overview of Equity Real Estate Investment Trusts (REITs): 1993-2009 (March 8, 2011). Journal of Real Estate Literature, Vol. 19, No. 2, pp. 307-343, 2011. Available at SSRN: http://ssrn.com/abstract=1743132
- ↑ Since 1972, the inception of the NAREIT Equity Index, the composition of equity REITs total return has consisted of 60% income return and 40% capital gain return. See also, Income history, Reit.com
- ↑ Vanguard REIT Index Fund does not invest in mortgage REITs since they are not part of the MSCI REIT index.
- ↑ The income return on an investment. This refers to the interest or dividends received from a security and is usually expressed annually as a percentage. See: Yield Definition on Investopedia
- ↑ Funds From Operations adjusts earnings by adding back such significant non-cash elements on the balance sheet as real estate depreciation and other amortization, and subtracting capital gains or adding capital losses from sales of real estate. See Funds From Operations - FFO, investopedia. A further adjustment, known as Adjusted Funds From Operations (AFFO) is often made to FFO. The most common adjustments are for regular expenditures used to maintain or improve a REIT's properties. See Adjusted Funds From Operations (AFFO), Investopedia. Over the 1993 - 2009 period, U.S equity REITs provided an average 10.00% Funds From Operations yield, compared to 4.16% Earnings Per Share yield. Over the same period, equity REITS provided an average dividend payout ratio (Dividends/Net Income) of 131.48%. See See Feng, Zhilan, Price, S. McKay and Sirmans, C. F., An Overview of Equity Real Estate Investment Trusts (REITs): 1993-2009 (March 8, 2011). Journal of Real Estate Literature, Vol. 19, No. 2, pp. 307-343, 2011. Available at SSRN: http://ssrn.com/abstract=1743132.
In terms of dividend yield, Vanguard research reports that the FTSE NAREIT index provided an average 6.70% dividend yield over the 1989 - 2008 period, which is consistent with the 1993 - 2009 index return (6.70% average yield) derived from index data available for download at NAREIT. See Commercial Equity Real Estate: A Framework for Analysis by Christopher B. Philips, CFA, Vanguard Investment Counseling & Research, 08/17/2007.
- ↑ Over the 1993 - 2009 period, the leverage ratio (long-term liabilities divided by total assets) for U.S equity REITS averaged 44.37%. The annual average leverage ratio has ranged from a low of 29.96% in 1993 to a high of 51.31% in 2008, and has generally risen over the measurement period. See See Feng, Zhilan, Price, S. McKay and Sirmans, C. F., An Overview of Equity Real Estate Investment Trusts (REITs): 1993-2009 (March 8, 2011). Journal of Real Estate Literature, Vol. 19, No. 2, pp. 307-343, 2011. Available at SSRN: http://ssrn.com/abstract=1743132
- ↑ Green Street Advisers. This link does not represent an endorsement, but this approach seems like a useful way to think about REIT valuation. Look in the lower right side of the page for the graphs of Average Premium to NAV. Click on the "Learn More" link to expand the graph. Average Premium to NAV: The premium (discount) ascribed to a company’s net asset value that is implied by the current share price compared to Green Street’s assessment of net asset value. Observed premiums/discounts in the public market have historically been reliable predictors of future changes in private-market prices.
- ↑ The dividend yield, is based on the payout of Funds from Operation minus the costs of maintaining property. Ruff in his paper "Commercial Real Estate: New Paradigm or Old Story, applies this metric to direct investment in real property, where it is referred to as the Cap rate, which is the net cap rate minus the expense cap rate, which is assumed to average 2%.
- ↑ "Commercial Real Estate (CRE) tends to have a long cycle, typically over 10 years, and the booms and busts are spectacular. The CRE bust in New England in the early 1990s brought down at least one bank (Bank of New England, wikipedia) and left empty office buildings dotting the area for years. Something similar happened in Toronto at the same time. In London, the bankruptcy of the Canadian developer Olympia and York, wikipedia, the owner of the Canary Wharf supercomplex, left Barclays Bank in possession of 10 per cent. of the UK’s entire office space Similar patterns were seen in western US states during the S&L Crisis of the early 1990s. Before that, Calgary and Houston were particularly badly hit in the early 1980s when oil prices fell. There were office buildings built in Calgary in 1980 that were still empty in 1992." from Valuation of REITS, unpublished document, by forum member Valuethinker.
- ↑ For more information on the tax ramifications of holding Vanguard REIT index fund in a taxable account, see Vanguard REIT Index Tax Distributions.
- ↑ For example, Vanguard provides a current estimate of unadjusted yield, and adjusted yield accounting for the return of capital on their Current REIT index fund yield estimate page. They do not quote a 30-day SEC yield for the fund due to these complications.
- ↑ Annual returns for the NAREIT Mortgage Index are tabulated below:
- ↑ Whether equity REITS act as a suitable proxy for direct investment in commercial real estate is an unsettled question in academic finance. Among recent papers, Hoesli, Martin and Oikarinen, Elias, Are REITs Real Estate? Evidence from International Sector Level Data (March 1, 2012). Swiss Finance Institute Research Paper No. 12-15. Available at SSRN: http://ssrn.com/abstract=2034377 or http://dx.doi.org/10.2139/ssrn.2034377, concludes:
"Both the variance decompositions and impulse responses suggest that the long-run REIT market performance is much more closely related to the direct real estate market than to the general stock market. Consequently, REITs and direct real estate should be relatively good substitutes in a long-horizon investment portfolio."
On the other hand, Pavlov, Andrey D. and Wachter, Susan M., REITS and Underlying Real Estate Markets: Is There a Link? (June 27, 2011). U of Penn, Inst for Law & Econ Research Paper No. 11-20. Available at SSRN: http://ssrn.com/abstract=1879968 or http://dx.doi.org/10.2139/ssrn.1879968 finds:
"a statistically significant relationship between REIT and real estate returns only in the office sector. Other property types offer only very weak and insignificant relationships. This finding suggests that direct real estate investment or investment through the property price index derivatives cannot be replicated using REITs."
- Vanguard REIT Index Tax Distributions
- Percentages of REITs Present in Vanguard Index Funds
- International REITs
- ↑ Feng, Zhilan, Price, S. McKay and Sirmans, C. F., An Overview of Equity Real Estate Investment Trusts (REITs): 1993-2009 (March 8, 2011). Journal of Real Estate Literature, Vol. 19, No. 2, pp. 307-343, 2011. Available at SSRN: http://ssrn.com/abstract=1743132
- ↑ Non-Traded REITs Are Designed to be Sold, Not Bought, REIT Wrecks
- ↑ How To Assess A Real Estate Investment Trust (REIT), investopedia.
- ↑ The Two-Percent Dilution, Efficient Frontier, 2002.
- ↑ See Current REIT index fund yield estimate, for the current yield of the Vanguard REIT index fund.
- ↑ MSCI REIT index, table data from Vanguard REIT Index Fund
- ↑ Research Reports: Real Estate Investment Trusts, American Institute for Economic Research, November 2, 1974.
- ↑ Historical REIT Industry Market Capitalization: 1972-2012, REIT.com
- ↑ Early 1990s recession in the United States
- ↑ The S&L Crisis: A Chrono-Bibliography,FDIC
- ↑ Clayton, Jim F. and MacKinnon, Greg H., Explaining the Discount to NAV in REIT Pricing: Noise or Information? (December 18, 2000). Available at SSRN: http://ssrn.com/abstract=258268 or http://dx.doi.org/10.2139/ssrn.258268
- ↑ Great Recession in the United States
- ↑ source of returns data: Index Data, from REIT.com (NAREIT®) (National Association of Real Estate Investment Trusts®); source of market capitalization data: Historical REIT Industry Market Capitalization: 1972-2012, REIT.com
- ↑ By the Numbers: Asset Correlations, Fall 2006, Portfolio Solutions
- ↑ Cointegration of Real Estate Stocks and REITs with Common Stocks, Bonds and Consumer Price Inflation - An International Comparison by Westerheide, Peter (2006)
- ↑ See US Real Estate Investment Trusts for mutual funds and ETFs covering the asset class.
- Ilmanen, Antti, "Expected Returns: An Investor's Guide to Harvesting Market Rewards", John Wiley & Sons, Incorporated, 2011. ISBN 1119990726 or Amazon.com
- Commercial Property Price Index, from Green Street Advisors. In the lower right side of the page is a Valuation Data section which contains Green Street Advisors Commercial Property Price Index, a time series of current and historical unleveraged commercial property values. (Click on MOPI for the Manhattan Office Price Index.) This section also contains graphs of Average Premium to NAV.
- Index Data, from REIT.com (NAREIT®) (National Association of Real Estate Investment Trusts®)
- FTSE NAREIT US Real Estate Index Series: A family of REIT performance indexes that spans the commercial real estate space across the US economy.
- FTSE EPRA/NAREIT Global Real Estate Index Series: Represents general trends in eligible real estate equities worldwide.
- REIT Wrecks
- MSCI REIT Index
- Journal of Real Estate Research
- International Real Estate Review
- The Core Four is a good forum discussion thread regarding the inclusion of REITs in a portfolio.
- How Would Mr.Bogle Calculate Expected REIT Returns?, forum discussion