Why An Intelligent Investor Considers REITs To Be A Fundamental Asset Class

by: Brad Thomas

You all know the secret of Monopoly, by becoming a landlord and patiently owning and investing in property you generate a durable source of income, and better yet, your tenants' rent checks help you accumulate equity overnight. I don't recall ever winning Monopoly by just investing in utilities or railroads, or waiting to pass Go.

Indeed real estate is the most powerful way to accumulate wealth, and more people have become millionaires through real estate than any other means, regardless of the economy. It's true. Prior to the onset of the industrial revolution, wealth and power were measured in terms of the amount of land owned.

Wealth in land was replaced by "brick in mortar" and in the twentieth century America was "built on commerce" as factories, industrial complexes, office buildings, and shopping centers resulted in extraordinary growth and wealth creation. As commercial real estate ventures became more successful, and changes in corporate structure occurred, banks and other lenders saw real estate developers, partnerships, and commercial contractors as safe investments and began to offer more liberal financing.

Then the case for owning rental real estate became more widely accepted after 1960 when Congress passed the Real Estate Investment Trust (REIT) Act. The legislation exempted special-purpose companies from corporate income tax if certain criterion were met. The law was designed so that the financial incentive would cause investors to pool their resources to form companies with significant real estate assets, providing the same opportunities to the average American as were available to the elite.

REIT legislation served as a vehicle to allow real estate investors to invest in large-scale, income-producing real estate, through the purchase and sale of liquid real estate equities. Prior to the REIT Act, access to the investment returns of commercial real estate equity, as a core asset, was available only to institutions and wealthy individuals having the financial wherewithal to undertake direct real estate investment.

Would Benjamin Graham Invest in Real Estate?

One of the biggest advantages to owning REIT securities is that unlike direct property ownership, a REIT offers full liquidity and daily price quotations. Many investors mistake this for added volatility risk. Although the legendary value investor Ben Graham didn't live long enough to enjoy the benefit of REIT ownership, he understood that real estate fluctuates in price just as any common stock would. He made the case by explaining that the lack of a quoted price (full liquidity) can be mistaken for stability (from The Intelligent Investor):

There was then [during the Great Depression] a psychological advantage in owning business interests that had no quoted market. For example, people who owned first mortgages on real estate that continued to pay interest were able to tell themselves that their investments had kept their full value, there being no market quotations to indicate otherwise. On the other hand, many listed corporation bonds of even better quality and greater underlying strength suffered severe shrinkages in their market quotations, thus making their owners believe they were growing distinctly poorer. In reality the owners were better off with the listed securities, despite the low prices of these. For if they had wanted to, or were compelled to, they could at least have sold the issues - possibly to exchange them for even better bargains. Or they could just as logically have ignored the market's action as temporary and basically meaningless. But it is self-deception to tell yourself that you have suffered no shrinkage in value merely because your securities have no quoted market at all.

In other words, Graham believed that despite the fact that the quoted price of the stock (or REIT) may fluctuate on a daily basis, the economic reality of direct real estate investing is no different. In other words, it's as if the owner of a REIT simply didn't pick up the paper and examine the price offered to him by Mr. Market. Taking it one step further, this perceived disadvantage is actually one of the perks of owning REITs. Unlike direct real estate holdings, REITs are a liquid asset that can be sold fairly quickly to raise cash or take advantage of other investment opportunities.

Would Ben Graham Buy REITs Today?

There's no way to know whether or not the legendary Ben Graham would own REITs today but we do have some facts that could point us in the right direction. In The Intelligent Investor Graham wrote:

The outright ownership of real estate has long been considered as a sound long-term investment, carrying with it a goodly amount of protection against inflation. Unfortunately, real-estate values are also subject to wide fluctuations; serious errors can be made in location, price paid, etc…

Graham was certainly intrigued by the notion that a "defensive investor must confine himself to the shares of important companies with a long record of profitable operations" and he believed that "the most persuasive tests of high quality is an uninterrupted record of dividend payments going back over many years". As evidenced by Graham's fascination with dividend investing, he wrote the following:

Paying out a dividend does not guarantee great results, but it does improve the return of the typical stock by yanking out at least some cash out of the manager's hands before they squander it our squirrel it away.

Because REIT shareholders are legally entitled to 90% of the REIT's taxable income each year, the shareholders are allowed to participate in income reinvestment decisions. This more disciplined approach in effect forces the REIT manager to payout substantially more income (to investors) and defend against "squandering or squirreling" it away.

Accordingly, it's obvious to me that Graham would have adored REIT stocks and because of the high-yields, REITs are especially suited to retirement portfolios because the cash dividend not only provides income upon which to live, but establishes a phantom floor to the share price. In a market free fall, for example, the dividend yield will eventually become attractive enough to prevent further sell offs (assuming the fundamental business isn't in jeopardy.) This results in greater stability at times of market crises.

Although many academics claim that it shouldn't matter to shareholders how much of its net income a corporation pays out in dividends, many argue that dividends really do matter with respect to shareholders' total returns. I am certain that Graham would have argued the point as he wrote (in The Intelligent Investor):

One of the most persuasive tests of high-quality is an uninterrupted record of dividend payments going back over many years.

Using REITs for Diversification and Asset Allocation Programs

Ben Graham believed that one of the most fundamental elements of asset allocation is diversification. In my opinion, true diversification involves having several distinct asset classes that perform differently from each other in different financial environments. Accordingly, it makes sense to have exposure to at least a few and perhaps several asset classes.

Real estate investing offers an attractive alternative to common stock, bond and mutual fund investing. As Mark J.P. Anson wrote in the Handbook of Alternative Assets:

Real estate is not an alternative to stocks and bonds-it is a fundamental asset class that should be included within every diversified portfolio. Equity, fixed income, cash, and real estate…are the basic asset classes that must be held within a diversified portfolio.

Burton G. Malkiel (Princeton) wrote (The Random Walk Guide to Investing):

Basically, there are only four types of investment categories that you need to consider: Cash, Bonds, Common Stocks and Real Estate.

David Swensen, Yale University's Chief Investment Officer said (in Unconventional Success, 2005):

a basic formula for individual investors with 20 percent invested specifically in REITs and the rest in equities, bonds and cash.

I'm Buying Blue Chip REITs

After a turbulent few months, REIT investors are now beginning to see prices stabilize. The fear of rising interest rates has overshadowed the recovery that we are seeing in commercial real estate and that has muted the appetite for some. However, for others, the sell-off has created a window of opportunity as REIT valuations have moved from a "moderately expensive" range into a "fair value" range. Brad Case, Ph.D., CFA, CAIA, Senior Vice President with NAREIT explained to me this week:

Investors are likely to be reassured that REITs will continue to be one of the only sources of strong, steady income. To me, though, announcements about interest rates are less important than the longer-term macro outlook, which is still one of steady-though slow- improvement in office employment, domestic and international trade, consumer spending, household formation, all the drivers of demand for commercial space. That steady improvement in the macro economy is always good news for REITs.

As intelligent REIT investors know, the "margin of safety" strategy of buying stocks at below their calculated value came from Benjamin Graham and his philosophy was framed around the notion that investors must wait patiently for storms to subside, while waiting on a sunnier and more plentiful time to resume investing activities.

As Graham believed, buying companies trading below intrinsic value leaves a cushion for error, thus giving you a margin of safety in case your analysis of the stock's value is too high. Accordingly, Warren Buffett advises holding stocks for the long-term, an investor with a cheap blue chip stock pick has the luxury of waiting it out until the price goes up again. Back in April (2013), I was in favor of buying blue-chip REITs but not at current prices; as I wrote:

Blue chip REITs are trading at outrageous pricing levels. Should we wait for a correction before we put money to work? Or, should we ease valuation standards and look for small cap REITs even though they lack the fortress balance sheets and untested management teams possessed by the blue chip REITs?

Since my above-referenced article on blue-chip REITs, the peer group's average share price fell by almost 16% with Digital Realty (NYSE:DLR) leading the pack with a 29% price decline (see my article on Digital Realty earlier this week).

Other blue-chip REITs with significant price reductions include Ventas, Inc. (NYSE:VTR), Realty Income (NYSE:O), and Taubman Centers (NYSE:TCO). As I explained in my previous article, "at the end of the day, blue chip REITs can provide terrific SLEEP WELL AT NIGHT income; however, investors must approach these securities much like the legendary investor Ben Graham would. Simply said, he would not look so much to buy them cheaply but perhaps he would look to "buy a wonderful business at a moderate price."

In closing, Ben Graham summarized his own philosophy by stating that intelligent investing consists of analyzing potential purchases according to sound business principles. This includes: an understanding of what you are doing, making your own decisions, ensuring that you are not risking a substantial portion of your original investment, and sticking to your own judgments without regard to market opinion. In the end, Graham believed:

You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right. In the world of securities, courage becomes the supreme virtue after adequate knowledge and a tested judgment are at hand.


Newsletter: For more information, check out my REIT newsletter HERE. Starting in October, I will provide a full Triple Net REIT Report in addition to my time-tested "defensive" investor stock picking model.

Source: SNL Financial

Disclaimer: This article is intended to provide information to interested parties. As I have no knowledge of individual investor circumstances, goals, and/or portfolio concentration or diversification, readers are expected to complete their own due diligence before purchasing any stocks mentioned or recommended.

Disclosure: I am long O, ARCP, VTR, HCP, HTA, UMH, STAG, DLR, CSG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.