Co-produced with R. Paul Drake
The investment website zacks.com has a page entitled “REITs vs. Stocks”, written as though these are two distinct and different types of security. Yet when one looks on a stock screener, one sees the investments one can purchase in REITs labeled as common stock. What gives?
This article, aimed at novice REIT investors, explores the differences between the business structures of REITs and of the ordinary corporations whose stocks one can buy.
REITs come in two flavors. Much more numerous are equity REITs, or eREITs. These are often today just called REITs, as we do here. The smaller group is mortgage REITs, or mREITs. Our focus here is on eREITs.
We start with some historical context on limiting the liability of people who own shares in organizations.
Before the enlightenment, there was no legal recognition anywhere of combinations of people beyond one of shared liability. Partners shared the liability and the gains associated with their partnerships, including all debt.
The first legal form to emerge and change this was called a corporation. The classic historical example is the British East India Company, founded in 1600.
In the first few centuries of the corporate form, corporations were considered agents of the state, founded in theory to advance the common interest, and closely regulated by governments. In practice, of course, they were an early form of crony capitalism, restricting access to markets and enriching their owners at the expense of the customers.
This remained the view of corporations as of the founding of the United States. Soon after, though, corporations began hiring lawyers to push interpretations of the US Constitution that ultimately gave corporations substantially the same rights as individuals.
Famous lawyer, statesmen, and intellectual Daniel Webster was a major advocate for corporations in the early Supreme Court cases. The story is convoluted and entertaining. Adam Winkler wrote a fascinating book about it.
Figure 1. Daniel Webster argues one of the first major cases establishing corporate rights. Fun fact not shown here: in some of those early decades the Supreme court heard cases in a local tavern. Source
A crucial aspect of the corporation is that it limits the liability of the owners to the loss of their equity. This enables businesses that are not viable to fail quickly without creating enduring debt burdens that would drag down the economy.
The point of view is that if you invest in a company, or loan money to it, you take the risks that you may lose the value of your investment or loan. But once the chips are counted, that is the end of the story. You can move on and do something productive with the rest of your chips.
The 20th Century: An Explosion of Corporate Forms
Today there are many types of business structure that would all, in the 19th century, have been called corporations. These include
- C Corporations (ordinary corporations like Coca Cola (KO) or Ford (F))
- S Corporations
- Mutual Funds (open-end)
- Closed-End Funds (CEFs)
- Exchange Traded Funds (ETFs)
- Business Development Companies (BDCs)
- Real Estate Investment Trusts (REITs)
There are also some hybrid business types that include elements of both partnerships and corporations, specifically Master Limited Partnerships (MLPs) and Limited Liability Companies (LLCs).
The US Congress and other national governments created these distinctions. Sometimes the aim was to open up investment opportunities to individuals. In other cases, the aim was to impose specific regulations and limitations. In almost all cases tax considerations are primary.
We will say a bit more about these organizational types later on.
What REITs Are About
The idea behind a REIT is pretty simple. A group of investors contribute funds to the REIT. The REIT buys real estate (sort of—see below). It leases out the real estate. The rent provides the income for the investors.
We like to say that investing in a REIT is not investing in companies but rather in their rent checks. Rents (lease payments) are an operating cost. They are senior to any form of debt.
When companies go bankrupt, REITs are likely to get their lease payments and then get the property back. It costs something to repurpose and release the property, but this is a lot better than a complete loss of principal.
Most REITs own large numbers of geographically diverse properties, providing protection against local economic problems. An added benefit is that real estate is an excellent inflation hedge in the long run.
Individual REITs tend to concentrate in one area of business (storage, industrial, hotels, various shopping, and many others). As Figure 2 illustrates, an investor can diversify across much of the economy by investing in a collection of REITs from different sectors.
Figure 2. Distribution of REITs by Property Sector
Avoiding Double Taxation
Ordinary corporations pay corporate taxes, after which investors are also taxed on the dividends. This is known as double taxation.
REITs, in contrast, distribute at least 90% of the otherwise taxable earnings to investors as dividends. By meeting this threshold, the REIT escapes the obligation to pay taxes on the dividends, avoiding double taxation.
The REIT dividends are then taxed as ordinary income, with adjustments. The latest tax law changes increased the complications. Our understanding, as non-tax-experts, is as follows.
For many investors there is a 3.8% Net Investment Income Tax on top of ordinary income taxes. This applies to most investment income and not just REITs. There is also a deduction of 20% of the value of the REIT dividends. Various thresholds affect what any given individual pays.
REITs can be held in traditional or Roth IRAs. In those vehicles, the income accumulates tax free. REITs do not lead to any of the hidden taxes that sometimes accompany MLPs.
You can invest in REITs with ETFs that cover the entire market, such as (VNQ). Or you can invest in blue-chip, large-capitalization REITs such as Realty Income (O), Public Storage (PSA), or STAG Industrial (STAG).
At High Yield Landlord we identify REITs that offer high yield and value. They pay higher dividends than typical large-cap REITs and are underpriced by the market, in our judgement. These are most often REITs with smaller capitalizations that are ignored by the majority of investors.
The Contrast With Common Stocks of C Corporations
The companies discussed most often on the news, whether Apple (AAPL) or Facebook (FB) or Tesla (TSLA) or General Electric (GE), are corporations. As is ably explained by Batavia Law, “In a corporation, the owners are the stockholders, and they appoint directors, and directors appoint officers, and the officers oversee the day to day business of the corporation. Corporations are intended to operate businesses for profit for the benefit of the shareholders (the owners).”
Of course, the reality is that the individual shareholder has negligible influence on a large company. But major investors do have influence and sometimes produce major changes.
Ordinary common stocks represent ownership shares in corporations. If these corporations are public, they trade on open markets. The price is set by the market.
Corporations face few legal constraints regarding their operation. They can decide to pay no dividends and plow all their profits into growth. They can decide to grow slowly and pay out most of their profits as dividends. They can decide to use their profits to buy back shares, increasing the ownership fraction of the remaining shares. Or they can decide to sell shares, reducing this ownership fraction.
As a stockholder, you have no direct control over any of this. Companies can and do change directions on a dime. They often do this without warning. One can understand that telegraphing their plans might cause problems for them, so this can often be understood. However, when the market reacts to these actions by dropping the price, investors suffer.
Despite these disadvantages, common stocks are a good place to invest, as Figure 3 shows. Their returns have on average beaten inflation by a substantial amount for more than a century. Investing in stocks that pay dividends is even better. Ways to do this with ETFs include (SPY) for the entire S&P 500 and (NOBL) for stocks that have a long history of increasing dividends.
That said, we think REITs deserve your attention as much or more than common stocks. You can see in the figure that REITs overall have outperformed common stocks during most periods. We favor diversification, having several categories of investment as part of a total portfolio.
Figure 3: Long-term returns of ordinary stocks vs REITs
Where REITs came from
The US Congress created the category of REITs in 1960, to enable individual investors access to income producing commercial real estate. Early REITs were mostly mREITs, which are not our favored form of investment.
Equity REITs started to emerge in larger numbers in the 90s, when Taubman Centers (TCO) created the organizational structure that is common today. The REIT is the general partner in an operating partnership. The partnership purchases and operates the real estate. This structure has some tax advantages for owners who sell property to the REIT.
There is some room for management to adjust taxable income, especially by how they manage debt. But the leeway is far smaller than it is for ordinary corporations. This is an area where expert advice can help one avoid the bad actors. One place to find such advice is here on Seeking Alpha.
REITs are RICs but are not RICs
The taxonomy surrounding REITs and the other classes of investments listed above can be quite confusing. As part of the long-term reaction to the Great Depression, the Investment Company Act of 1940 established regulation of investment companies (ICs).
A number of classes of investment company, but not REITs, are required (or may choose — long story) to register with the SEC as Registered Investment Companies. Many Closed-End Funds, Exchange Traded Funds, Business Development Companies, and most Mutual Funds are Registered Investment Companies.
Publicly traded REITs are required to register with the SEC, but they do so as REITs, not as Registered Investment Companies. So they are registered but not Registered. REITs are subject to SEC regulation, and at times are described as Regulated ICs.
Since the acronym RIC is used for both Regulated and Registered ICs, confusion abounds on the web.
This nonsense does have implications
An important difference is that while the leverage of Registered Investment Companies is legally limited, the leverage of any type of REIT is not. It turns out that mREITs need to operate with leverage far above the 33% limit of debt to total assets that applies to Registered ICs.
eREITs often carried a lot of leverage too, until the Great Recession. A substantial number of mREITs went bankrupt. Only one eREITs did, but many did have to reduce or eliminate their dividends to survive.
Subsequently, eREITs generally have reduced their leverage to levels much more able to tolerate recessions. Small cap eREITs, which are growing rapidly and offer higher returns, also often carry more leverage. It is good to have expert help to navigate that market segment.
Figure 4. Showing the percentage of debt to assets for REITs on a scale from 25 to 70 percent, against year from 2000 to 2019. The assets used are book assets for the dark blue curve and market assets for the light blue curve. Source: NAREIT
The ratio of debt to total market assets is now down near 33%. This corresponds to debt that is roughly half of net equity. This range is also the limit of leverage legally allowed for Registered Investment Companies.
Concluding Remarks and Portfolio Implications
Both ordinary (“C-“) corporations and REITs sell securities technically described as common stock. In both cases, these stocks are legally described as equities and represent ownership shares.
For C-corporations, the corporate common stock provides one with a percentage of the proceeds from whatever the company decides to do, modulated by the overall movement of the corporate-stock market. This might be capital gains, capital losses, or dividends.
For REITs, the REIT securities provide one with a guaranteed share of the taxable income of the Trust. This income derives from rent checks and comes to you as dividends. Taxation of the dividends has some advantages compared to taxation of ordinary investment income.
You also can experience capital gains or losses, reflecting the success of the REIT to grow its assets, modulated by the overall movement of the REIT market.
We advocate that you include REITs as a significant element in a diversified portfolio. Depending on your goals, this might include large-cap REITs or small-cap REITs. The best opportunities and highest yields are found today in the small-cap segment which is 40% underpriced relative to large caps – solely based on the smaller size.
You must however exercise very prudent caution to your selection of individual REITs as return disparities can be massive.
To illustrate this point, consider the following: The best REIT investors have achieved up to 22% annual returns over the past decades, whereas the average individual investor earned only 2.6% per year over the same time frame:
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.