Why REITs are not real estate: Understanding asset class exposure

Many investors who are looking to add diversification to their portfolio turn to real estate as an alternative class that is traditionally both non-correlated with the general equities market and provides substantial tax benefits that are not available in other asset classes. However, most investors are lacking either the substantial cash needed to purchase a property directly, or the inclination/experience to manage a property once purchased. To overcome these obstacles, most investors turn to investing in Real Estate Investment Trusts (REITS). REITS are a special type of corporation wherein specific laws require them to originate nearly all of their income from real estate investment activities, either through ownership of real property or investing in mortgages. While REITS generate their income through real estate investing activities, owning a REIT is not the same thing as owning real estate, nor is it the same as owning or participating as an investor in a real estate investment company. Publicly traded REITs are listed on a stock exchange and trade like any other stock. While being publicly traded does have the benefit of liquidity, the price of the shares is not necessarily indicative of the underlying real estate. For example, Realty Income (O), one of the largest net-lease REITS has paid a near-perfect monthly dividend for over 10 years. The firm makes investments in net-lease properties, which generally provide an unlevered return of 6-8%. However, the current dividend yield to investors is substantially lower at 4.4%, and this doesn't account for the levered yield which could easily reach 10%! Due to the substantial overhead required to run a public REIT, investors receive only about half of the return that was generated from real estate. One might assume that a firm that is invested in real estate should be valued based on the underlying value of its investment portfolio. However, this is not the case with publicly traded REITS, as can be inferred from the correlation to the stock market. A stock's correlation to the broad equities market is referred to as its Beta, with a Beta of 1 meaning that it moves in perfect correlation to the market; a Beta of -1 means it moves perfectly inverse to the market, and a Beta of 0 means it has no correlation to the market. For a person looking to add real estate to their portfolio as an alternative, non-correlated asset, one would expect the correlation of REITS to the market to be fairly low, but this is not the case. Acadia Realty Trust has a Beta of 1.1, Omega Health Care Investors .92, National Retail Properties .88. Each of these REITS, while investing in what should be a non-correlated asset, are actually far more correlated to equities than they are to their underlying assets. One major benefit of owning real estate is the tax benefits that come from depreciation, effectively giving the investment a higher after-tax rate of return. While REITS do not pay tax at the corporate level, the distributions they give and their tax rate are far below what normal real estate investing would provide. Generally about 1/3 of a REIT dividend is deemed "a return of capital" and carries no ordinary income liability. However, in direct real estate investing, the tax benefits usually cover far more than 50% of distributions. By purchasing shares in a REIT an investor loses out on substantial tax saving they would have received by actually owning real estate. Investors who are looking to add real estate to their portfolio, but do not wish to manage, should look to private real estate funds. Private real estate funds, in the form of either an LP or LLC, act as pass-through vehicles, giving the owner indirect exposure to real estate, but still providing all the benefits. Private funds may invest in as little as one property or grow to well over $1 billion in value. While private funds are generally far less liquid than a REIT, the exposure and benefits they provide make the investment a true real estate addition to any portfolio. Investors who want to add real estate to a portfolio must invest either directly or through a private real estate fund. A REIT should not be considered the answer to ones desire or perception that they are including real estate in a diversified portfolio. At the end of the day, investing in a publicly traded REIT is about the same as investing in any other stock. Investing in a REIT is not the same as investing in real estate. Marilyn Kane is the president and Sean Shanahan is the CFO at Iridium Capital, New York, N.Y.