Real estate investing: Baltic, Boardwalk and beyond
Many people gained an interest in real estate investing by playing the board game Monopoly, which was introduced in the early 1900s. Buying properties, building houses and hotels and, ultimately, collecting rent from opposing players, offers an awareness, albeit a simplistic one, of the importance of the types of property and location.
It was not until 1960, however, when President Dwight D. Eisenhower signed legislation that paved the way for the modern REIT investment structure, giving individual investors the opportunity to participate in the commercial real estate market. The growth of the U.S. REIT industry has been consistent over time, with a notable increase in the number of REITs over the last several years. According to the National Association of Real Estate Investment Trusts, a worldwide representative group of REITs and publicly traded real estate, 233 such investments were operating in the U.S. at the end of 2015. Moreover, the market capitalization of these investments has grown dramatically since 1971, when the market capitalization of REITs was approximately $1.5 billion. The market capitalization of all REITs at the end of 2015 was nearly $939 billion.
Since 1960, 35 countries around the globe have adopted REIT structures similar to that of the U.S. Given the growth of the global REIT industry investors may want to consider a global approach to investing in these strategies, as opposed to limiting the universe exclusively to the United States. Investing in real estate, either through a REIT or directly, remains tied to the axiom that it is all about location, location, and location. By taking a global approach, an investor has a wider array of property types as well as locations to consider.
The investable universe of U.S. REITs ranges from shopping centers and office properties to less obvious sectors such as student housing. Each sector has its own unique dynamics and presents differentiated risk and return opportunities throughout the economic cycle. As further evidence of the scale of the REIT universe, index providers Standard & Poor’s and MSCI both will be implementing new real estate sector categories, separating these assets from the current financials sector later this year.
Within the global real estate market, the sectors remain similar to that of the U.S. while the number of investment opportunities increases significantly. As a point of reference, the FTSE NAREIT All Equity REITS Index, which tracks U.S. REITs and publicly-traded real estate companies, had 165 constituents as of the end of May 2016. The FTSE EPRA/NAREIT Global Index, which incorporates REITs and real estate holding and development companies around the globe, had 479 individual securities in it. By thinking more globally about investing in REITs and/or real estate, it expands the investable universe by nearly three times.
Over the last 20 years, there has been a meaningful relationship between interest rates and the performance of U.S. equity REITs.
Furthermore, investors need to drill down and understand how a REIT index is being constructed, as many are market capitalization based giving the largest REITs more of an allocation within the index. This becomes a point of consideration when investors compare actively managed portfolios to an index. If a manager is benchmark-oriented he or she may be limited in how far away from the index they can allocate capital.
Many investors view a real estate investment as a way of generating income, whether it is from a rental home, office space, storage unit, or even a cellular tower. A commonly used measure for assessing the value of an income-generating property is net operating income. The calculation accounts for all revenue from the property, less operating expenses such as insurance, property management fees, utilities, repairs, and property taxes. Professional investors often compare the NOI of similar properties to determine which investment is more attractive. Expenses related to property types can vary substantially: hotels and apartments are capital intensive and require ongoing maintenance while cellular towers require little care after the initial construction. The long-term contribution of income to total return has become meaningful in this asset class, regardless of property type. The percentage of cumulative return generated from income grew from 50% in 1971 to nearly 80% in May of 2015, assuming the full reinvestment of dividends.
REITs will behave at times like equities, at other times more like fixed-income.
A consideration for any investor in a yield-oriented strategy, REITs included, is the impact of rising interest rates in the U.S. Over the last 20 years, there has been a meaningful relationship between the movement in interest rates and the performance of U.S. equity REITs. It is also important to note that there has been a strong relationship between REITs and equity securities. Taking this into account, the investor needs to understand that REIT investments will behave at times like equity-related securities and at other times more like income-producing securities. This will ultimately be determined by the prevailing market environment. That said, REITs can complement a balanced portfolio, providing both income and growth.