There is no single right way to look at real estate investment trusts, or REITs, although there are many wrong ways. So what is a REIT and why should you invest in one?

The simplest explanation is that REITs are companies just like any other. They sell a product, pay their expenses and report their results. In this case, the product is physical space, a non-depleting asset that is essentially sold over and over.

In fact, "REIT" is just a box on a corporate tax form that frees a company from paying income tax, thus enabling shareholders to escape the double taxation they face with other investments. The tax code is quite generous to the real estate industry. Essentially, all a REIT has to do is "jump through a few hoops" -- including having real estate comprise the majority of its assets and revenue, and distribute high levels (90%-plus) of its taxable income to shareholders via dividends -- and it receives a free pass on corporate-level taxes.

Publicly traded REITs such as Equity Office ( EOP), Boston Properties ( BXP) and Trizec Properties ( TRZ) are common stocks just like any other; they can go up or down, though they tend to be less volatile than the general market, making them an attractive element in one's investment portfolio. (Non-traded REITs are still stocks, but as the name suggests, there is no market in which to sell them.) At the end of the year, investors receive a Form 1099-DIV, just like other companies. They are not partnerships with complicated tax provisions.

Many in the mainstream press make the mistake of thinking about REITs as closed-end mutual funds that own real estate. This is like saying Exxon Mobil is a mutual fund that makes gasoline.

Others lump REITs with fixed-income securities like bonds because of their income component. Although REITs may possess some characteristics that may give them the appearance of these other types of investments, there are important differences:

REIT Rights and Wrongs
May not be what you think...
Common Perception Why It's a Mistake
Just as bond prices move with interest rates, REITs' dividend yields react to interest rate changes in the short term. Although their share prices may have short-term reactions to interest rates, it has been demonstrated that REITs are correlated to real estate cycles in the long run, not interest rates. Unlike with bonds, common dividends are not guaranteed, and no one is promising to pay back your investment.
Mutual funds and REITs are both subject to several requirements (distributions, income/asset tests, etc.) in order to receive an exemption from corporate level income taxes. Mutual funds are pooled investments in securities, with external administrators. The only decision-making in a mutual fund relates to which securities to buy, hold and sell. By contrast, REITs are living, breathing companies with teams of real estate professionals responsible for implementing corporate strategy. Management decisions include not only which properties to buy, but also whether to develop new properties, leasing and re-leasing space to tenants, positioning properties in their markets, and how to finance those properties, with debt or equity.
Source: Louis Wolfowitz

So why should you invest in REITs?

  • Portfolio diversification: A typical securities portfolio is comprised of equities (stocks), fixed income (bonds) and cash. A study by Ibbotson Associates found that a hypothetical portfolio invested from 1972 to 2003 with a portion (about 10%-20%) allocated to real estate securities produced greater overall returns vs. a hypothetical portfolio without such an allocation. Just as important, portfolios that included REITs also reduced volatility (i.e., risk). Historically, returns on real estate securities have shown low correlation to stock returns and interest rates.
  • Superior after-tax yield: The median REIT dividend yield is about 4.5%. This compares quite favorably with other income-oriented investments, such as Treasury securities, investment-grade corporate bonds and utilities. This isn't a true apples-to-apples comparison, since these investments carry differing levels of risk. A reform to the tax code in 2003 that reduced the double-taxation effect for most corporate dividends excluded REITs. Despite this, the average REIT dividend is still twice the S&P 500 dividend on an after-tax basis.
  • Low volatility and low-tech: Tracked over nearly any time period, the real estate securities universe has demonstrated a low "beta" (a measure of a security's volatility relative to the broader market). A stock with a beta of 0.8 suggests that, on average, it will return 8% if the broad market returns 10%. However, if the broad market loses 10%, that stock will lose only 8%. The lower volatility makes real estate securities a suitable alternative for most investors.
  • The low volatility makes real estate securities the tortoise to the tech stocks' hare, and real estate stocks are the antithesis to those kinds of investments in other ways too. Their assets are tangible, and they generate positive cash flow.

  • Alternative to D-I-Y: Most real estate companies provide one-stop shopping: management teams with expertise in their chosen property type (i.e., office and industrial, retail and residential) or geographic area, portfolio diversification through ownership of multiple assets, and liquidity for investors to enter and exit at times of their own choosing. Some companies emphasize development of new properties, while others grow only through acquisitions. Some companies are exclusively property owners and managers, and others incorporate other aspects of the real estate business, such as fee-based property management for third parties, brokerage and leasing services. Whichever the case, real estate securities offer a better deal for most investors than trying to make direct property investments.
  • Transparency: Via periodic filings with the Securities and Exchange Commission, public real estate companies provide a treasure trove of information about their business strategy and properties. Real estate securities investors have demanded that companies provide more detailed supplemental information regarding their assets and liabilities, in addition to SEC filings.
  • Asset class for the long haul: Most products ultimately reach a point of obsolescence. Remember the slide rule, the rotary phone and the typewriter? Fashion is fickle, and today's hot retailer may be tomorrow's bankruptcy. Even in the modern age of the Internet, real estate endures. For as long as human civilization has existed, people have needed places to live and work and shop. Real estate is a non-depleting asset (meaning space can be leased over and over again). As an asset class, it will never go out of style.
  • Next week, I'll suggest a few approaches to analyzing REITs and making investment decisions. Readers are encouraged to send feedback, including suggestions for topics to cover.
    Louis Wolfowitz is a managing director in Cushman & Wakefield's Capital Markets Group and leads the firm's real estate securities research business. Prior to joining Cushman & Wakefield, he was a Senior Vice President in the Business Development Group at GE Real Estate (GE Capital). Previously, Wolfowitz was an investment banker with Merrill Lynch & Co., Smith Barney, and Donaldson, Lufkin and Jenrette. He is a registered securities principal, an NASD-qualified research analyst, and a licensed real estate broker in New York.