Investment real estate comes in many forms. There’s raw land, apartment buildings, hotels, hospitals, warehouses and shopping centers to name a few.
Real estate as an asset class is a wonderful diversification tool. It produces returns – usually with little correlation with those of financial assets (e.g. stocks/bonds) – that decrease overall portfolio risk.
The limited partnership (“LP”) was the preferred investment vehicle for real estate but has lost attractiveness over the years. One reason is the closing of a tax loophole with Reagan’s 1986 tax reform. Another is the lack of diversification since the typical LP owns one or two properties. Mostly, LPs were out of reach to the majority of investors as initial buy-ins had high minimums.
The popularity of mutual funds solved the diversification and high minimum investment problems. We saw an explosion in demand for real estate stocks such as homebuilders, construction/engineering firms and home improvement retailers.
The real estate evolution continues today with a plethora of companies whose sole purpose is to own and operate commercial properties. The two most common corporate forms are real estate investment trusts (“REITs”) and real estate operating companies (“REOCs”). They are similar in many ways but their differences are crucial in understanding which is right for your portfolio.
WHAT THEY HAVE IN COMMON
- own and/or operate real estate
- may be concentrated in or diversified across sub-sectors (e.g. warehouses, hotels)
- corporate form of ownership (i.e. purchaser has limited liability)
HOW THEY DIFFER
One word – taxes. To be precise, they differ in the way they are taxed by the IRS.
To qualify for REIT status, a company must distribute a minimum of 90% of its cash flow.
Doing so allows the REIT to avoid corporate income taxes that, in turn, allows the shareholder to avoid “double taxation.”
REOCs may choose to distribute a high dividend but they are not subject to a minimum.
The tradeoff for this flexibility is that REOCs are subject to corporate taxation and, thus “double taxation” from the shareholder’s perspective.
OK…fine…whatever. What’s this got to do with anything? Is this important? Why do I care?
Yes, there are definitely important implications ranging from cash flow to taxes to asset allocation to portfolio management. Let’s take a look at each…
Investors seeking a relatively high/steady income stream should prefer shares in REITs, a REIT-based ETF or a mutual fund that invests primarily in REITs. REOCs are a poor investment if cash flow is the primary consideration since they have no legal minimum distribution requirement.
Investors seeking to maximize after-tax returns should prefer REITs – particularly if owned in a tax-advantaged account (e.g. 401(k), IRA). REOCs are a poor investment if after-tax return is the primary consideration since they are subject to the corporate income tax and, subsequently, individual income tax on the distributions.
Investors seeking a purer form of real estate exposure should prefer REOCs. REITs are a relatively impure form because of their 90%+ cash flow distribution. Although they own/operate real estate (and, thus, have a real estate component to their return), the high level of cash distributions make them rather bond-like.
This is what sets REITs and REOCs apart. Specifically, allowing companies to manage their portfolio of properties based on market conditions, access to credit markets, etc. (which REOCs can do with their flexibility) rather than on minimum cash distribution requirements (which REITs are subject to) is the preferred method.
Consider financing costs. In a low-rate environment, both REITs and REOCs can tap the credit markets to buy properties. But what happens when rates rise? REOCs have the flexibility to use cash flow while REITs are handcuffed by their 90% distribution requirement. As a result, REITs are left with two unattractive options – (1) lose out on opportunities to acquire properties due to insufficient funding or (2) acquire properties at a higher borrowing cost (relative to REOCs that can “lend to themselves” through the use of internally generated cash flow).
The strength of the real estate market is another factor. Both REITs and REOCs can sell properties at acceptable prices. But what happens when there’s weakness in the real estate market? Again, REOCs have the flexibility to capitalize on opportunities by using internally generated cash flow while REITs continue to be handcuffed by their 90% distribution requirement.
Finally, the financial health of the company must be considered. REOCs may choose to conserve cash if conditions warrant whereas REITs are forced to distribute their cash flows even if it’s financially unsound from a liquidity and/or solvency perspective. It’s not hard to imagine a scenario where a REIT suffering financial hardship must dump a property at a fire sale price and a REOC (with its cash flow flexibility) jumping in to buy at a bargain.
The continued decline of the Dollar will only further bolster demand for “hard assets” such as real estate. Hopefully the ins and outs of the alphabet soup that is REITs and REOCs will provide clarity regarding available investment options.