The facts simply do not add up and the old excuses no longer apply. Advisors should begin using real estate investment trust mutual funds in their clients’ asset allocation portfolios. During the first week in October, Standard & Poor’s announced that it would be including real estate investment trusts (REITs) in the the S&P 500 index. “REITs were not eligible for the [S&P] indices for several years. The old policy reflects REITs’ role as passive investment vehicles during the late 1970s through the mid 1990s,” S&P says. But now, “REITs have become operating companies subject to the same economic factors as other publicly traded U.S. companies.”
No one knows quite the effect that this announcement will have on the performance of the industry or on the use of REITs by advisors. David Blitzer, chairman of the S&P index committee, says that following the addition of America Online to the index in 1998, the Internet sector came to be viewed with an additional measure of respectability. “I remember that a reporter told me during a phone interview at the time that we had blessed the Internet,” Blitzer says. “That wasn’t our intention. We just meant to show that that sector of American industry had come to play a sufficiently significant part in the overall scheme of things.” The implication for REITs? Now S&P regards REITs in a similar fashion–as major business concerns.
Such recognition may surprise many advisors unfamiliar with the evolution of REITs since they were first allowed by Congress in 1960. Indeed, during much of the first three decades of their existence, REITs functioned mostly as investment products rather than as going concerns. Robert Steers, who manages the nation’s largest REIT mutual fund along with partner Martin Cohen at Cohen & Steers Realty Shares, tells of how a third-party real estate advisory firm would put together a number of properties and then form a shell corporation. Shares in the shell would be underwritten by large wirehouses and sold to clients. “It wasn’t a company,” says Steers. “The real estate advisory firm and wirehouse would get a big commission up front and there was no incentive to manage the properties correctly. They would have no stake in whether or not the property succeeded.”
Typically, the properties would be low in quality so as to bolster the potential annual returns, and make the product more marketable to wirehouse clients. Strip malls were the big fad in this environment, says Steers, with their high rental margin throwing off 9% to 11% in annual rental returns. “Every drop of cash flow was sent back to the investor and, in many cases, the REIT would eventually be liquidated. It wasn’t a real company with a real staff.”
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A lot has taken place since then. Suffice it to say that REITs are now actual operating companies, just as S&P acknowledges. They have real, full-time staffs that often number into the hundreds of employees that deal with financing, acquisition of new properties, development, and the management of existing properties. As Peter Haas Calfee of Calfee Financial Planners in Cleveland, says, “It was hard in the past to get a handle on what REITs were actually doing. You now know that they are running it in the best manner that they know how.” Indeed, go to the Web site of any REIT and look at the detailed description of floor plans, properties, and rents. These are real companies with real assets.
Despite this, however, REIT funds are still largely unused. AMG Data, which tracks mutual fund flows, estimates a net of just over $270 million has gone into REIT mutual funds since the beginning of the year. Comparatively, the entire REIT mutual fund universe has a total of $11 billion under management. One might argue that this amount is comparatively large, considering the redemptions being recorded by traditional stock-oriented funds. Yet, while most of the equity mutual fund categories have suffered losses over the past 18 months, real estate is up. The National Association of Real Estate Investment Trusts Composite Index, which tracks the performance of all publicly-traded REITs, was up 26% last year, and has risen another 14.35% this year through October 9. In a year when investors are seeking a respite from investments in traditional large-cap stocks, REIT mutual funds, despite their stellar performance, have gone largely neglected.
This is doubly hard to understand when you consider that these recent results are only indicative of a larger trend. Over the course of the last 10 years–the period that is considered the modern REIT era–REITs have been up an average of 11.49% annually. However, they were down significantly in 1997 and 1998.