right investment mix for your personal financial situation, tolerance, and goals … all of which we'll discuss going forward.
CHAPTER 3 REITs over the Decades
“Investing isn't about beating others at their game. It's about controlling yourself at your own game.”
—Benjamin Graham
As we discussed briefly in Chapter 2, few assets are more illiquid than commercial real estate such as office buildings, shopping centers, apartments, and the like. They're also very expensive to own and operate, which made them a “boom and bust” business in the past. Fueled by unreliable information (or at least a serious lack of good information), fortunes could be lost on these purchases.
Then again, fortunes could also be made – provided one already had a small fortune to begin with. Commercial real estate was the quintessential “you've got to have money to make money” example before the mid‐twentieth century. It was a wealthy man's game until REITs came along.
The concept was really spawned by a real estate management company in Boston, Massachusetts, that used a business trust vehicle to avoid paying double taxes on its holdings. It was ultimately taken to court over this, with the court's decision basically boiling down to “if it walks like a duck and acts like a duck, it's probably a duck.” And so ended the earliest REIT ancestor.
Yet that defeat prompted a new battle as the same company hired a law firm – Goodwin Proctor – to design a vehicle that would be legally acceptable. This time, it met with success. Congress accepted the accurate argument that small investors were unable to benefit from commercial real estate investing. As such, it agreed to allow a new business classification using mutual fund rules as a model.
(Interestingly, that's why REITs originally had to involve outside property managers: because the company that created them was precisely that. Self‐interest, right? It's a beautiful thing.)
REITs were officially defined and authorized by Congress in the Real Estate Investment Trust Act of 1960, and the first actual examples were organized that same year under the following understanding:
1 A REIT must distribute at least 90% of its annual taxable income, except for capital gains, as dividends to its shareholders (most pay out 100%).
2 A REIT must have at least 75% of its assets invested in real estate, mortgage loans, shares in other REITs, cash, or government securities.
3 A REIT must derive at least 75% of its gross income from rents, mortgage interest, or gains from the sale of real property. And at least 95% must come from these sources, together with dividends, interest, and gains from securities sales.
4 A REIT must have at least 100 shareholders with less than 50% percent of the outstanding shares concentrated in the hands of five or less shareholders.
The concept was pretty popular right out of the gate. Some of the earliest to go public were Washington, Pennsylvania, and Bradley REITs (the latter of which was not named after me) – small companies for small investors who only wanted to buy up 10, 100, or 1,000 shares. A large number of other equity REITs queued up for their IPO (initial public offering) spotlights as well. But the assassination of President John F. Kennedy in 1963 threw the markets into turmoil, permanently pushing most of those debuts back.
It was a major setback to the sector's early evolution.
According to The REIT Investment Summary, a 1996 report published by Goldman Sachs, there were really only 10 of these businesses worth noting in that first decade. The companies in question ran portfolios worth $11 million to $44 million, and many of them were attached to management companies that were affiliated with members of their boards. It goes without saying that this could and did too easily create issues.
Even so, they did manage to perform well enough, thanks in part to the real estate market at the time. Cash flow (the original stand‐in for the to‐be‐explained funds from operations, or FFO) grew an annual average of 5.8%, with 6.1% average dividend yields. All told, they easily returned more than the S&P 500 between 1963 and 1970 (11.5% versus 6.7%).
The Tax Reform Act of 1986
In 1968, big banks began to realize they could use the REIT structure to lend money to companies building commercial real estate. And so they created construction and development mortgage REITs – far too many of them and all of which acted far too aggressively. All told, these bank‐backed entities lent more than $20 billion to such companies and contractors, which helped fuel overbuilding. Which led to a subsector disaster.
As developers walked away from projects that no longer made sense to continue, the financial forces behind them failed as well. Their shares fell and fell hard – 21.8% in 1973 and 29.3% in 1974. Only a few actually went bankrupt after that, but the rest were liquidated for pennies on the dollar. The debacle gave REITs in general a bad name all the way into the early nineties.
This was a shame considering how equity REITs continued to perform well in the 1970s, all things considered. When Goldman Sachs studied 10 representative entities during this period, it found they offered an annual average 6.1% compounded cash flow growth rate. This was fairly consistent too, with only one year ending with that calculation going negative. They also enjoyed 4.2% average annual price appreciation and dividend‐yield‐enhanced total returns of 12.9% per year.
Still, it was clear that more could be done to enhance their abilities and reputation. For one thing, because REITs were pass‐through entities that relied on yields for most of their returns, many saw them as proxies for Treasury bills and public utilities. This led them to fall in and out of favor depending on how they held up comparatively speaking.
REITs were also hampered by their structure as passive flow‐through investments and the fact that they couldn't manage their own properties. Frankly, they remained too illiquid, too disorganized (in that they weren't focusing their efforts on certain property types and/or areas), and too difficult for the average investor to calculate. The way most publicly traded companies reported generally accepted accounting principles (GAAP) net income simply did not line up well with the intricacies of owning real estate.
This came to further light in the 1980s, when mortgage loans were coming complete with 12.5–14.8% interest rates, depressing their ability to grow. According to the Goldman Sachs January 1996 REIT Investment Summary, its equity REITs’ per‐share FFO growth fell from 26.1% at the turn of the decade to 4.4% in 1983. Higher rents and a continuing undersupply of new real estate did help balance things out though to produce an 8.7% average for overall FFO. And shareholder average annual total returns from 1980 through 1985 were a whopping 28.6%.
That's not to say they didn't have competition. Because they did, and lots of it, thanks to the Economic Recovery Act of 1981. That legislation allowed real estate owners to cite property depreciation as a tax write‐off. Just like that, both public and private investors wanted to get involved in real estate, putting a dollar in and deducting four off their tax liabilities. It was a win‐win for developers – who got money to develop – and investors, who got outsized returns. And so what if buildings were going up that might or might not be economically viable?
This is when groups like major brokerage firms first formed real estate limited partnerships, adding to the growing bubble. Unlike REITs, they (and private investors) didn't have to show positive cash flow. Therefore, they could outbid for properties without facing any negative short‐term side effects. This
