REITS 101 AN INTRODUCTION TO REAL ESTATE INVESTMENT TRUSTS
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REITS 101
AN INTRODUCTION
TO REAL ESTATE
INVESTMENT
TRUSTS
A Real Opportunity
While they have been around for over fifty years, real estate investment trusts
(REITs) have been slow to move into the mainstream. This was partially a
by-product of only a moderate number of REITs existing prior to the 1990s,
but also a result of REITs’ characteristics, which are different from stocks
and bonds and require specialized analysis. However, the low interest rate
environment that has prevailed since the global financial crisis has introduced a
new wave of investors to REITs. We believe a continuation of low rates, coupled
with the addition of REITs as a new GICS sector at the end of August (they
previously were a subgroup of financials), will likely result in continued growth
for the asset class.
In this paper, we provide an overview of REITs: what they are, their
characteristics, what drives their performance, how to value them, as
well as how to allocate to them within a diversified portfolio.2
What Is a REIT?
In simple terms, real estate investment trusts—or REITs—are investment vehicles that offer exposure
to real estate. They are corporate entities that own, operate, develop, manage, acquire, or finance real
estate. By filing as a REIT, a company avoids taxation at the corporate level in exchange for passing on
90% or greater of its taxable income to shareholders. This has historically resulted in significant and
reliable income streams for investors. While there are different types of REITs, this paper will address
those that are listed and publicly traded.
A REIT typically falls into one of two categories. Equity REITs, which make up approximately 90% of
REITs, generally own and operate real estate. Mortgage REITs lend to owners and operators or acquire
real estate-related debt or mortgage-backed securities.
Growth of an Asset Class
REITs were first established in the United States in 1960 as a means to provide retail investors access
to larger and more diversified portfolios of commercial real estate, similar to mutual funds. Originally
REITs, like mutual funds, were designed as passive investment vehicles. However, over time, reforms
were made to allow REITs to actively manage and operate their portfolios. At first, the REIT model
was slow to catch on, with just over 50 equity REITs formed from 1960 to 1990. However, due to the
savings and loans crisis and the closing of some tax loopholes, growth accelerated in the early 1990s,
with 113 equity REITs launched from 1991 to 1995 and total market cap expanding from $9 billion in
1991 to $50 billion in 1995.1
Today, US REITs have a market cap of $972 billion and own more the $1.8 trillion of commercial real
estate (including non-listed REITs) (Exhibit 1).2 There are 219 REITs in the FTSE/NAREIT All REIT Index
and 26 REITs in the S&P 500 Index. More than 193 trade on the New York Stock Exchange. In addition,
the average daily trading volume has nearly doubled over the past five years, from $3.3 billion in 2011 to
$6.0 billion in 2015.
Exhibit 1
Equity REIT Market Cap
($B)
1,200,000
800,000
400,000
0
2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
As of 30 June 2016
Source: NAREIT3
A Diverse Asset Class
REITs own and/or manage a variety of property types, or sectors, though the majority of US REITs
specialize in a specific sector such as office buildings, regional malls, or apartments. As the real
estate market has matured in the United States, specialty sectors such as data centers, timber, or
infrastructure have developed. Each sector has its own unique economic drivers and lease terms
(Exhibit 2), which can enhance diversification within portfolios. Due to the potential variance of
performance among different property sectors, the average spread between the best- and worst-
performing sectors over the last five years has been 40% (Exhibit 3). As such, it is critical to understand
how each sector is impacted by both economic and real estate cycles.
Exhibit 2
REIT Sectors' Different Economic Drivers and Lease Terms
Real Estate Market Cap % of US
Sector ($B) Listed Market Economic Drivers Key Tenants Lease Duration
Office 98.2 9.8 Corporate Profits, Business Corporations, Professional 5–10 yrs
Segment Growth, GDP Service Industries
Industrial 58.4 5.8 Consumer Spending, Logistics, Manufacturing, 3–5 yrs
Retail Sales Retailers
Regional 117.1 11.7 Disposable Income, Soft Good Retailers, 7–10 yrs (in-line)
Malls Consumer Sentiment Jewelry, Department Stores
Shopping 79.3 7.9 Consumer Spending, CPI, Grocery and Drug, 3–5 yrs (in-line)
Centers Population Local Necessity Retail
Single Tenant 37.7 3.8 Consumer Spending, Restaurants, Banks, 10–15 yrs
Retail CPI, Population Gas/Convenience
Multi-Family 113.4 11.3 Age Cohort Growth, 21–35 yrs and 65+ 9–12 months
Interest Rates Age Cohorts
Manufacturing 12.0 1.2 Interest Rates, Population, 55+ Age Cohort, Lower Various
Housing Age Cohort Growth Middle Class Families
Diversified 54.2 5.4 Various Various Various
Lodging 41.8 4.2 Business Spending, Business and Daily (consumer);
Disposable Income, Leisure Travel 10–15 yrs (management
Consumer Sentiment contract)
Health Care 104.9 10.5 Aging Population, 65+ Age Cohort 9–12 months (resident);
Government 10–15 yrs (management
contract)
Self Storage 66.4 6.6 Population Adults Monthly
Timber 27.3 2.7 Construction, Construction Industry Various
New Home Sales
Mortgage 55.9 5.3 Interest Rates, Health of the Real Estate Owners 3–10 yrsa
REITs Financial System
As of 30 June 2016
a Maturity duration
Note: Not every sector and subsector are represented.
Source: Lazard, NAREIT4
Exhibit 3
US REIT Sector Performance Is Diverse
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
Malls Net Lease Office Health Care Storage Malls Apartments Storage Industrial Hotels Apartments Storage
46% 51% 47% 2% 7% 75% 47% 36% 31% 28% 40% 41%
Net Lease Storage Health Care Net Lease Health Care Hotels Hotels Malls Malls Storage Malls Apartments
42% 27% 43% 2% -12% 64% 43% 21% 29% 9% 33% 16%
Retail Malls Storage Industrial Net Lease Net Lease Malls Apartments Net Lease Industrial Health Care Net Lease
37% 16% 42% 1% -19% 39% 39% 15% 28% 7% 33% 6%
Apartments Industrial Apartments Retail Apartments Office Net Lease Health Care Retail Office Storage Retail
34% 16% 38% -15% -26% 38% 36% 14% 25% 7% 31% 5%
Hotels Apartments US REITs Malls Retail Apartments Retail US REITs Health Care Retail US REITs Malls
33% 15% 36% -15% -35% 31% 30% 9% 20% 6% 28% 4%
Industrial Office Retail US REITs US REITs US REITs Storage Office Storage Net Lease Retail Industrial
33% 13% 35% -17% -38% 29% 29% 0% 18% 4% 28% 3%
US REITs US REITs Net Lease Office Office Health Care US REITs Retail US REITs US REITs Hotels US REITs
31% 12% 33% -20% -39% 25% 28% -2% 18% 2% 27% 3%
Storage Retail Hotels Hotels Malls Industrial Office Industrial Office Malls Office Office
30% 8% 28% -24% -60% 9% 19% -5% 13% 0% 26% 0%
Office Hotels Industrial Storage Hotels Storage Health Care Net Lease Hotels Apartments Industrial Health Care
24% 8% 26% -24% -60% 7% 19% -5% 13% -6% 21% -7%
Health Care Health Care Malls Apartments Industrial Retail Industrial Hotels Apartments Health Care Net Lease Hotels
21% 1% 24% 25% -67% 2% 19% -13% 7% -7% 10% -24%
% Difference between Best/Worst Sectors
25 50 23 27 73 73 28 49 24 35 30 65
As of 31 December 2015
The performance quoted represents past performance. Past performance is not a reliable indicator of future results. This information is for illustrative
purposes only and does not represent any product or strategy managed by Lazard.
Source: FTSE NAREIT All Equity Total Return Index
Why Own REITs? Exhibit 4
REITs Have Historically Outperformed
Stocks and Bonds
US REITs can offer investors attractive risk-adjusted
Annualized Returns (%)
returns, a potential source of income, diversification
benefits, and a hedge to inflation. BofA/
BofA/ Merrill
• Attractive Long-Term Returns: Since their inception, Merrill Lynch
US S&P Lynch High
REITs have historically outperformed stocks and Years REITs 500 Corporate Yield
bonds over every long-term time period except the 5 11.9 12.6 3.5 5.0
last five years, where they lagged by only 70 bps
(Exhibit 4). 10 7.4 7.3 4.5 7.0
15 11.1 5.0 5.0 7.6
• Strong Relative and Absolute Income: Due to the
25 12.1 9.8 6.2 9.0
underlying property leases and requirement that they
pass through 90% of their taxable income, REITs 30 10.7 10.4 6.8 8.3
have generated attractive and consistent income. 40 13.7 11.4 7.6 N/A
• Enhanced Diversification: Real estate has
historically had a low correlation to other asset As of 31 December 2015
classes (Exhibit 5). The performance quoted represents past
performance. Past performance is not a reliable
indicator of future results. This information is for
• Inflation Hedge: REIT dividends have historically illustrative purposes only and does not represent
any product or strategy managed by Lazard.
grown faster than inflation as stronger economic
Source: FTSE NAREIT All Equity Total Return REITs
growth increases the demand for real estate Index, S&P 500 Total Return Index
(Exhibit 6).5
Exhibit 5
Real Estate Has a Lower Correlation to Other REIT Correlations Decline over Long
Asset Classes Holding Periods
Correlation of Listed US Real Estate to Other Correlation of Returns on Publicly Traded Equity
US Asset Classes, 1997–2016 REITs to the S&P 500 Index
(%) (%)
60 60
40 40
20 20
0 0
-20 -20
S&P Nasdaq Barclays BofA US Treasury 12 36 60
500 Corp. Corp. Agg. Month Month Month
As of 31 January 2016 As of 31 January 2016
Correlations with financials may decline. For all periods from April 1995 through January 2016.
Source: FactSet Source: FactSet
Exhibit 6
REIT Dividend Growth Has Exceeded Inflation
Listed Equity REIT Dividend Growth vs. CPI, 2005–2015
(%)
70
REIT Dividend Growth
Consumer Price Index
35
0
-35
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
As of 31 December 2015
Source: Bloomberg6
Drivers of Performance
• Economic growth: Economic expansion is one of the primary drivers of commercial real estate,
typically increasing demand for space, rents, and ultimately growth in net operating income (NOI).
Resulting job creation and wage increases reverberate throughout all property sectors. Additional
office space is required to house new employees; warehouse and distribution space is needed to
address increased inventories; retailers, many with leases tied to a percentage of sales, pay higher
rents to landlords as consumers spend more; new households are formed, increasing demand for
apartments; and business and leisure travel accelerate, raising hotel occupancy and room rates.
• Demographics: Population change, immigration, migration patterns, and household income
are significant contributors to the growth, development, and consumption of real estate. Equally
important are the trends and preferences of large age cohorts. Millennials for example have put off
getting married, having children, and buying a house, which has fueled multi-family housing and urban
densification. As demand and space requirements change, buildings may be at risk of becoming
obsolete, and once-popular neighborhoods or destinations can experience a decline (Exhibit 7).
• Supply and demand: Excess demand and tight supply will favor landlords, whereas a prolonged,
favorable environment can lead to a glut of new construction and downward pressure on occupancy
and rents. A cycle of oversupply, equilibrium, and undersupply has historically been the norm for real
estate. However, the global financial crisis was unique for the slow pace of new development prior
to the crisis. Coupled with a near shutdown in new construction post-crisis, landlords have benefited
despite a less-than-robust economic recovery due to constrained supply.
Exhibit 7
Millennials Have Preferred to Rent over Buy
Share of under 35-Year-Old Households That Rent (%)
68
58
48
1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016
As of 30 June 2016
Source: US Census Bureau7 Valuing REITs While REITs share a number of valuation metrics with equities such as multiples, growth, and yields, other metrics are particular to real estate: • Funds from Operations (FFO): Like most companies, REIT net income is reduced by depreciation expenses. However, unlike assets such as equipment, property generally appreciates. As a result, FFO adds back certain real estate–related deprecation expenses and is akin to EPS for equities. • Adjusted Funds from Operations (AFFO) or Cash Available for Distribution (CAD): As FFO can overstate income, certain items like recurring expenses (e.g., tenant improvements, leasing expenses) and capital expenditures are subtracted and rent increases are included. • P/FFO: Price to FFO can be thought of as a price to earnings (P/E) equivalent used to calculate relative value. However, as a result of different property sectors and individual companies having different ranges, the metric is better suited to top-down analysis. While some third-party research firms may provide P/Es on REITs, they treat depreciation as an expense, resulting in significantly higher ratios than P/FFO. • Net Asset Value (NAV): NAV is one of the most important valuation metrics because the value of a REIT is mainly derived by the assets it owns. This is also why NAV doesn’t apply to companies that don’t own hard assets. Determining NAV requires calculating a REIT’s 12-month projected net operating income (NOI) and dividing by an appropriate cap rate. This results in an estimated value of a REIT’s properties. After including additional income sources, cash, and land and subtracting liabilities, we arrive at the NAV. • Capitalization Rates: Capitalization rates (cap rates) represent the rate of return, or yield, based on the income that a property is expected to generate in its first year. It is calculated by dividing the property’s projected 12-month net operating income (NOI) and dividing by the current market value of the asset. The lower the cap rate, the higher the multiple on the asset. • Dividend Yield: Due to the significant contribution to a REIT’s total return (on average around 60%), comparing yields among REITs as well as bonds (the 10-year Treasury and corporate bonds being most relevant) can provide investors as useful relative valuation tool. Not every property or portfolio is created equal and, as a result, qualitative factors should be accounted for when valuing real estate. These factors include portfolio quality and location, development pipeline, pending acquisitions, lease term and structure, and management quality. Investing in REITs What allocation should REITs have in a portfolio? We believe REITs offer a hybrid of equity and bond characteristics, along with some distinct features of their own. Some have viewed real estate as akin to equities due to their strong total returns and volatility. Others equate REITs to bonds due to their high yields. In reality, real estate is a distinct asset class warranting a separate allocation within an investor’s portfolio, depending on one’s investment goals and risk tolerance. An appropriate allocation to real estate can improve a portfolio’s potential to generate higher returns at lower volatility. Institutional investors have historically allocated strategically to real estate and at higher levels than other investors. Generally this is a result of better understanding the asset classes’ characteristics by employing dedicated analysts. While US institutions who choose to invest in real estate generally allocate between 7%–10% of their portfolios to commercial real estate today, others have held significantly higher levels.
REITs: A Real Opportunity
While some may consider REITs to be similar to either stocks or bonds, what makes them a distinct asset class is
their differentiated source of returns. Through the contractual lease obligation of the tenant to the landlord (REIT), a
stable income stream is generated. And through occupancy growth, rent growth, or redevelopment of properties,
REITs have the ability to grow their income stream. So, whether through attractive potential total returns, stable
and significant income, enhanced diversification, or a hedge against inflation, we believe REITs can serve most
investors’ objectives. Up until recently, listed real estate has not enjoyed the same wide-scale adoption as stocks
or bonds. But through organic growth, strong results, and industry changes that formalize REITs as a separate
asset class, that will likely change. As a result, investors who haven’t previously invested in real estate would be
well served by taking a more in-depth look at the asset class.
Notes
1 Source: NAREIT, ULI
2 As of 29 April 2016
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Published on 22 August 2017.
This document reflects the views of Lazard Asset Management LLC or its affiliates (“Lazard”) based upon information believed to be reliable as of 23 August 2016. There is no
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