history
And Mythology
P A R T
C H A P T E R
REITs:
MYSTERIES
AND MYTHS
S O U R C E : B P T H E S A N S - P L A I N 5 / 1 2 S M A L L C A P S T R A C K 5 0
T
here’s no question about it: In spite of their growing
acceptance, there have been lingering mysteries and myths
that REITs haven’t been able to shake off. This chapter
addresses these misconceptions and lays the fading myths to rest
once and for all.
C H A N G I N G A T T I T U D E S
T O W A R D R E I T S
For many years, REITs were regarded as odd and uninteresting
investments. Even their unusual name—REIT—implied that the
standard criteria applicable to most investments didn’t apply to
them. Bruce Andrews, the former CEO of Nationwide Health
Properties, noted that the term trust, as in real estate investment
trust, implies that REITs are oddities, that they are not like normal
corporations whose shares are traded on the stock exchanges. One
of the main reasons that REIT stocks were suspect for so long is
that many people who traditionally invested in real estate didn’t
really understand—or trust—the stock market, while most people
who invested in the stock market were uncomfortable with, or had
little understanding of, real estate. REITs just didn’t fit into either
category and therefore fell between the cracks.
All this has finally changed. In October 2001, Standard & Poor’s
admitted the largest REIT, Equity Office Properties, with an equity

of capital spending by businesses, not the overbuilding that’s been
the main culprit in prior real estate cycles. Perhaps operating in a
fishbowl, as public REITs do, imposes substantial development dis
-
cipline, which even carries over to the private markets.
THE B IAS OF TRADI TIONAL R EAL E STATE IN VESTORS
Traditionally, most real estate investors have chosen to put their
money directly into property—apartment complexes, shopping
centers, malls, office buildings, or industrial properties—and not in
real estate securities like REITs. In other words, bricks and mortar,
not stock certificates. Direct ownership historically has provided the
opportunity to use substantial leverage, since lenders have tradi
-
tionally been willing to lend 60–80 percent of the purchase price of
a building. Leverage is a wonderful thing—when prices and rents
are going up.
Since the Great Depression, real estate values pursued a profit
-
able upward bias, notwithstanding a few potholes along the way.
Appreciation of 10 percent on a building bought with 25 percent
cash down would generate 40 percent in capital gains. In addition,
owning a building directly provided the investor with a tax shelter,
via depreciation expenses, for other operating income. As a result,
real estate continued to appreciate and provide easy profits, and
most real estate investors tended to focus on what they knew—
direct ownership.
Many individual real estate investors harbored a distrust for
public markets (REITs included), which they saw as roulette tables
where investors put themselves at the mercy of faceless managers—
or worse, speculators and day traders whose income depended

tors have complained that REITs, even though traditionally less
volatile than the broader stock market, nevertheless do fluctuate in
price. However, to be fair, any asset fluctuates in price. With illiquid
assets that were held, not traded (and by relying upon occasional
appraisals), the private-fund managers could maintain the illusion
that the values of their assets were “steady as a rock,” despite the
continuous ebb and flow of the real estate capital markets. Every
asset fluctuates in value, but owners are sometimes unaware of these
changing valuations until they try to sell the asset.
Finally, institutions buy and sell stocks in large blocks, and it’s
been only recently that REIT shares have had sufficient liquidity
to attract institutional investors. In fact, one of the most oft-quoted
reasons why pension funds have been reluctant to invest in REITs is
their lack of liquidity. The REIT market was so thinly traded prior
95
R E I T S : M Y S T E R I E S A N D M Y T H S
S O U R C E : B P T H E S A N S - P L A I N 5 / 1 2 S M A L L C A P S T R A C K 5 0
to 1993–94, when the size of the REIT market began to expand
geometrically, that it would have been extremely difficult for an
institution to accumulate even a modest position without disrupting
the market for any particular REIT stock.
THE B IAS OF COMMO N STO CK INVES TORS
What discouraged common stock investors from buying REITs? The
flip side of the coin is that REITs’ only business is real estate and
stock investors didn’t invest in real estate; they focused primarily
on product or service companies. Real estate was perceived as a dif
-
ferent asset class from common stock; this problem was particularly
acute in the institutional world.
REITs have also been perceived as real estate mutual funds, and

were devoted to REIT investments—and those did not advertise
widely. Many of those investors who did their own research and
made their own investment decisions quite likely felt that REITs
were too much of an unknown territory for them to venture into.
Even income investors, for whom REITs would have been particu
-
larly suitable, invested primarily in bonds, electric utilities, and
convertible preferred stocks.
REITs, of course, given their favorable investment characteris
-
tics, were bound to be noticed sooner or later. They are gradually
but inexorably becoming well known to real estate and common
stock investors alike, and REITs’ long period of being neglected is
now ancient history. Interest in REIT stocks will ebb and flow with
changes in investor fads and preferences, but they are now firmly
recognized as strong and stable investments that help to diversify a
broad-based investment portfolio.
T H E M Y T H S A B O U T R E I T S
In addition to—and sometimes because of—the other obstacles
REITs have had to overcome, some myths exist, myths that in the
past scared off all but the bravest investors. Although these myths
were based on misunderstandings of the investment characteristics
of REITs, they discouraged many would-be investors. Let’s confront
them, one by one.
M Y T H 1
REI TS ARE PACKAG ES OF RE AL PR OPERTIE S
This myth, which probably sprang from investors’ experience
with the ill-fated real estate partnerships of the late 1980s, may be
the single most significant reason for REITs’ failure in the past to
attract a substantial investor following. Although at one time REITs

savvy and highly motivated by their own ownership stake and other
equity incentives. They plan intelligently for expansion either in
areas they know well or in areas where they believe they can become
dominant players, and they frequently have access to the capital nec
-
essary for such expansion. They attempt to strengthen their rela
-
tionship with their tenants by offering innovative and cost-efficient
services. To categorize highly successful real estate companies, such
as AMB Property, Alexandria, Archstone-Smith, Avalon Bay, Boston
Properties, the “Equities,” General Growth, Kimco, Home, Macerich,

Reckson, SL Green, Simon, Taubman, Vornado, or Weingarten, to
cite just a few examples, as just collections of properties, or “mutual
funds of real estate,” is to underestimate them seriously. Yet this myth
still persists, even among some institutional investors.
M Y T H 2
REA L EST ATE IS A HIGH- RISK INVESTM ENT
It’s amazing how many people believe that real estate (other than
one’s own home, of course) is a high-risk investment through which
investors can be wiped out by tenant defaults or declines in prop
-
erty values. And, they surmise that if real estate investing is risky,
then REIT investing also must be risky. Let’s analyze risk here.
98
I N V E S T I N G I N R E I T S
S O U R C E : B P T H E S A N S - P L A I N 5 / 1 2 S M A L L C A P S T R A C K 5 0
Three essential determinants of real estate risk are leverage,
diversification, and quality of management (including the assets and
property locations chosen for ownership by such management).

WHEN ONE REIT encounters difficulty, investors sometimes rashly
conclude that REITs as an asset class are very risky. Yet no one would
condemn the entire stock market just because the price of one stock
had collapsed.
99
R E I T S : M Y S T E R I E S A N D M Y T H S
S O U R C E : B P T H E S A N S - P L A I N 5 / 1 2 S M A L L C A P S T R A C K 5 0
a similar apartment building in another location is doing well, or
that an office building upstate is raking in cash. Diversification
should be the mantra of every investor.
◆

Management quality.
Then, of course, there is the issue of man-
agement. Good management is crucial—but that is not only true
in real estate. If you look around at major U.S. non-REIT corpora
-
tions, you can see, for instance, the value of a Jack Welch to General
Electric, or how Bill Gates’s vision brought Microsoft to where it
is today. Incompetent management can ruin a major corporation
or a neighborhood candy store. Real estate, like all other types of
investments, cannot simply be bought and neglected; it requires
active, capable management. And good management teams are
able to select real estate for acquisition and ownership that is likely
to appreciate, not depreciate, over time. Despite this, many other
-
wise intelligent investors have bought apartment buildings, small
offices, or local shopping centers, often in poor locations, and tried
either to manage them themselves in their spare time or to give
control to local managers who have little incentive to run the prop

inflation can also increase operating expenses such as maintenance,
other management costs, insurance, and taxes and thus restrain a
property’s net operating income growth, which could negatively
affect its market value.
The value of a commercial building is determined essentially
by three principal factors: the net operating income the owner derives,
or is expected to derive, from the property; the multiple of that income
that the buyer is willing to pay for it (which, in turn, is based upon a
myriad of factors); and its replacement cost. And these factors fluctuate
in response to various market forces; the expected rate of inflation is
only one of those forces.
High inflation can positively or negatively affect rental rates and
net operating income. A positive influence resulting from inflation,
at least in the retail sector, can come from the higher tenant sales
that normally result from increased inflation and higher prices on
goods sold to consumers. Although these higher sales can translate
into higher rents for property owners, this benefit will be short-lived
if the retailers can’t maintain their profit margins. If stores are not
returning profits, it will be difficult for the owners to raise rents.
Similarly, higher inflation can help apartment owners by increas
-
ing tenants’ wages and thus their ability to afford higher rents, but
only if wages are rising at least as rapidly as the price of goods and
services.
When supply and demand are in balance, inflation may enable
owners to raise rents because, as the cost of land and new construc
-
tion rises, rents in new buildings will have to be high enough to
cover these higher costs. If the demand is sufficient to absorb the
new units that are coming into the market, owners of preexisting

asset, like oil and other commodities, they may be willing to pay a
higher multiple for every dollar of operating income if they per
-
ceive that accelerating inflation will lead to higher rents.
The counterargument is that cap rates may indeed be influenced
by inflation, but in reverse. Higher inflation will often drive up
interest rates, which in turn will increase the “hurdle rate of return”
demanded by investors in a property, and have the effect of increas
-
ing the required cap rate and thus decreasing the price at which the
property can be sold. Conversely, property values may rise even with
no inflation whatever, as interest rates decline in a zero-inflation
environment. Property values certainly increased in 2003–04 when
interest rates and inflation were at very low levels. Consider the fol
-
lowing example:
If the demand for apartment units in San Francisco exceeds the
available supply of such units, rents will increase and the apartment
building owner’s net operating income will increase. Thus, one
might think that the value of the apartment community would also
rise. However, if this demand for apartment space has been fueled
102
I N V E S T I N G I N R E I T S
S O U R C E : B P T H E S A N S - P L A I N 5 / 1 2 S M A L L C A P S T R A C K 5 0
by an over-heated economy, which brings on higher interest rates,
the cap rate applied by a potential buyer of the property to the net
operating income might also rise, perhaps even causing a loss in
value of the asset.
On the other hand, if the supply of apartment units in San


estate industry, property owners will be able to generate growth in
rental rates and operating income much in excess of the rate of
inflation, which is 2–3 percent annually. Some pockets of opportu
-
nity will always surface from time to time, but today most real estate
103
R E I T S : M Y S T E R I E S A N D M Y T H S
S O U R C E : B P T H E S A N S - P L A I N 5 / 1 2 S M A L L C A P S T R A C K 5 0
is in “strong hands,” and distressed sellers are scarce. Thus, the easy
money has been made here, too.
The rapid industrialization and intense competition occurring
today in North America, Europe, Asia, and Latin America seem to
be major and perhaps long-lasting phenomena. U.S. companies
must now go toe-to-toe with foreign competitors virtually every
-
where in the world. This, in turn, requires U.S. businesses to be
very cost-efficient. Downsizings, restructurings, outsourcing of jobs,
and layoffs have been the result. Companies are finding it difficult
to raise prices, and employees are finding it equally difficult to get
significantly higher wages. The bottom line for real estate investors
is that, as long as these competitive trends continue, and if excessive
supplies of new developments do not trash real estate prices and
create opportunities for bargain hunters, it will be difficult for them
to generate returns above long-term norms.
Nevertheless, if real estate investors can obtain initial investment
returns of 5–7 percent from property acquisitions and enjoy operat
-
ing income growth in line with inflation, REITs should remain very
solid investments—competitive with other asset classes. Furthermore,
many REITS may, at times, be able to take advantage of opportunities

-
tive and capable real estate organizations with access to capital.
Conversely, it can also happen that a great real estate market is
bad for REITs. For example, many REITs saw their profit growth
“hit the wall” in the mid-1980s, when real estate prices were sky
-
rocketing. Not only were properties simply not available at prices
that would provide acceptable returns, but owners were also facing
competition from new construction. Before anyone realized what
was happening, the cycle moved into the overbuilt phase and cash
flow growth slowed markedly.
As we’ll see in more detail later, REITs can grow their profits
both internally, through rising operating income, and externally,
through property acquisitions and new developments. Poor real
estate markets may create external growth opportunities if distressed
sellers are numerous, but it doesn’t always happen this way; there
were few distressed sellers during the last real estate recession, and
there were numerous buyers. One never knows how any particular
real estate or capital market cycle will play out, but the point here
is that strong REIT organizations with access to ample capital may
be able to take advantage of opportunities often created by tough
real estate markets. While cash flow growth would slow temporarily
in response to such difficult rental markets, these REITs’ ability, at
certain times, to buy sound properties at cheap prices enables them
to create substantial value for their shareholders.
The extent to which a well-managed REIT can avail itself of the
opportunities presented in a down market depends upon the amount
and cost of available capital, the depth of the market weakness, and the
extent of competition from other buyers.
Some of the best investment opportunities arise when a company

stocks that must be market-timed if one is to make any money in
them.
This mind-set is, I believe, one of the most dangerous myths of
all. It makes several assumptions, all of which are erroneous. These
include: (a) REIT stocks must be bought and sold at the right time
if one is to do well with them; (b) real estate and REIT stock prices,
market conditions, interest rates, and capital markets can be suc
-
cessfully anticipated and timed by astute investors; and (c) that the
reason for buying and selling REIT stocks is to score big wins and to
avoid equally large losses. Wrong, wrong, wrong!
First, REIT stocks needn’t be bought and sold frequently; indeed,
they are the ultimate “buy and hold” investment. Their total return
performance, averaged over many years, has been outstanding, and
certainly competitive with the broader equities markets. More than
50 percent of their returns to investors come from the dividend
yields, so investors get paid to wait for the additional reward of stock
106
I N V E S T I N G I N R E I T S
S O U R C E : B P T H E S A N S - P L A I N 5 / 1 2 S M A L L C A P S T R A C K 5 0
price appreciation that comes, over time, with earnings, dividend,
and net asset value growth.
Second, the most wealth has been created by investors who buy
and hold the stocks of excellent companies, for example, Warren
Buffett. There is little evidence that traders or market-timers have
been able to consistently make money in the stock market. And this
is certainly true in REIT world. To successfully time the purchase
and sale of REIT stocks, one must be able to forecast accurately the
direction of interest rates (both long-term and short-term), real
estate markets throughout the U.S., capital flows of both institu

tion, and quality of management (including the assets chosen for owner
-
ship by such management).
◆
Although real estate investments have often been highly leveraged, it is
the high leverage, rather than real estate itself, that is the major risk.
107
R E I T S : M Y S T E R I E S A N D M Y T H S
S O U R C E : B P T H E S A N S - P L A I N 5 / 1 2 S M A L L C A P S T R A C K 5 0
◆
Real estate as an investment can be hurt as much as helped by inflation.
◆
Market factors like supply and demand, interest rates, the existing and
future strength of the economy, and investors’ preferences and available
investment alternatives are almost always more important than inflation
in determining property value. REIT investors should focus more on market
conditions and management ability than on inflation.
◆
Even if the near-term outlook for real estate is not good, REITs with access
to capital will be able, at times, to grow their profits by taking advantage
of favorable acquisition opportunities.
◆
REIT stocks are not “trading vehicles,” and should be owned for dividend
yields and modest capital appreciation over long periods of time.