REITs as an investment tool for family businesses

REIT stocks can offer family business owners a low-risk investment opportunity – an attractive alternative to direct ownership of real estate where the investor still gains stability and diversification benefits combined with quality professional management

This article is intended to provide background for family business owners considering an investment in a real estate investment trust (REIT stocks). Before making any investment or sale decision you should consult with your financial and legal advisors.

Why consider investing in a REIT?
REITs are well-established financial vehicles in the US that allow pooling of investors' funds for participation in real estate ownership. They are a bit like mutual funds that hold real estate, or real estate mortgages, rather than securities. REITs can provide an attractive alternative to direct ownership of real estate, offering the stability and diversification benefits of real estate ownership with quality professional management. Investors can select among broad, national REITs or specialist REITs focused on a particular type of property (eg office, residential or industrial) or geographic region, including non-US properties. There are close to 200 REITs, many of which trade on major US and international markets, making them readily available to European investors.

For the second consecutive year, REIT stocks outperformed other equities with one popular index of REIT stocks posting a return of over 15% in 2001. REITs have also demonstrated historically low price volatility and a low correlation with equity stocks. As a result, REIT stocks may help investors increase their longterm risk-adjusted returns.

In addition, the bursting of the tech stock bubble helped launch a renewed appreciation of investments with predictable cash-flows and high dividends – two important characteristics of REIT stocks. Indeed, REITs are required by US tax law to distribute annually at least 90% of their taxable income.

Background
REITs were originally authorised by the United States Congress in 1960 to 'democratise' property ownership by creating a way for small investors to realise the financial benefits of real estate investments. These had largely been enjoyed only by wealthy investors or institutions investing directly or through limited partnerships. In practice, these newly authorised investments were similar to the limited partnership interests used for many years to pool investor funds for investments in diversified portfolios of real estate assets. Both REITs and limited partnerships generally:

- pay out cash flows and sale proceeds directly to their investors;
- preserve their investors'limited liability;
- are not subject to US tax if the entity complies with certain provisions of the US tax code; and REIT stocks can offer family business owners a low-risk
- provide professional real estate management expertise.

However, as more REIT stocks have become publicly traded, the free transferability and liquidity of these securities present a huge advantage over limited partnerships, which typically can only be transferred with the approval of the general partner. Moreover, the minimum investments in REIT stocks are usually much smaller than limited partnership requirements and, unlike limited partners, REIT stockholders are not required to file special tax forms relating to their investment. REITs can also provide greater management accountability as their directors are, in most cases, elected annually at shareholder meetings.

The dodgy past
For all of their potential, REITs were not immediately popular. During most of the 1960s, there was little analyst coverage and few REIT stocks were traded. The REIT industry experienced higher growth in the early 1970s with the emergence of mortgage REITs, which held pools of real estate mortgages rather than real property. However, the construction cycle that fuelled this trend ended with the high interest rates of the 1970s and REIT stocks plummeted from view.

Although property prices recovered and rose strongly in the early 1980s, limited partnerships were the favoured vehicle for real estate investment. Unlike REITs, limited partnerships could pass through to investors their losses as well as gains, and investors could use the partnership losses to lower their taxable incomes. The US Tax Reform Act of 1986 put an end to these practices and the resulting decrease in demand for real estate investments hastened the collapse of real property prices in the late 1980s.

REITs were generally unharmed by the 1986 tax reform because their valuations are traditionally based on income streams from properties rather than with regard to tax incentives. In the early 1990s, following the perceived bottoming out of the commercial and residential real estate markets, a series of large REITs went public. These entities began to receive attention for their renewed ability to raise capital in the equity markets.

The end of history?
Although the property markets will almost certainly continue to experience cycles related to general economic conditions, there is some sentiment that property markets have become inherently more stable.

The property market has also become increasingly transparent as more public company REITs emerged, which are subject to the reporting requirements of the US Securities and Exchange Commission. This has enabled both public and private investors to better assess supply and demand in the real estate market.

Furthermore, the current generation of REITs are generally much stronger than their predecessors. Today's REIT market is dominated by high quality equity REITS, which are typically selfadministered and have fully integrated real estate management operations. REITs today also typically finance their properties with far less debt than their predecessors. According to the National Association of Real Estate Investment Trusts (NAREIT), the average debt ratio (total debt divided by the sum of debt plus common equity market capitalisation) of REITs has not risen much above 50% in recent years, even when REIT stock prices declined in 1998 and 1999.

What's next?
Although REITS have benefited from the back-to-basics mood of Wall Street, the recent terrorist attacks in New York have raised questions about the ability of REITs to protect their commercial assets. According to NAREIT's Composite Index, REIT shares fell in October 2001, with industrial office REITs particularly hard hit. NAREIT has publicly expressed its concern over the availability of insurance against terrorist attacks. Insurance industry executives have testified before the US Congress that insurance policies issued after the September attacks will likely exclude both terrorism and acts of war. Congress is currently debating legislation to ensure that insurance against terrorist acts will be available in the future.

A more positive development has been the effectiveness in 2001 of the REIT Modernization Act, which gives REITs new opportunities to increase their funds from operations (FFO). The Act was based upon growing recognition that the real estate industry has evolved into a more customer-oriented service business. It therefore removes longstanding limitations on the services that REITs could provide, allowing them to invest up to 20% of their assets in taxable subsidiaries that provide services which were previously prohibited. As examples of newly authorised services, office REITs will be able to provide internet and highbandwidth services to tenants, and residential REITs can provide digital television services to tenants.

NAREIT has recently joined the European Public Real Estate Association (EPRA), an Amsterdam-based association promoting the European quoted real estate sector, to establish a global real estate index. The index combines NAREIT's existing Real-Time index and EPRA's European Index, and initially consists of approximately 250 companies in 21 countries in North America, Europe and Aisa.

Conclusion
Family business owners tend to have special wealth management requirements. As much of their wealth can often be tied up in their own businesses, family business owners may be particularly sensitive to additional investment risk in their portfolios and may benefit from cash-generative investments. REIT stocks can offer family business owners a relatively stable investment and the diversification benefits of adding property to their portfolios, but without the management and liquidity problems associated with a direct investment in real estate. In addition, because REITs pay at least 90% of their taxable income each year, these stocks can offer family business owners a steady stream of investment income.