Portfolio manager Greg Kuhl provides an overview of how REITs have evolved since first created sixty years ago to being an asset class very much relevant today and beyond.
- The first REIT was established in the US in 1960 as a means for individual investors to access the benefits of commercial real estate ownership.
- Since then, REITs have evolved to become companies with formidable scale, operational excellence and continuous access to capital, with the potential to offer investors a new level of compounding growth.
Although it may not seem like it, listed real estate investment trusts (REITs), as we know them today, form a relatively young asset class that is still gaining acceptance with investors. In this and a series of posts to follow, focusing on US REITs being the largest and most established property market, we discuss the development of the asset class and, more importantly, what may be in store for its future.
To start, a brief review of REIT history is helpful. We have condensed this into three distinct periods, which we refer to as REITs 1.0, REITs 2.0, and REITs 3.0.
REITs: a brief history
Source: Janus Henderson Investors, National Association of Real Estate Investment Trusts (NAREIT) as at 30 September 2021.
REITs 1.0: 1960-1990
US REIT Rules were established in 1960 to allow individual investors access to the benefits of commercial real estate ownership. REITs brought liquidity1 to a previously illiquid asset class by being tradeable on stock exchanges, while offering tax efficiency2 and exposure to high-quality property for investors. The first REIT listed on the New York Stock Exchange (NYSE) in 1965. Most early REITs invested in commercial mortgages rather than in the ownership of buildings. They were typically run with high levels of financial leverage3 and ‘externally managed’, meaning their executives were not employees of the REIT and instead collected a management fee for allocating the REITs capital (a relationship fraught with conflicts of interest that generally does not exist in US-listed REITs today). In many ways, several of these early vehicles were more akin to banks or specialised lenders than actual owners of real estate.
REITs 2.0: 1991 – 2015
The 1991 initial public offering (IPO) of Kimco Realty Corporation (KIM), a shopping center REIT, is widely regarded as the first successful IPO, heralding the start of the ‘modern REIT era.’ Also, in 1991, the US REIT industry trade body – National Association of Real Estate Investment Trusts (NAREIT), defined Funds from Operations (FFO)4, which would become the primary cash flow metric reported by all listed REITs. FFO is widely recognised as a more accurate proxy for cash flows than earnings per share (EPS)5 derived from Generally Accepted Accounting Principles (GAAP)6 and likely helped lead to greater investor understanding of the real estate business. The 1990s saw the issuance of more than 150 REIT IPOs, taking the market capitalisation7 of the sector in the US from $16bn in 1992 to $138bn by the end of the decade. Many of these new listings consisted of private family-controlled real estate portfolios of relatively small breadth and scale, operating with high leverage.
The asset class continued to grow in scale and breadth while REIT regulations were further clarified and expanded during the latter half of the REITs 2.0 period. The Global Financial Crisis (GFC) dealt a major blow to many listed REITs that had been operating with high levels of financial leverage and poorly laddered debt8 maturity structures (weak risk management), though the vast majority survived after being refinanced with huge stock offerings at the expense of highly diluted shareholder equity. This post-GFC recapitalisation was a major turning point for the sector as it helped shape the capital structure deemed appropriate for a listed REIT. Today’s REITs typically operate with a much higher proportion of equity to debt than they used to pre-GFC, with much greater attention paid to the cadence of future debt maturities.
REITS 3.0: 2016 – present
In 2016, US REITs surpassed $1 trillion in market capitalisation and real estate was added as the 11th sector within the Global Industry Classification Standard (GICS)9. Until this point, real estate, including REITs were classified within the GICS financials sector along with banks and insurance companies. Importantly, the newly distinct sector significantly raised the profile of the asset class among investors and signaled its emergence as a more meaningful component of public markets.
Today the listed REIT industry features a vastly expanded array of property types, having evolved beyond the traditional core sectors such as retail, office, industrial and residential; increasingly investing in more diverse, non-core or emerging and growth-oriented sectors such as cell towers, data centres, self-storage and laboratory space. REITs now own and control market-leading portfolios, and benefit from powerful secular tailwinds such as e-commerce, cloud computing, 5G and changing demographics.
REITs: a dynamic and evolving asset class
Source: NAREIT, FTSE, Janus Henderson Investors, as at 30 June 2021. The FTSE NAREIT All Equity REITs Index is a free-float adjusted, market capitalisation-weighted index of US equity REITs. Constituents of the index include all tax-qualified REITs with more than 50 percent of total assets in qualifying real estate assets other than mortgages secured by real property.
Many REIT companies possess formidable scale, are conservatively capitalised and highly sophisticated at accessing and deploying capital opportunistically. These large‑scale, operationally excellent companies, with continuous access to permanent capital, have the tools to potentially offer a new level of compounding growth to investors.
In our next post, we discuss the concept of ‘REITS 3.0: flywheel of value creation,’ and how its various drivers are working in tandem to provide the tools to drive the long-term outperformance of REITs.
1Liquidity: the ability to buy or sell a particular security or asset in the market. Assets that can be easily traded in the market (without causing a major price move) are referred to as ‘liquid’.
2REITs are considered to be tax efficient because in exchange for distributing approximately 90% or more of taxable income to shareholders, REITs gain tax-exempt status at the corporate level.
3Financial leverage: the use of borrowing to increase exposure to an asset/market. This can be done by borrowing cash and using it to buy an asset or by using financial instruments such as derivatives to simulate the effect of borrowing for further investment in assets
4FFO: Funds from Operations is a more accurate measure of REITs cash flow since it takes into account the depreciation expense, and therefore the ability for a REIT to maintain its dividends. Generally, FFO is calculated by taking the REIT's earnings and adding back the depreciation and amortisation of mortgages.
5Earnings per share (EPS): the portion of a company’s profit attributable to each share in the company. It is one of the most popular ways for investors to assess a company’s profitability. It is calculated by dividing profits (after tax) by the number of shares held.
6Generally Accepted Accounting Principles (GAAP): a common set of accounting principles, standards, and procedures. Publicly-listed companies must follow GAAP principles in their financial statements.
7Market capitalisation: the total market value of a company’s issued shares. It is calculated by multiplying the number of shares in issue by the current price of the shares. The figure is used to determine a company’s size, and is often abbreviated to ‘market cap’.
8Laddered debt: a portfolio of several smaller bonds with varying dates of maturity rather than one large bond with a single maturity date. The aim is to minimise interest rate risk, increase liquidity and diversify credit risk.
9GICS or Global Industry Classification Standard: widely used by investors, analysts and economists to define sectors of the public markets and classify companies into these sectors.