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What Are Real Estate Investment Trusts (REITS)?

Kevin Grogan explains the origin of Real Estate Investment Trusts and what role they can play in diversifying your portfolio.

Transcript

Tim Maurer:
Hello, I’m Tim Maurer. We’re back with another episode of Ask Buckingham, a video podcast designed to bring clarity in the midst of confusion by connecting your great personal finance questions with straightforward answers from industry thought leaders.

Tim Maurer:
Today’s question will be answered by Kevin Grogan, Managing Director of Investment Strategy for Buckingham Wealth Partners. And Kevin, I’d like to talk about real estate investment trusts. What are they and how do they work?

Kevin Grogan:
Real estate investment trusts are essentially a vehicle that allow individual investors or just smaller investors in general to invest in real estate. And they actually go back quite a ways. They were first provided for in legislation back in the Eisenhower Administration. So going back about 60 years now was when that was first allowed for in the law, which allowed smaller investors to pool their money together to invest in real estate through a great legal tax structure.

Kevin Grogan:
And there are actually lots of different ways that you can invest in real estate investment trusts and what those trusts are, are essentially groups of investors who form an entity to buy real estate and/or manage real estate. It could be one or the other or both. So it could take multiple different forms, but most often they’re formed as a publicly traded company. And so any individual investor can buy one of those individual real estate investment trusts.

Kevin Grogan:
Or the way we recommend accessing that marketplace is using a fund that purchases the entire marketplace of real estate investment trusts. So you’re getting broadly diversified exposure to owning all of the real estate investment trusts, as opposed to just picking a handful of them. And so that’s sort of the public side of that market and there’s also a private side of the market.

Kevin Grogan:
So there can also be real estate investment trusts that aren’t publicly traded that are formed via a limited partnership type of structure, where you can own a private vehicle that might have liquidity lockups, and generally will have higher fees than the publicly traded counterparts. But that’s a whole other aspect of the market that we tend not to recommend as much, again, because of those higher fees and limited liquidity. But there are lots of different avenues where you can access the real estate market.

Tim Maurer:
So Kevin, let’s talk a little bit more about what could be inside of these real estate investment trusts or REITs as they’re often called. What if, for example, I’ve got a REIT that has a bunch of shopping mall exposure to it. That is that something that could be possible? And if so, should I be concerned right now when we see the impact of COVID-19 on so many shopping malls?

Kevin Grogan:
It would be a concern if you owned a real estate investment trust that only invested in shopping malls. And certainly there are some REITs that aren’t as diversified. Some might specialize in particular areas like commercial real estate retail. Some might focus in on office space, some might focus in on industrial. And so certainly we received a good bit of questions as the COVID pandemic began about should we get out of real estate?

Kevin Grogan:
But one thing for investors to realize is that real estate got hit very, very quickly as the pandemic started. In fact, earlier than the rest of the stock market did earlier this year. So it was already reflected in prices before you could make those decisions and kind of figure out exactly what was going to happen as a result of the pandemic. And then another aspect that I think is somewhat underrated about real estate is that there are huge components of the REIT market that have nothing to do with office space and that have nothing to do with retail space.

Kevin Grogan:
So a huge fraction of that marketplace is in data centers. So places where you’re storing mainframe computers and other technology, which arguably would do better in this environment than other types of investments. Another aspect of it are cell phone towers. We don’t think of those as real estate, but they are critical infrastructure for how the economy functions.

Kevin Grogan:
And again, you could argue that those types of real estate investments perspectively could do better moving forward. So it’s not as simple to say just see people not going shopping and working from home and saying real estate is doomed. Certainly some aspects of real estate are likely to be challenged moving forward, but other aspects could do well coming out of this.

Tim Maurer:
Yeah. All right. Well, so having talked about some of the components that tend to be inside, some of the details about REITs. Let’s talk about the bigger picture for a second as it relates to real estate investing in general. Do you think for someone who owns a home, they can or should have exposure to real estate more broadly in their investment portfolio if they already have some real estate of their own in the form of their home?

Kevin Grogan:
I do. And so the main reason there is that your home is not a diversified investment. It’s exposed to one city or one neighborhood. And so it’s a very heavily concentrated investment in real estates. So you’d want to build around that with a more broadly diversified basket of REITs, not just even in the US, but also outside of the US.

Kevin Grogan:
So that I think, alone, argues for an additional allocation to real estate. Now I also think of it as analogous to someone who owns a restaurant doesn’t mean you should exclude all restaurant stocks from your portfolio. It’s a similar kind of concept that you want to have in more broadly diversified exposure to that asset class than just one single investment.

Tim Maurer:
Okay. So then if we are going to dedicate some of our investment portfolio to real estate, can you give us an idea about a general percentage that could make sense for the typical homeowner who’s looking to include a diversified real estate holding in their portfolio?

Kevin Grogan:
Yes. So if you looked at world market capitalization, which is kind of where we start. Now real estate, publicly traded real estate represents about 5% or so of the world equity markets. So if you had kind of a 60% stock allocation that might argue for say two and a half, 3% allocation to real estate. So basically just keeping it roughly in line with market cap weights.

Kevin Grogan:
Now, of course, one aspect of this is that we all know that … so let’s say publicly traded real estate represents 5% of the world market. Real estate is a huge aspect of how the world allocates capital, but unfortunately, a lot of that isn’t publicly traded so you don’t have access to it. But with that said, we still think kind of roughly matching world market caps can make sense and that should be your starting point.

Kevin Grogan:
But we don’t in general recommend excluding it altogether from a clients’ portfolio. So it typically does make sense to include it as part of the portfolio, either as a standalone investment or as part of a fund that you hold that would include real estate.

Tim Maurer:
Yeah. And then coming back full circle to where we started this conversation specifically about REITs, am I hearing you correctly that while it does make sense for your average investor to have some exposure to a broadly diversified real estate portfolio inside of their investment holdings,

Tim Maurer:
It sounds to me like you’re not recommending individual REITs as the best way to do that, that you’d rather see a fund that includes a diversified spread of these REITs across the industry?

Kevin Grogan:
Exactly right. I don’t want to own one REIT because of the question you raised earlier. Who knows what will happen with any one property manager or any one portfolio REIT. I just want to own all of the REITs. So that way, if any one winds up getting hit, then I’m diversified and I won’t have that exposure to any one REIT falling down or experiencing kind of a drawdown in returns.

Kevin Grogan:
And it’s the same concept as individual stocks is that you don’t know where the next Enron or Lehman Brothers is going to be, but if you own everything, then nothing is a huge percentage of your portfolio. And I think that’s really the key with real estate investing just as it is with stock investing.

Tim Maurer:
Plus then I guess I assume it also is going to aid you in terms of better understanding what the expense ratio is for that particular holding and having more liquidity exposure, as opposed to privately held REITs where it can be very expensive and challenge liquidity.

Kevin Grogan:
So Private REITs have a few different issues associated with them. So there’s a liquidity issue, generally higher fees and then the aspect I didn’t mention earlier is the lack of transparency. So sometimes it can be difficult to even ascertain what the total fees are and also where the conflicts of interest are. And so that’s another aspect of private real estate is that you don’t know if the manager of your private REIT is then hiring another company that they also manage to manage the REIT.

Kevin Grogan:
And so how does that work from a fee structure and making sure that your interests are being kept in mind throughout all of these transactions, particularly if there are related parties? Now, to be fair, all of this is disclosed in the prospectus, but prospectuses aren’t known for their use of ability to understand or process. They’re normally 100s of pages, but that is another potential issue with private real estate. It’s really understanding the conflicts of interest and the related party transactions and those sorts of things.

Tim Maurer:
Now, Kevin, I’m glad that folks like you are reading those prospectuses. Because for me, I think it’s just good reading if you’re having trouble falling asleep.

Kevin Grogan:
Absolutely, it doesn’t hurt.

Tim Maurer:
Thank you, Kevin Grogan And thank you for tuning into this episode of Ask Buckingham. If you have a question that you’d like to see us address, you can do so by navigating to the website, askbuckingham.com or by emailing your question to question@askbuckingham.com or just click in the corner of your screen. It’ll take you directly to the website where you can ask your question.

Tim Maurer:
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