Real estate investment trusts (REITs) were originally developed to overcome difficulties that small investors encountered when putting money into commercial real estate properties. But that simple concept launched in 1960 has evolved greatly, leading REITs to become much more active and powerful than initially envisioned. In fact, today's REITs dominate many commercial property markets.

Before REITs, individuals and financial institutions faced major obstacles to investing in commercial real estate. The best commercial properties were large and costly, far beyond the reach of most individuals. Also, owning one or just a few like-kind properties focused the investor's prospects on a narrow part of the market, greatly increasing risk.

REITs helped overcome a potential liquidity problem for investors. The traditional strategy for property ownership had been simple. Owners borrowed most of the capital needed to acquire a property, and then waited for inflation to increase the property's market value, thereby expanding the investor's initial equity. Then the investor would sell or refinance, extracting much larger equity than originally supplied.

But during cyclical downturns, cash flows often fell below the debt service because of heavy borrowing. That caused high bankruptcy rates in adverse parts of the cycle, such as in 1974 and 1990. Furthermore, commercial properties are hard to sell — it may take months or years to finish a transaction at a reasonable price. Hence direct ownership in such properties is extremely illiquid.

REITs helped solve the liquidity problem. By selling many shares into these trusts, REITs made it possible for even small-scale investors to enter into commercial property ownership. What's more, by pooling many properties into a single trust, investors could diversify their risk. Also, selling shares to many investors of all sizes enabled REITs to amass the large amounts of capital necessary to buy and hold many costly properties.

Entrepreneurial Organizations

To encourage the emergence of REITs, these trusts were made free from income taxation at the enterprise level. But if they could retain all their cash flows, they could indefinitely expand with tax-free capital. As a result, they were required to distribute 90 percent of their net taxable income to their shareholders annually. This was to prevent the traditional strategy of holding onto properties and refinancing them, amassing ever more capital from recurring cash flows and expanding the trust's portfolio. Thus, compulsory distribution of most earnings was consistent with the idea that a trust was a passive instrument for the management of large amounts of initially acquired wealth.

But REITs have evolved into much more aggressive entrepreneurial organizations since their early years. Many have been able to generate huge internal, tax-free cash flows they do not distribute to their shareholders. Owners of real properties can deduct depreciation from taxable earnings, which permits REITs to hold back a significant amount of their cash flows from the earnings they must distribute annually. That tax-sheltered cash can be used to buy more properties, develop new ones or renovate existing properties, thereby adding to shareholders' investment value. Also, consolidation of small REITs into very large ones has increased the absolute size of such undistributed cash flows. So, the largest REITs can buy or develop even the biggest properties.

In addition, REITs can borrow money and leverage their tax-free equity cash flows, even though investor pressure has kept REIT leverage ratios to between 50 percent and 70 percent, far less than the 80 percent to 100 percent used by traditional developers. And many REITs have entered into joint ventures with financial institutions, further increasing their access to equity capital.

However, the most important evolution has been in the attitude of REIT managers. They long ago abandoned passivity and became aggressive entrepreneurs seeking to maximize the values of their entire portfolios. This enables the best REIT managers to achieve faster overall growth rates in earnings than would occur if, like many purely financial trusts, they acted as stewards protecting collections of individual assets.

A Hybrid Status

Does this mean the best REITs are really growth stocks rather than value stocks? That is what they would like investors to believe, and it can be at least partially true. But the ability of any REIT to grow consistently faster than the overall economy is limited by two factors.

The cyclical nature of all real property markets makes steady earnings expansion over long periods difficult. Also, most types of commercial real estate are in mature industries not likely to grow faster than the economy. Even so, the best REIT managers have been able to achieve a hybrid status between value and growth stocks.

MONEY AND REAL ESTATE

ANTHONY DOWNS is a senior fellow at the Brookings Institution in Washington, D.C. He can be reached at anthonydowns@csi.com.