My Assessment Of The Current REIT Landscape

I like real estate investment trusts, provided that they are invested in some kind of tax-advantaged vehicle. This is because the cash payouts from REIT investments often comprises half or more of your total return, and the attractiveness of the investment relies upon letting the dividends reinvest undisturbed. Because the U.S. Congress decided in the early 1990s to exempt REITs from taxation at the trust level, any dividend paid out can be taxed at the maximum 39.6% rate rather than the maximum 23.8% rate that you see with qualified dividends from traditional corporations.

In a taxable account, taxation on dividends can eat up a quarter of your total returns. That creates a high hurdle–any REIT investment contemplated in a taxable account would have to be extremely attractive compared to your best idea among c-corporations.

Take something like Public Storage. I would love nothing more than to stuff a giant block of stock somewhere and let it compound for decades. It is, in my opinion, the most stable cash generator of all real estate investments that are available to the public at large.

Recessions pose no obstacle to its cash-generating ability–Its funds from operations grew from $4.74 on the eve of the 2008 recession to $5.03 during the low point of it. The dividend held steady at $2.20 per share. When you downsize, you need storage in the interim. When you upsize, you need storage in the interim. When a business goes bankrupt, it needs storage. When it is expanding, it uses storage. Units to store stuff get used whether the general economy waxes or wanes.

But yet, there are two obstacles that need to be overcome when establishing an ownership position.

The first is that you have to pay attention to the asset allocation, as noted above. If someone used a tax shelter to house $10,000 worth of PSA shares in 1980, the net wealth today would be $650,000 for an annual compounding rate of 12.2%. If a high-income earner put those some shares in a taxable account, the compounding rate drops to 9.1%. The same 36 years of compounding only got you $291,000. I know talking about the tax side is boring as heck, but I mean, look at that difference. The differences are so extreme you have to eat your broccoli and self-teach yourself the basics of the tax code.

The second obstacle is valuation. People are saying there has been a dip and REITs are starting to look good. That is not my view. While they are not as pricey as they were last year, REIT investments still have to burn off some overvaluation.

Public Storage trades at $215 per share right now. Even though it has come down from a recent high of $277, it is still trading at a valuation of 22x funds from operations. For most of its history–basically all of its history except for the past few years–you could buy shares at a valuation of 18x funds from operations or cheaper. That suggests the stock needs to come down from $215 to $175 for it to reach fair value based on current earnings.

As long as current tax laws persist, you will always need to pay attention to the location of your holdings. There is a substantial wealth differential for the REIT investor that owns the stock in a tax-deferred account compared to one that does not have tax protection available. Under the current rules, this will remain the case. And you must pay attention to the valuation. REITs tend to grow at 5-8% annually and are supposed to pay out big dividends. All sorts of high-quality REITs have characteristics similar to Public Storage–the valuation remains 15-20% higher than you’d like to see. We still have a ways to go before the landscape become broadly attractive for new REIT investments.