In the light of recent increased appetite for REITs in the GCC region, it is worth taking a step back to understand what REITs are and how investors can classify them in their asset allocation efforts. In a recent survey conducted by CFA Society Emirates, respondents indicated that a general lack of understanding, along with a regulatory environment perceived to be weak, are the biggest challenges for the growth of REITs in the Middle East.
By definition, a REIT, or Real Estate Investment Trust, is a company that owns and, in most cases, operates income-producing real estate such as apartments, office buildings, warehouses, shopping centres, regional malls, and/or hotels. REITs were initially formed in the 1960s in the United States as a way for small investors to obtain ownership in commercial real estate without the barriers to entry associated with traditional property ownership; mainly large price tags and illiquidity. Therefore, REITs are designed to allow investors to gain exposure to a portfolio of real estate assets by simply owning equity shares of a REIT.
Many of these companies are fully integrated organisations, which engage in the acquisition, development and management of commercial real estate for their own account. Most REIT property portfolios are concentrated in a specific sector which is referred to as their core portfolio. The management of most developed REITs follows an active owner-and-operator model rather than simply owning the assets.
Transparent investment vehicle
REITs grow internally through occupancy, rent increases or redevelopment of existing properties and also grow externally through accretive acquisitions and ground-up development. It is recommended to have a management team of experienced professionals that offer investors a unique investment opportunity in a liquid and transparent investment vehicle.
From a portfolio construction point of view, REITs are typically attractive to investors seeking consistent, regular income and long-term growth. Commercial real estate, in particular, can be viewed by investors as an asset with potential to provide strong and stable income flows. The stability of the income flow can be derived from the multi-year term of most leases while the strength can be generated from the contractual nature of the lease structure through which tenants gain access to the use of the property. Certain REITs were designed to create an income-oriented investment vehicle that would mimic the strong and stable income flows of direct real estate ownership. Due to this structure, returns driven primarily by dividends have become one of the chief drivers in listed real estate performance.
The return profile of a REIT has characteristics similar to both bonds and equities. The long-term nature of commercial leases in a REIT portfolio provides income visibility, like bonds, while the mark-to-market valuation of leases allows REITs to take part in the economic cycle, similarly to equities. The low correlation of listed REIT stocks with the returns of other equities and bonds also provides portfolio diversification benefits to investors.
The income return performance is certainly attractive, but the relation of income return and its growth relative to inflation helps substantiate real estate’s role as an inflation hedge; as REITs offer cash flow growth to investors in the form of dividends. In the US, the primary benefit of the REIT structure is that the entity does not pay corporate income taxes. But in the GCC, and especially in the UAE where income taxes are quasi-non-existent, this is less of a concern.
Lower cost of trading
The advantage of listed real estate securities is that they are designed to be more liquid than direct real estate itself. Also as listed securities, REITs provide a lower cost of trading, faster execution and a more certain execution environment. Developed listed real estate markets are growing gradually and are witnessing increasing overall market capitalisations and trading volumes. But for the GCC region, REITs are still very much nascent and are being oversubscribed at their issuance. As professionals, we hope that the high-appetite investors are aware of the risks they are taking when buying a security that is soaring in price and by consequence dropping its yield. Investors also need to be aware of the limited liquidity of regional REITs, which will add to the risks of being able to trade those REITs and impact the market price.
As an emerging region, the GCC is expected to gain in cost and efficiency of acquiring real estate exposure through listed securities versus going direct. The result of this large cost and efficiency advantage of listed over direct should put the growth of regional listed real estate on a faster track going forward. Over the long term, REITs have the potential to deliver attractive returns to investors. Additionally, publicly traded real estate securities generally offer investors income stability, diversification, inflation protection and liquidity. These traits have been especially visible in the US real estate market, with many global markets catching up. However, investors must consider the trade-off between these attributes and recognise the greater short- and medium-term volatility for listed real estate companies.
By William Tohme, CFA, Vice President of CFA Society Emirates
