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A Class of Its Own

To many observers, it’s about time real-estate investment trusts got their own sector classification.

Investment yields across many asset classes have lately been disappointing, but a recent report seemed to show that real estate investment vehicles outperformed most other asset classes over the last 15 years.

REITs Outperforming Other Liquid Assets?

A recent Wall Street Journal article remarked on the planned move by Standard & Poor’s to create a new real estate sector in its classification systems and pointed to a report out of J.P. Morgan Asset Management asserting that, since 2000, REITs have returned an average of 12 percent annually. The next major category, high-yield bonds, was reported to have been further behind at a 7.9 percent annual return rate, and large-cap stocks rang in at just 4.1 percent.

The Journal faulted the nearly 40 percent of large-cap core mutual funds that had avoided REITs because of their different analytical character. It cited recent Goldman Sachs research that indicated that real estate has recently outperformed both its former “financials” sector and the S&P 500 as a whole.

Real Estate Coming into Its Own as an Asset Class?

Giving real-estate investment trusts their own sector classification will put the grouping alongside technology, health care, utilities and the like. REITs will no longer be a part of the financial sector, where they have held an awkward place alongside banks and insurers since those sectors were created in 1999.

In a way, it’s a wonder that the recategorization didn’t occur before. The famous (and successful) Yale Endowment model has long stressed the importance of alternative assets like real estate. “Investments in real estate provide meaningful diversification to the Endowment,” it said in its 2015 annual report. “A steady flow of income with equity upside creates a natural hedge against unanticipated inflation without sacrificing expected return. … While real estate markets sometimes produce dramatically cyclical returns, pricing inefficiencies in the asset class and opportunities to add value allow superior managers to generate excess returns over long time horizons.”

A Good Alternative in a Low-Yield Environment?

Many commentators have argued that we are returning to historical patterns that had been in place for years prior to the more recent experience of relatively high interest rates and the resultant higher yields on bonds and other investment types. “We’re returning to normal, and it’s just taken time for people to realize that,” said Bryan Taylor, chief economist of Global Financial Data, which scours old records to calculate historical financial data. “I think interest rates are going to stay low for several decades.”

Investment returns come from two sources: income and capital gains. The income portion is much lower than it used to be. The yield on long-dated Treasury bonds 25 years ago was more than 8 percent, but now the yield on the 10-year Treasury bond is just 2.3 percent. Yields on corporate bonds, which pay a spread over government debt, have fallen in tandem.

Corporate profits have also been affected. “Fourth-quarter profits at S&P 500 companies fell by 3.6 percent year on year. Even without financial and energy stocks, profits would be up by just 0.1 percent. In the absence of higher profits, stock markets need higher valuations if they are to generate positive returns. But Wall Street started 2015 on a cyclically adjusted price-earnings ratio of 26.8, compared with the historical average of 16.6.” According to Professor Robert Shiller of Yale University, it should end the year at nearly the same figure.

Low (and sometimes negative) yields on cash and government bonds mean that the stock market can seem like the only plausible source of decent returns. But many wonder whether the bull run in equities, which began in 2009, can be maintained in the face of a sluggish economic recovery and faltering corporate profits. The Economist reported that “McKinsey reckons that, in a slow-growth environment, real annual returns from equities over the next 20 years may be 4-5 percent, well below the average of the past 30 years; real bond returns may be just 0-1 percent. Even a rebound in American growth to 2.8 percent a year might generate real equity returns of only 5.5-6.5 percent, below the average of the past three decades.”

Meanwhile, “commercial real estate fundamentals—such as demand, occupancy and rents—remain strong, which has kept property values up in the private market,” said Steven Marks, a managing director at Fitch Ratings who specializes in U.S. REITs. Indeed, “the long-term returns from property look very respectable; in the 10 years to last September, American commercial property delivered a total annualized return of 7.9 percent, according to IPD, a property-information group.”

Direct Participation Vehicles vs. REITs

Although the Journal article focused on REITs because those are the publicly traded vehicles that most mutual funds utilize, REITs aren’t always the investment vehicle of choice. Recent surveys estimate that institutional investors continue to place between 80 percent and 95 percent of their real estate allocations into private real estate investments, rather than publicly traded REITs. In part, this may be because the tradability and leverage associated with REITs means they are subject to factors such as market sentiment. They are effectively part of the quoted equities universe, and so can be correlated with it—thus effectively negating one of real estate’s primary features as an asset class that is not directly correlated with the stock and bond markets.

Some of the appeal, too, of direct participation vehicles lies in the inability of REITs to fully take advantage of the various tax benefits available through LLC structures. In addition to often being property-specific (as opposed to REITs and their “pools” of properties), pass-through investment vehicles such as LLCs not only avoid double taxation but also allow investors to obtain the full benefit of tax losses or incentives relating to depreciation, interest and other deductions that act to shelter or defer much of the income that is distributed from the investment property. With real estate, the magnitude of the depreciation and interest expense deductions make this advantage potentially significant. Crowdfunding sites like RealtyShares allow smaller investors to follow the lead of institutions in potentially allocating most of their real estate investments into private pass-through entity syndicates.

Risk Factors for Private Direct Participation Vehicles

The direct participation vehicles discussed above still carry significant risk factors: All of the investments offered by RealtyShares are private offerings, exempt from registration with the SEC. The required disclosures associated with the offerings are therefore less detailed than an investor would typically expect from a registered offering, and ongoing disclosure requirements are negligible. The offerings are also illiquid, with no preset liquidity terms. An investor should have no expectation of liquidity before the final liquidation of the real estate project. Because these offerings are only available to accredited investors, the liquidity in any circumstance will be more limited than for registered, publicly traded securities. Lastly, all investment involves risk of loss, and past performance is not indicative of future results.

Neither RealtyShares, Inc. nor North Capital Private Securities Corporation, as institutions, advise on any personal income tax requirements or issues. Use of any information from this article is for general information only and does not represent personal tax advice, either express or implied. Readers are encouraged to seek professional tax advice for personal income tax questions and assistance.