5 Reasons Why Public REITs Outperform the S&P 500

Over the last 40 years, public REIT stocks have outperformed the broader S&P 500 on both an absolute and risk-adjusted basis and, yet, most people have little to no exposure to this asset class. A public REIT is a company that owns and operates real estate and real estate-related assets. Between 1978 and 2016, public REITs averaged close to 12.87%, while the S&P 500 generated 11.64%.

Theoretically, a Public REIT shouldn’t beat the index. REITs have risk characteristics that lie somewhere between bonds and equities. In-place leases in the REIT’s underlying properties behave like a series of bonds due to long-term contractual lease obligations. The lease terms can often be ten years or more, creating a predictable and dependable cash flow stream for investors. Contractual and market rent escalations also lead to more cash flow and increasing property values, creating upside potential in the stock price. Given these characteristics, public REIT returns should fall between bonds and equities—but they don’t. Why?

Here are five reasons that explain why public REITs outperform the S&P 500:

1. Public REITs have a major tax advantage. Unlike most public companies, a public REIT is not subject to taxation at the corporate level. This is an enormous advantage for shareholders because it means less goes to the government and more goes to the investor. Prior to the Tax Cuts and Jobs Act of 2017, the median tax paid by companies in the S&P 500 was around 30%, which means a non-REIT publicly traded corporation needed to make 30% to 40% more in income to deliver the same dividend to shareholders. The new tax law has brought the corporate rate down to 21%, lessening the public REIT tax advantage, but a distinct advantage remains.

2. Cash is king. A company that elects to be a REIT typically owns properties that deliver a stable and predictable income stream. This can’t be said for many of the companies in the S&P 500. In 2017, around 10% of the companies that make up the S&P 500 actually lost money. Other companies do make money, but choose to reinvest in the company, rather than pay a dividend to investors. This increases risk if the reinvested money doesn’t generate a decent return on equity. Many REITs do keep some cash on the books by shielding the income from depreciation. Using a stable stream of income to fund riskier development projects has proven to be a sound way to manage risk and deliver shareholder value.

3. Real estate has intrinsic value. Very few assets have residual value when plans don’t go as expected. Stocks become worthless when companies go bankrupt, but the real estate they occupy still has value when those bankrupt companies leave. This concept is one of the fundamental reasons why real estate has been such a great investment. Real estate has built-in downside protection because it’s a physical asset with value even when it’s unoccupied.

4. REITs provide a way to gain industry exposure with less risk. Real estate is not just four walls and a roof. Public REIT performance is largely correlated to the growth of an industry, a location, a sector or a demographic trend. When an investor buys a data center REIT, they are betting on the growth of the technology sector. A healthcare REIT that owns senior living facilities is a bet on the aging baby boomer demographic and a timber REIT can be a great way to gain exposure to natural resources and a booming housing industry. When an investor buys a REIT whose office portfolio is largely concentrated in places like Seattle and San Francisco, they are betting on the continued growth of technology companies. REITs are incredibly dynamic and different from one another and yet people tend to treat them as a single asset class. However, the only thing a healthcare REIT and a timber REIT have in common is that they share the same legal structure. Investors who want exposure to an entire industry with downside protection should consider public REITs.

5. REITs are less susceptible to price variation. Risk-adjusted returns are defined by the Sharpe ratio, which measures both return and volatility. Public REITs have experienced less volatility than the S&P 500 over the last 40 years, likely as a result of a high dividend yield and a share price that is easier to value. Dividends provide price support in down markets and a decent return during stagnant times. Public REITs deliver substantially more income to shareholders through their dividend. As of November 2018, the NAREIT dividend yield was 4.31% versus 2.05% for the S&P 500. The value of a public REIT is closely tied to its underlying properties which are fairly easy to value. On the flipside, if 30 analysts were asked to value Amazon, the variance around the answers would be quite large because of the complexity of the underlying businesses. In a complex investment world, simple and predictable wins every time.

These five reasons are all structural advantages that have given public REITs an edge over other companies, and they aren’t changing anytime soon. Public REITs are a great investment—one that has largely been overlooked by the investment community. Investors should want more exposure to this liquid asset class that has beaten the S&P 500 every decade for 40 years. Maybe we’ve gotten portfolio construction wrong all these years. Perhaps the recommended portfolio should be 90% REITs and 10% the S&P 500, instead of the other way around. This mix would have created far greater wealth over the last 40 years.