Bogleheads® on Investing Podcast 066: Dr. Jim Dahle and John Worth, Ph.D. on real estate investing
00:00:00.000 | [MUSIC]
00:00:10.000 | Welcome, everyone, to the 66th episode of Bogleheads on Investing.
00:00:15.400 | Today, we're going to be talking about real estate investing with two special guests,
00:00:20.000 | Jim Dawley, who created an in-depth course on real estate investing, and
00:00:25.400 | John Worth, who's a chief economist at NARIT, formerly known as
00:00:30.400 | the National Association of Real Estate Investment Trusts.
00:00:33.400 | [MUSIC]
00:00:43.200 | Hi, everyone, my name is Rick Ferry, and I am the host of Bogleheads on Investing.
00:00:47.920 | This episode, as with all episodes,
00:00:50.480 | is brought to you by the John C. Bogle Center for Financial Literacy.
00:00:54.720 | A nonprofit organization that is building a world of well-informed, capable, and
00:00:59.720 | empowered investors.
00:01:01.240 | Visit the Bogle Center at boglecenter.net, where you will find
00:01:05.680 | a treasure trove of information, including transcripts of these podcasts.
00:01:10.440 | Before we get started today, I have a special announcement.
00:01:14.040 | On behalf of all Bogleheads worldwide, we wish Taylor Larimore a happy birthday.
00:01:20.280 | Taylor is 100 years old this month.
00:01:23.800 | He is the founder of the Bogleheads.
00:01:26.480 | Jack Bogle called him the king of the Bogleheads.
00:01:30.000 | Back in 1998, he founded the organization by putting the very first post
00:01:36.120 | on the Morningstar Forum, at the time called Vanguard Diehards.
00:01:40.520 | It has since moved on to its own website, bogleheads.org.
00:01:45.120 | He is also the author and co-author of three Bogleheads books, and
00:01:49.080 | was instrumental in creating the John C. Bogle Center for Financial Literacy.
00:01:54.160 | Taylor was a graduate of the University of Miami School of Business.
00:01:57.680 | He served as a paratrooper in World War II in the 101st Airborne Division
00:02:02.680 | during the Battle of the Bulge, earning five combat decorations.
00:02:06.760 | He's an avid sailing enthusiast, and
00:02:09.080 | was named the American Sailing Association's Instructor of the Year.
00:02:13.440 | Taylor now continues to spend his time sailing and
00:02:16.000 | helping others discover the Bogleheads way.
00:02:18.560 | If you'd like to wish Taylor a happy birthday,
00:02:20.880 | there will be a special post on bogleheads.org for
00:02:24.760 | you to add your birthday wishes and special thanks.
00:02:28.120 | Today our conversation is about real estate, and it is primarily directed at
00:02:33.360 | people who are interested in adding real estate as an asset class, or
00:02:38.920 | expanding their real estate holdings into different parts of the real estate market.
00:02:44.320 | Our first guest is Dr. Jim Dolly.
00:02:47.480 | Jim is an avid Boglehead.
00:02:49.240 | He is a practicing emergency room physician and
00:02:51.960 | founder of the White Coat Investor.
00:02:54.640 | Jim has developed many courses helping individual investors and professionals.
00:03:00.960 | And one of the courses that he recently developed is a no frills
00:03:05.720 | real estate investing course, where he covers all aspects of real estate investing,
00:03:10.600 | along with the faculty of more than a dozen highly qualified instructors.
00:03:14.880 | So we're gonna be talking about that with Jim.
00:03:17.120 | And our second guest is Dr. John Wirth.
00:03:20.760 | John is the Executive Vice President, Research and
00:03:24.960 | Investor Outreach at NARED,
00:03:27.720 | formerly known as the National Association of Real Estate Investment Trust.
00:03:32.640 | He was a former chief economist at the National Credit Union Administration.
00:03:38.120 | And prior to that, he spent nearly a decade at US Treasury,
00:03:42.440 | where he served as the Director of the Office of Microeconomic Analysis.
00:03:47.240 | And he was there during the entire financial crisis.
00:03:51.480 | So with no further ado, let me welcome back Dr. Jim Dolly.
00:03:55.240 | Welcome to the Bogleheads on Investing, Jim.
00:03:58.040 | >> Thank you, it's always a pleasure to be here, and
00:03:59.760 | a pleasure to be with Bogleheads, especially in person at the conference.
00:04:02.840 | >> Yeah, we had a great conference, and thank you and your wife so
00:04:05.560 | much for helping out.
00:04:07.040 | Today, our topic is real estate.
00:04:10.680 | I came to you because of two reasons.
00:04:13.120 | You've always talked about real estate, and you talk about it in your books.
00:04:17.160 | But recently, you put together a course on real estate that you call
00:04:22.040 | the No Hype Real Estate Investing course.
00:04:26.480 | First, why do you say no hype?
00:04:29.280 | And secondly, why do you think you needed to put together a course like this?
00:04:32.800 | And thirdly, what kind of real estate investing do you do?
00:04:36.400 | >> One of the biggest things I don't like about real estate is it's full of hype.
00:04:42.040 | You pick up a real estate book, and there's all kinds of hype in it.
00:04:45.000 | You take a course, there's hype in it.
00:04:46.360 | You go to a website, there's hype in it.
00:04:48.600 | I don't like it.
00:04:49.320 | It turns me off.
00:04:50.320 | I feel like I'm being sold to.
00:04:52.440 | And I know a lot of Bogleheads don't like that either.
00:04:54.520 | And so I kind of took the approach of, if we're gonna make a course,
00:04:58.560 | let's have it be just the facts, ma'am.
00:05:01.160 | And I think people respond well to that.
00:05:03.520 | >> And you pulled together a lot of professionals,
00:05:05.240 | a lot of people in the industry.
00:05:06.400 | It isn't just you that's speaking in this course.
00:05:09.320 | >> Absolutely correct.
00:05:10.160 | There's a whole bunch of other people that have recorded material for the course.
00:05:14.640 | And I don't pretend to be an expert in every single part of real estate.
00:05:18.680 | I haven't done every type of real estate investing.
00:05:21.080 | And so that's one of the benefits of having other faculty members in the course,
00:05:24.680 | is you can hear about flipping homes, for instance,
00:05:27.720 | from someone who's actually flipped homes,
00:05:29.080 | rather than me, who only knows about it theoretically.
00:05:31.520 | >> Tell us a little bit about yourself and
00:05:33.560 | your own experiences with real estate investing.
00:05:36.480 | >> Sure, I have a little bit of experience with direct real estate investing,
00:05:40.320 | kind of an accidental landlord situation.
00:05:43.320 | And realized fairly early on that I prefer to be mostly on the passive
00:05:47.320 | side of the spectrum.
00:05:49.040 | I think it was Michael LaBouf who talks about investing your time actively and
00:05:53.400 | your money passively.
00:05:54.680 | And Bogleheads obviously try to do that for the most part.
00:05:59.600 | And I've been a Boglehead for a long time.
00:06:01.400 | And so I try to invest pretty passively for the most part.
00:06:05.040 | And so I end up on the passive side of the spectrum.
00:06:07.080 | What does that mean?
00:06:08.080 | That means publicly traded REITs, and
00:06:10.920 | the holding I use there is just a real estate index fund.
00:06:14.800 | It means syndications,
00:06:16.960 | essentially going in with 99 other people and buying an apartment complex.
00:06:21.160 | But for the most part, my main other holding outside of publicly traded REITs
00:06:25.840 | are private real estate funds.
00:06:27.840 | These are investments that are only available to accredited investors, but
00:06:32.160 | allow you to have some diversification.
00:06:33.840 | So instead of getting one apartment building,
00:06:35.840 | you get 15 apartment buildings in the fund, for example.
00:06:39.280 | And that allows you to be diversified if one of those goes bad.
00:06:42.880 | On the debt side, these tend to be loans to developers.
00:06:46.520 | Typical fund might have 75 or 300 different loans to developers.
00:06:51.360 | And they pay pretty good interest in order to have access to money
00:06:55.800 | without having to go to a bank.
00:06:57.680 | And so they might borrow money at 10 or 12% plus two points.
00:07:02.640 | And even after paying the fees in the fund,
00:07:05.440 | you may come out with 8, 9, 10, 12% return on that money.
00:07:10.440 | So I invest in both private equity and private debt funds.
00:07:14.560 | Those are my main holdings outside of publicly traded REITs.
00:07:18.080 | If I didn't know anything about real estate, which I don't really know that
00:07:21.040 | much, I've only owned residential real estate plus real estate investment for
00:07:24.520 | us, index fund.
00:07:25.880 | If I was going to learn, you have a really good blog on your website called
00:07:30.280 | Real Estate Investing 101.
00:07:32.600 | And it does give you an awful lot of information.
00:07:35.680 | When you first go into the blog and you start reading about it,
00:07:38.200 | you have this nice graph which talks about the four quadrants of real estate
00:07:42.040 | investing.
00:07:42.560 | I wonder if you could touch on that.
00:07:44.360 | It's pretty easy, I think, to talk about real estate to somebody who
00:07:47.960 | invests kind of traditional investments.
00:07:50.560 | You know, if you understand stocks and bonds,
00:07:52.560 | it's not that hard to understand real estate.
00:07:54.600 | You can invest on the equity side, the equivalent of a stock investor.
00:07:58.600 | Or you can invest on the debt side, the equivalent of a bond investor.
00:08:02.440 | So if you're investing on the equity side, the simplest form of real estate
00:08:06.280 | might be buying the house next door and renting it out to somebody.
00:08:10.600 | Your income for this equity investment is the rent.
00:08:14.960 | Now, it's not the only source of return.
00:08:16.760 | The house might appreciate in value as well.
00:08:19.000 | Maybe you get some tax breaks for it.
00:08:21.880 | And you can depreciate the house.
00:08:23.480 | And that gives you a substantial tax break.
00:08:25.320 | But for the most part, your income coming in is the rent.
00:08:28.160 | And your expenses for this business you now own
00:08:31.600 | are things like a mortgage, property insurance, property taxes, maintenance,
00:08:37.920 | all those sorts of things that it takes to run the business.
00:08:41.080 | So that's being an equity investor.
00:08:42.640 | When it goes up in value, you get the benefit of that.
00:08:45.920 | When you're able to raise rent on it or you're
00:08:48.000 | able to charge other fees to the renter, your income goes up on it.
00:08:51.080 | You benefit from all of that as the equity investor,
00:08:53.960 | the owner of the property.
00:08:55.800 | But there's another way to invest in real estate.
00:08:58.160 | And that's being the debt investor.
00:09:00.320 | Most people have investments in real estate that are leveraged,
00:09:04.360 | meaning they borrowed at least some of the money to invest in it.
00:09:08.440 | And you can invest on that debt side as well.
00:09:10.560 | You can loan money to somebody who is the equity investor in real estate.
00:09:15.200 | And just as bonds are less risky than stocks,
00:09:18.400 | investing on the debt side is less risky than being an owner.
00:09:22.960 | In the event that something terrible happens with the business,
00:09:25.600 | the debt side typically comes out with all or most of their capital.
00:09:28.720 | And when something terrible is going on and you're on the equity side,
00:09:31.600 | you might lose all of your capital, especially if it's highly leveraged.
00:09:34.940 | And so there's two ways to invest there.
00:09:36.560 | There's the equity and the debt.
00:09:38.120 | On the debt side, you split out two types of debt.
00:09:42.000 | There's called hard money loan.
00:09:44.600 | And then there's mezzanine debt or preferred equity.
00:09:48.120 | Can you describe the difference between the two?
00:09:50.480 | This is what gets a lot of people a little bit confused.
00:09:52.960 | There's these intermediate types of investments.
00:09:55.800 | It's the same way in the stock market, right?
00:09:57.440 | There's preferred equity.
00:09:58.520 | And it's the same thing on the real estate side.
00:10:01.240 | For example, there might be a debt investor that's
00:10:03.760 | got an 8% note on a property.
00:10:05.600 | Well, they're going to make 8%.
00:10:06.920 | But they're first in line.
00:10:08.500 | If this property has to be foreclosed on,
00:10:10.680 | they can foreclose on it, sell the property, get all their money back.
00:10:13.760 | And then, of course, the equity investor is at the bottom of the capital stack.
00:10:17.720 | So whatever's left over, in the event things go bad,
00:10:20.360 | goes to the equity investor.
00:10:21.840 | But there can also be different types of investors in between those two.
00:10:25.920 | And that's usually called preferred equity or mezzanine debt.
00:10:29.160 | Typically pays a higher interest rate.
00:10:31.440 | For example, if that first note is 8%, this next note might be 14%.
00:10:36.280 | And so it's a riskier position, has higher expected returns.
00:10:40.200 | But those come, obviously, with higher risk.
00:10:44.520 | I want to go through different types of properties
00:10:47.080 | because you list in your course class A properties, class B properties,
00:10:52.880 | class C properties, royal land.
00:10:54.880 | Could you quickly go through these different classes of properties?
00:10:58.600 | Yeah, sure.
00:10:59.280 | Class A is the nicest thing that just got built in the last few years.
00:11:03.240 | It's luxury.
00:11:03.960 | It's got granite countertops and tile floors.
00:11:06.520 | And it's in a nice neighborhood and a nice school district.
00:11:09.600 | And you're renting it out to professionals.
00:11:12.400 | That's a class A property.
00:11:14.000 | A class B property, it's a little bit older.
00:11:16.560 | It might have been built 15 years ago.
00:11:19.600 | Lower income tenants are in there.
00:11:21.440 | It's not quite as nice as it was when it was first built.
00:11:25.400 | Maybe there's some deferred maintenance issues
00:11:27.400 | that need to be done on the property.
00:11:29.520 | Class C properties might be 30 or more years old.
00:11:33.560 | Again, they're not as nice as a class B property.
00:11:37.360 | The tenants in there might be working class folks.
00:11:39.960 | They might be on government subsidies and lower rents.
00:11:43.680 | You're going to have a lot more ongoing maintenance, a lot more repairs
00:11:46.520 | than a class C property.
00:11:48.120 | And a class D property, of course, is in the bad part of town.
00:11:51.920 | If you've heard the term slumlord before, they own class D properties.
00:11:56.680 | And they're rundown.
00:11:58.040 | And the tenants don't have great credit.
00:12:01.840 | But you're also buying them at a much higher capitalization rate
00:12:05.080 | than you would a class A property.
00:12:06.760 | And so your returns might actually be better in a class D property
00:12:10.480 | than a class A property.
00:12:11.960 | But there's just a lot more issues you're
00:12:13.700 | going to be dealing with to have that sort of an investment property.
00:12:17.160 | And who decides whether what you're buying is class A, B, C, or D?
00:12:22.360 | Well, that's the beautiful thing about it.
00:12:24.120 | It's like a climbing grade for those rock climbers out there.
00:12:26.680 | It's just consensus.
00:12:28.200 | And of course, someone trying to sell something,
00:12:30.280 | they're going to try to convince you it's class B.
00:12:32.640 | And you as the buyer would have to really go look at it
00:12:35.400 | and understand it to realize this isn't class B property.
00:12:38.000 | This is class C property.
00:12:40.160 | And it's not worth paying nearly as much for.
00:12:42.480 | And so there's no government agency that goes out and says,
00:12:47.300 | this is class A and this is class B. It's
00:12:49.140 | just by consensus among the investors in the market.
00:12:52.540 | Let's discuss your real estate investing continuum.
00:12:57.000 | You've put together this very nice graphic
00:12:59.380 | on your website, which shows on one side,
00:13:02.940 | you've got the direct investor in real estate
00:13:05.740 | who actually builds it from the ground up.
00:13:08.580 | And all the way through the REIT investor
00:13:13.800 | at the end, who's just investing in public REIT.
00:13:15.760 | And you've got all of these different ways
00:13:18.140 | which you can invest in real estate in the middle.
00:13:20.220 | I'd like to just go through that list of eight different ways
00:13:23.440 | that you've laid out here very nicely in this chart.
00:13:27.540 | Moving left to right, you start with ground up construction.
00:13:29.960 | This is the person that goes to the city and gets the permits
00:13:32.500 | and digs the hole in the ground and puts the foundation in
00:13:35.440 | and builds the house and puts renters in it.
00:13:37.960 | This is ground up construction.
00:13:40.680 | Of course, you don't have to do that from the ground up.
00:13:43.120 | You can buy something that's already been built.
00:13:45.920 | You're just improving it and then
00:13:48.080 | selling it to somebody else who's going to rent it out.
00:13:50.280 | That's generally called fix and flip.
00:13:51.820 | A lot of people watch TV shows that talk about this
00:13:54.480 | and how people made money fixing and flipping up properties.
00:13:57.600 | But that's one way to invest.
00:13:59.000 | The next most active way to invest is short term rentals.
00:14:01.800 | And what you're really doing here
00:14:03.200 | is you're running a hotel business.
00:14:04.840 | You're renting these out to people.
00:14:06.640 | Typically, they will have a stay that averages 5, 6, 7 days.
00:14:11.440 | Lots of people are only in there for three or four days.
00:14:13.760 | Some people will stay for a month.
00:14:15.480 | But for the most part, short term rentals,
00:14:17.440 | you're renting to people for a matter of days.
00:14:20.440 | And so it's pretty active.
00:14:22.160 | Somebody's got to get in there and clean it
00:14:23.960 | every three or four days.
00:14:25.720 | You have to book a different tenant, essentially,
00:14:28.680 | a different guest, multiple times a month.
00:14:32.200 | And you're running a business.
00:14:33.680 | So it's a pretty active thing.
00:14:35.560 | Next, you come to long term rentals.
00:14:37.120 | And these are people you typically
00:14:38.520 | rent to for a year, two years, or five years.
00:14:40.880 | And so it's not nearly as actively involved
00:14:43.000 | as short term rentals.
00:14:44.360 | But as you might expect, you're also
00:14:45.960 | not charging them hotel rates.
00:14:47.440 | And so there's less revenue involved as well.
00:14:51.040 | That's a way a lot of mom and pop investors invest.
00:14:54.080 | They buy a house, or they buy multiple houses,
00:14:56.440 | or they buy a duplex or two, or some quadplexes,
00:14:59.480 | or they buy an eight-door apartment building.
00:15:01.800 | A few years later, they buy another 10-door apartment
00:15:04.140 | building, and that's how they invest in real estate.
00:15:06.520 | Some people do not want to be involved
00:15:09.060 | in that direct management role.
00:15:11.760 | But they still want to own the properties themselves.
00:15:14.320 | They want something they can drive by and show their friends
00:15:16.920 | or touch physically with their hands when they go to see it.
00:15:20.240 | But they don't want any hassles.
00:15:21.960 | And I call that category turnkey properties.
00:15:24.560 | This is where somebody else is building the home.
00:15:26.720 | Someone else is getting a renter in there.
00:15:28.760 | Someone else is managing the property.
00:15:30.760 | When it's time for you to get out of the investment,
00:15:32.920 | they will sell it.
00:15:34.000 | But you are the 100% owner of the home.
00:15:36.560 | And there are services out there that
00:15:38.460 | will do that for you if that's how you
00:15:40.080 | want to invest in real estate.
00:15:42.160 | The next step is what I mentioned earlier.
00:15:43.960 | This is when you go in and take advantage
00:15:46.360 | of some economies of scale.
00:15:47.720 | You want to own a big apartment complex.
00:15:49.960 | Let's say the apartment complex has got 400 doors.
00:15:52.760 | You can't afford this thing yourself.
00:15:54.240 | It might cost $10 million, and you
00:15:55.860 | don't have that, much less enough
00:15:57.240 | to diversify that investment.
00:15:59.200 | But if you went in with 100 other investors--
00:16:02.360 | typically it's 98 other investors,
00:16:03.960 | because of the way the laws are written--
00:16:06.000 | you could buy that apartment complex.
00:16:07.920 | But as that apartment complex does well or does poorly,
00:16:10.800 | you're going to share in the profits or losses there.
00:16:13.600 | And that's considered a syndication.
00:16:15.600 | You're a partner in a partnership.
00:16:17.560 | You get a K-1 every year.
00:16:19.400 | Losses and gains are passed through to you on that K-1.
00:16:22.440 | If you want more diversification than one apartment complex
00:16:25.160 | that you put $100,000 into, then you
00:16:27.600 | might want to look into private funds.
00:16:29.440 | Instead of one complex, you might own a dozen of them.
00:16:33.160 | They'll all be packaged together into a fund.
00:16:35.000 | The fund might hold them for five or 10 years
00:16:37.600 | or indefinitely, and then sells off the properties.
00:16:40.840 | And you get what you get in your share of the returns.
00:16:43.360 | Obviously, there's somebody putting all that together,
00:16:45.240 | the general partner.
00:16:46.360 | If it does well, they tend to do very well,
00:16:48.640 | charge fees that are similar to hedge fund fees.
00:16:52.040 | 1% a year and 20% of profits wouldn't
00:16:55.040 | be unusual for what they charge to run those funds
00:16:57.720 | and those syndications.
00:16:59.040 | But the nice thing about it is once you buy it for you,
00:17:01.880 | it's mailbox money.
00:17:03.080 | You have no role in the management
00:17:04.840 | after the initial due diligence period
00:17:07.000 | and purchasing the investment.
00:17:08.360 | Do those funds have a maturity date?
00:17:10.280 | Do they eventually dissolve, or are they just ongoing?
00:17:13.120 | It depends.
00:17:13.640 | Some are evergreen, and some--
00:17:15.160 | the intent is to dissolve them.
00:17:17.200 | For an equity-type investment, those
00:17:19.000 | will typically run three to 10 years.
00:17:20.960 | But they'll usually give themselves some wiggle room.
00:17:23.160 | So if the market's not really good for selling real estate
00:17:25.320 | in six years, they might hold it for eight years
00:17:27.860 | in hopes of getting the investors a better exit price.
00:17:31.000 | These are illiquid investments, terribly illiquid investments
00:17:34.200 | that you are locked into.
00:17:35.440 | Once you sign up for the ride, you're in there.
00:17:38.040 | And sometimes you don't even know exactly when your money is
00:17:40.520 | going to come back, especially if things are not going well.
00:17:43.240 | And then finally, on the far right side
00:17:45.240 | of this real estate investing continuum
00:17:47.440 | is publicly traded REITs.
00:17:49.160 | And these are typically large real estate properties,
00:17:52.880 | a large number of them that have been packaged up and securitized.
00:17:56.520 | And you can trade them any day the markets are open.
00:17:58.820 | You can buy a mutual fund that invests in 100 or more of them.
00:18:02.140 | And they're very liquid and very transparent,
00:18:04.700 | like every other company on the stock market.
00:18:07.220 | But you're not going to have any control over them
00:18:09.340 | like you might if you bought the property next door,
00:18:11.620 | for instance.
00:18:12.600 | And so as you travel from left to right across the continuum,
00:18:15.180 | you will see that less experience is required,
00:18:17.380 | but you will have less hassle.
00:18:19.020 | You get more diversification and more liquidity,
00:18:21.420 | but you get less control.
00:18:23.140 | The tax benefits tend to decrease
00:18:25.020 | as you move left to right.
00:18:26.500 | And you tend to pay more layers of fees.
00:18:29.340 | As a general rule, if you're not having to do anything,
00:18:32.860 | you should expect lower returns than if you're over there doing
00:18:35.500 | fixing and flipping.
00:18:36.900 | And so as a general rule, your returns will go down as well
00:18:39.620 | when you move left to right across the spectrum.
00:18:42.180 | My second guest is from the REIT industry,
00:18:44.820 | so we'll be covering that a little bit more later on.
00:18:47.740 | So thank you for that spectrum.
00:18:49.220 | But I want to get into, why do people buy real estate?
00:18:51.500 | Why do they get invested?
00:18:52.580 | Yes, you get a good rate of return,
00:18:54.300 | granted as you go across your continuum from left to right,
00:18:57.380 | the return drops, as does your control.
00:19:01.020 | But what are some of the other reasons?
00:19:03.780 | Well, I mean, the main reason you add anything
00:19:05.860 | to your portfolio is because it has solid returns
00:19:09.500 | and, hopefully, low correlation with the other assets
00:19:11.820 | in your portfolio.
00:19:12.700 | So the reason I invest in real estate, if you boil it all down,
00:19:15.700 | it's because it has high returns,
00:19:17.080 | similar to my stocks that I invest in through index funds,
00:19:21.460 | and it has lower correlation.
00:19:23.900 | How low that correlation is varies over time
00:19:26.340 | and, of course, is somewhat debatable,
00:19:28.180 | but that's the reason I invest in real estate.
00:19:30.140 | Yes, there are some great tax breaks.
00:19:31.900 | The one people like to talk about the most is depreciation.
00:19:35.180 | And as you depreciate a property,
00:19:37.340 | you're basically sheltering that rental income from taxation.
00:19:41.700 | And done properly, you depreciate the property
00:19:44.260 | for a few years, and then you exchange it
00:19:46.180 | into a more expensive property and depreciate
00:19:48.500 | that property a few years and exchange into a bigger property
00:19:51.940 | and depreciate that a few years, and then you die.
00:19:54.740 | And your heirs get a step up in basis of death,
00:19:57.460 | and nobody ever pays capital gains
00:20:00.300 | or the depreciation recapture taxes on that depreciation.
00:20:05.260 | So you could have tax-free income out of this property
00:20:08.160 | for decades and never pay taxes on that income.
00:20:12.380 | And, you know, obviously you have to set it up
00:20:13.820 | just right to accomplish that, but that's a big draw
00:20:17.300 | for a lot of people to get into real estate.
00:20:19.300 | A lot of other people, it bothers them
00:20:21.660 | to invest in paper assets, right?
00:20:24.060 | They don't like investing in mutual funds or stocks or bonds
00:20:26.900 | 'cause they don't feel like it's real.
00:20:28.360 | They can't drive by and see it.
00:20:30.300 | And some people really like that aspect
00:20:32.740 | of real estate investing.
00:20:33.980 | - So the exchange process where you exchange
00:20:38.240 | from one property to another, where you could,
00:20:41.740 | where you don't have the recapture of depreciation,
00:20:45.860 | and you don't have to pay the capital gain,
00:20:48.100 | 1031 exchange, certain rules go around that,
00:20:53.100 | such as having to buy a property or identify a property
00:20:58.020 | within a few months and then buy it within six months.
00:21:00.320 | Can you elaborate on that?
00:21:01.580 | - Yeah, I think that's exactly it.
00:21:02.980 | I mean, it has to be an exchange.
00:21:04.380 | It's supposed to be a similar property,
00:21:06.260 | but keep in mind that the IRS is pretty darn lenient
00:21:09.980 | on similarity between the properties.
00:21:12.500 | But I think it's 60 days you have to identify the property
00:21:15.260 | and then you have to close within six months.
00:21:16.980 | And so it's definitely something
00:21:20.180 | that a lot of people are very interested in.
00:21:22.380 | There are companies out there that help you to do exchanges,
00:21:26.220 | but obviously you don't want to let the tax tail
00:21:27.980 | wag the investment dog.
00:21:29.100 | Buying a crummy property,
00:21:30.220 | even if you're able to exchange into it is not a good move.
00:21:33.260 | And so you've got to find another good investment
00:21:35.960 | to exchange into and then somehow manage to sell the old one
00:21:39.700 | and buy the new one within six months of each other.
00:21:42.800 | - I do want to cover that tax benefit though.
00:21:44.700 | I mean, if you're in the highest tax bracket,
00:21:47.000 | even if you didn't get a 1031 exchange,
00:21:51.380 | even if you were just selling the property,
00:21:53.740 | the recapture tax of the depreciation.
00:21:57.540 | So you're in a 37% bracket.
00:21:59.940 | You're getting income that would normally be taxable,
00:22:02.820 | but the depreciation on the property reduces your income
00:22:06.020 | and you're in a high tax bracket, say 37%.
00:22:09.740 | But there's benefit to even those people if they sell,
00:22:14.060 | they don't get taxed on that recapture of the depreciation.
00:22:17.860 | They get taxed on the capital gain,
00:22:19.660 | but the recapture of the depreciation,
00:22:21.300 | the maximum tax rate on that is only 25%.
00:22:24.060 | So there's actually even a benefit there.
00:22:26.100 | - Yeah, absolutely.
00:22:28.220 | You can tell when you look at the tax code
00:22:30.800 | that there's a lot of incentives in there
00:22:33.400 | to people to invest in real estate, to develop real estate,
00:22:36.340 | to make places where people can live.
00:22:39.580 | This is clearly an activity that Congress
00:22:42.060 | and by extension, the IRS supports
00:22:45.460 | and they support it in the tax code.
00:22:47.980 | - Generally in a portfolio, you have stocks, bonds,
00:22:51.300 | and now we're talking about real estate.
00:22:52.860 | What's your view of proper diversification?
00:22:56.900 | Let's say, 60/40, 60% stocks, 40% bonds,
00:23:00.380 | just using that as a base.
00:23:03.600 | How would you fit real estate into your portfolio?
00:23:06.100 | - Well, I think you gotta remember
00:23:08.780 | that real estate's a risky asset to start with.
00:23:10.940 | These are not treasury bonds.
00:23:12.860 | Even if you're investing on the debt side,
00:23:14.460 | there's far more risk there
00:23:15.740 | than a typical bond portfolio would hold.
00:23:18.860 | So this is a risky asset.
00:23:20.580 | So when you think about stocks and real estate,
00:23:23.660 | they both go in the same category of risky assets.
00:23:26.940 | But I think a reasonable amount of real estate
00:23:29.140 | to have in your portfolio ranges anywhere from zero to 80%.
00:23:33.500 | I think it's fine not to invest at all in real estate.
00:23:37.100 | You do not have to invest in real estate
00:23:38.580 | to be a successful investor,
00:23:40.060 | to be financially independent,
00:23:41.300 | to leave lots of wealth to your kids.
00:23:42.500 | Whatever your investing goals are,
00:23:44.180 | you don't have to invest in real estate.
00:23:46.280 | Some people just love real estate.
00:23:48.600 | It is their thing.
00:23:49.980 | I would caution those folks,
00:23:52.180 | invest at least 20% of your portfolio
00:23:55.020 | into the most profitable corporations
00:23:56.760 | the world has ever seen, i.e. the stock market,
00:23:59.580 | and preferably via low-cost,
00:24:01.260 | broadly diversified index mutual funds, or ETFs.
00:24:05.880 | I think it's really silly
00:24:06.840 | to put everything into real estate.
00:24:08.160 | So even those folks,
00:24:09.020 | I think they ought to have at least 20% in stocks
00:24:13.140 | rather than everything in real estate.
00:24:15.020 | In my portfolio, it's 60% stocks,
00:24:16.980 | 20% bonds, 20% real estate.
00:24:19.360 | But you don't have to match my portfolio
00:24:23.940 | for me to think what you're doing is reasonable.
00:24:25.780 | I think someone that had 40% of their portfolio
00:24:27.620 | in real estate would be just as reasonable
00:24:29.580 | as somebody that only had 10%
00:24:30.540 | of their portfolio in real estate.
00:24:32.340 | - I guess it gets down to one of the last charts
00:24:34.820 | I want to talk about, which you wrote about,
00:24:37.520 | which is, what is the best way for me
00:24:40.140 | to invest in real estate?
00:24:41.460 | And this gets back to your spectrum of ways,
00:24:45.020 | or the continuum ways of, you know,
00:24:47.660 | you have to come up with a way of investing in real estate
00:24:50.300 | that suits you personally.
00:24:52.020 | So can you talk about that?
00:24:54.260 | - Yeah, that's exactly the whole point of that prior chart
00:24:56.900 | about the real estate continuum,
00:24:58.940 | is it's not that one way is better than another.
00:25:01.540 | It's that you've got to match yourself
00:25:03.580 | and what you want out of an investment
00:25:05.660 | to the particular type of investment.
00:25:07.880 | You don't have to invest in real estate.
00:25:09.280 | So the first thing you have to ask yourself
00:25:11.480 | is do you want to add a little bit of complexity
00:25:13.480 | to your portfolio in hopes of getting
00:25:15.380 | a little bit more diversification,
00:25:17.120 | in hopes of maybe boosting returns?
00:25:19.600 | Yes or no.
00:25:20.440 | And if the answer to that is yes,
00:25:21.560 | then, you know, you can start looking
00:25:23.600 | at the different types of real estate.
00:25:25.720 | So the next thing people need to ask themselves
00:25:27.320 | is are you willing to give up some liquidity
00:25:29.840 | and transparency and diversification?
00:25:32.880 | And do you qualify as an accredited investor?
00:25:35.440 | Because that's going to have a big impact
00:25:37.920 | on what's available to you.
00:25:38.920 | And if you're really not willing
00:25:40.360 | to give up liquidity and transparency,
00:25:42.480 | you're going to be staying in the publicly traded markets.
00:25:44.500 | We're talking about buying publicly traded REITs.
00:25:47.660 | But if you're willing to give up some of that,
00:25:49.660 | then you've got to ask yourself
00:25:51.400 | about how you feel about fees.
00:25:54.720 | Because a lot of fees get added into this real estate space,
00:25:58.400 | especially when you're looking at syndications,
00:25:59.920 | when you're looking at funds.
00:26:01.240 | You know, these fees look like hedge funds.
00:26:04.400 | You know, they're substantial fees.
00:26:06.240 | And if that really bothers you,
00:26:07.840 | again, stick with the publicly traded REITs,
00:26:11.200 | and you won't see those sorts of fees.
00:26:13.440 | Okay, the next question you'd ask yourself is hassle.
00:26:15.880 | How much hassle are you really willing to deal with?
00:26:18.640 | And if you're willing to deal with a lot of hassle,
00:26:21.880 | and you love real estate, you love making deals,
00:26:24.160 | you love looking for properties,
00:26:26.660 | you don't mind working with tenants,
00:26:28.120 | you can go do direct real estate investing.
00:26:30.800 | People have retired off nothing
00:26:33.080 | but their direct real estate investments.
00:26:35.120 | It's a very profitable way to invest.
00:26:37.880 | You got to learn what you're doing.
00:26:39.120 | There's a learning curve.
00:26:41.240 | But this is a very reasonable way to invest.
00:26:43.560 | And some people do that.
00:26:44.540 | They don't invest in mutual funds.
00:26:45.880 | They invest in properties.
00:26:47.280 | But again, if you're willing to deal with some hassle,
00:26:53.060 | now you're asking yourself,
00:26:54.160 | are you an accredited investor or not?
00:26:56.520 | Because if you are not,
00:26:58.680 | then there are a very limited number
00:27:00.880 | of investments out there.
00:27:02.480 | Most of them are what I call crowdfunded investments
00:27:05.800 | that don't require you to have accredited investor status.
00:27:08.760 | I'm not as bullish or positive about those returns.
00:27:13.760 | I think a lot of times those are not
00:27:16.520 | the most experienced operators running those investments,
00:27:19.860 | but it is an option.
00:27:21.320 | - You've mentioned accredited investor a couple of times.
00:27:23.660 | Could you explain that?
00:27:24.840 | - An accredited investor, by definition,
00:27:28.000 | is somebody who has at least $200,000 in income
00:27:30.900 | each of the last two years,
00:27:32.720 | or $300,000 together with their spouse,
00:27:35.920 | or has a million dollars in investable assets.
00:27:38.600 | And there's some other requirements
00:27:39.720 | for trusts and businesses, et cetera.
00:27:42.040 | However, that's just the legal definition.
00:27:44.600 | The definition I think you should use
00:27:46.760 | when you decide if you're an accredited investor
00:27:48.600 | is number one,
00:27:49.560 | are you capable of evaluating the merits of an investment
00:27:52.820 | without the assistance of an attorney,
00:27:54.660 | an accountant, and a financial advisor?
00:27:56.940 | And number two,
00:27:57.840 | can you lose your entire investment
00:27:59.900 | without it affecting your financial life
00:28:01.640 | in a significant way?
00:28:03.400 | And if those two are not both true,
00:28:05.240 | I wouldn't call yourself an accredited investor,
00:28:07.160 | even if you met the $200,000 income limitation,
00:28:10.200 | which by the way, hasn't gone up with inflation for years.
00:28:13.920 | - This is for syndicated real estate,
00:28:16.240 | for private equity type real estate,
00:28:18.640 | not for REITs, not for building your own.
00:28:21.320 | - Yeah, this is for the most part,
00:28:22.480 | we're talking about syndication.
00:28:23.640 | We're talking about, you know, these private funds.
00:28:25.520 | But keep in mind, we say REITs,
00:28:27.560 | but the truth is a large number of these private funds
00:28:30.260 | have adopted REIT status for some various benefits.
00:28:33.860 | So, you know, we throw out this term REITs,
00:28:36.060 | and most of the time,
00:28:36.900 | we mean these big publicly traded REITs,
00:28:38.600 | but the truth is at least half the funds I'm invested in
00:28:41.100 | are REITs too.
00:28:42.760 | - Well, that's a great place to end
00:28:43.820 | because my next guest is all about REITs.
00:28:46.140 | Jim, thank you so much for joining us today.
00:28:48.500 | - Thank you, Rick.
00:28:49.340 | It's a pleasure as always.
00:28:50.740 | - Our next guest is Dr. John Wirth,
00:28:53.180 | Executive Vice President,
00:28:54.540 | Research and Investor Outreach at NARIT.
00:28:57.860 | With no further ado, let me introduce John Wirth.
00:29:01.380 | Welcome to the "Bogle Heads on Investing" podcast, John.
00:29:04.140 | - Thanks for having me.
00:29:05.060 | - So you're the Executive Vice President,
00:29:07.260 | Research and Investor Outreach at NARIT.
00:29:10.460 | Tell us a little bit about your background
00:29:11.820 | and something interesting about yourself.
00:29:14.160 | - Sure, well, I did a PhD in economics
00:29:16.540 | back in the mists of time,
00:29:18.300 | and then proceeded to go join the U.S. Treasury.
00:29:21.860 | And I spent about 10 years at Treasury
00:29:24.300 | between 2000 and 2010.
00:29:26.540 | So that included working through many aspects
00:29:29.440 | of the financial crisis and financial crisis recovery,
00:29:32.620 | which was probably the time in my life
00:29:34.800 | where I spent the least amount of time at home.
00:29:37.140 | Many more all-nighters as a professional
00:29:39.220 | than I did as a student.
00:29:40.660 | - Tell us a little about the environment at Treasury
00:29:42.400 | at that time during the financial crisis.
00:29:44.820 | You were under Paulson, correct?
00:29:47.280 | - Yeah, with Hank Paulson in the Bush administration,
00:29:49.820 | and then there was a handover to Tim Geithner
00:29:52.620 | as the Obama administration came in.
00:29:54.900 | I would say the attitude was one of a lot of flexibility.
00:29:59.460 | That response crossed two administrations.
00:30:01.720 | People tend to forget that.
00:30:03.480 | And I think that there was a degree
00:30:06.260 | of admirable ideological flexibility
00:30:09.560 | and an ability to work together.
00:30:11.860 | The handoff wasn't seamless,
00:30:14.140 | but it was as close to seamless
00:30:16.180 | as I think it could have been
00:30:17.300 | between a Republican and Democratic administration.
00:30:20.260 | And I think that was a sense of common purpose
00:30:22.700 | that I think too often is lost today.
00:30:25.180 | But I would say that had a lot to do
00:30:27.180 | with some of the successes in those programs
00:30:30.940 | that we ended up with and keeping the nation
00:30:33.900 | out of even more difficult economic environment
00:30:36.620 | than what we went through.
00:30:38.260 | - And after that, you went to join
00:30:40.220 | the National Credit Union administration.
00:30:42.940 | What was your role there?
00:30:44.740 | - I was the chief economist there,
00:30:46.460 | and I actually went there to create
00:30:48.620 | the role of chief economist and stand up
00:30:50.500 | in office of chief economist.
00:30:52.100 | And it was a great experience,
00:30:53.740 | a really educational experience.
00:30:55.080 | I had been on the policymaking side,
00:30:57.500 | but not really on the regulatory side.
00:30:59.420 | So going over and working for a regulator,
00:31:01.800 | getting an appreciation for the challenges
00:31:04.420 | associated with bank and credit union regulation
00:31:07.100 | and what that means on a real day-to-day basis.
00:31:10.300 | - And then you decided to go to NARATE,
00:31:12.900 | the National Association of Real Estate Investment Trust,
00:31:15.540 | which is what that stands for, or used to stand for.
00:31:17.700 | Now I think it's its own word, correct?
00:31:19.980 | - Correct.
00:31:20.820 | - Can you tell us a little bit about NARATE
00:31:22.260 | and what your mission is?
00:31:24.060 | - Our mission is really to represent
00:31:27.340 | and be the voice for REITs and listed real estate companies
00:31:31.140 | that have an interest in the U.S.
00:31:33.020 | Virtually every listed real estate company in the U.S.,
00:31:36.500 | every REIT in the U.S. is a member of NARATE.
00:31:38.820 | We represent REITs of all types.
00:31:41.420 | And that runs the gamut from making sure
00:31:43.780 | that REITs are well-represented in terms of policymaking
00:31:47.520 | and the political process, to what I do,
00:31:50.340 | which is our research efforts, but also investor outreach,
00:31:53.860 | getting out and making sure that investors of all types
00:31:56.740 | understand the attributes of real estate
00:31:58.980 | and how REITs can provide those attributes
00:32:01.560 | in a low-cost liquid form,
00:32:03.740 | as well as holding meetings, communications,
00:32:06.700 | making sure that the industry is cohesive
00:32:09.540 | and giving them opportunities to come together.
00:32:12.140 | - Just for basics, how does a company qualify as a REIT?
00:32:16.180 | How does it become a REIT?
00:32:18.140 | - You qualify as a REIT by meeting a number
00:32:21.100 | of IRS requirements that are built into the law.
00:32:25.180 | The most basic and the most key
00:32:28.400 | is that you need to be owning real estate assets
00:32:32.940 | and you need to be paying out 90% or more
00:32:36.380 | of your taxable income in the form of dividend.
00:32:38.780 | And that's why REITs often are thought of
00:32:41.620 | as income-producing stocks,
00:32:44.060 | because of that 90% requirement.
00:32:46.380 | And the quid pro quo there
00:32:48.420 | is that if REITs meet those requirements,
00:32:51.540 | then they don't pay corporate taxes on that dividend
00:32:55.620 | that they've paid out to their shareholders.
00:32:58.100 | Instead, the taxes are paid at the shareholder.
00:33:01.260 | And what that does is that really aligns the taxation
00:33:05.060 | between owning real estate in the form of a partnership
00:33:08.060 | and owning real estate through a REIT.
00:33:10.100 | To a very close approximation,
00:33:12.500 | a dollar of income through a REIT
00:33:14.660 | and a dollar of income through a partnership
00:33:16.700 | are gonna be taxed exactly the same way.
00:33:19.260 | - Taxation of REITs is interesting
00:33:21.420 | because it is not taxed at a corporate level,
00:33:24.660 | which makes these investments unique.
00:33:27.260 | And the dividends that come in is three types of income
00:33:30.620 | that come in from REITs.
00:33:31.500 | There's ordinary income,
00:33:32.900 | which is the income you were talking about,
00:33:34.300 | generally from rent or from a mortgage payment.
00:33:37.740 | Capital gains, sometimes they sell properties
00:33:40.580 | and make a profit.
00:33:42.060 | And then there's a return of capital.
00:33:44.100 | So I can understand the ordinary income from rent.
00:33:47.980 | I can understand capital gains.
00:33:49.140 | What is the return of capital?
00:33:50.500 | - So return of capital is important
00:33:52.060 | because the portion of the dividend
00:33:54.620 | that is paid as return of capital
00:33:56.500 | is not taxed at the shareholder level,
00:33:58.940 | although it does reduce the basis in the stocks.
00:34:01.780 | So ultimately, when that stock is sold,
00:34:04.340 | that will be accounted for.
00:34:05.580 | And return of capital is really there
00:34:07.620 | to account for the situation
00:34:09.620 | because of various sort of accounting and tax situations
00:34:13.900 | where essentially a REIT or any other company
00:34:16.780 | is doing exactly what it says.
00:34:18.020 | It's really returning capital
00:34:19.820 | that essentially hasn't been invested to the shareholders.
00:34:22.660 | So that's the theory behind not having it taxed,
00:34:25.900 | but also reducing the basis.
00:34:28.580 | - Now, there's a couple of other things about real estate.
00:34:30.820 | The ordinary income portion of it
00:34:33.060 | is subject to the qualified business income deduction.
00:34:38.060 | This changed during the Trump administration
00:34:40.660 | because corporations were being taxed at a lower tax rate.
00:34:44.740 | Therefore, now this income from corporations
00:34:47.460 | needed to be taxed at a lower tax rate.
00:34:49.060 | But since it was coming to us,
00:34:50.940 | it was gonna be taxed as ordinary income.
00:34:52.820 | So they said, well, we'll give you a reduction on this
00:34:56.220 | of 20%.
00:34:57.340 | Did I say that correctly?
00:34:58.340 | - Yeah, I think you did a great job with that, Rich.
00:35:00.180 | We tend to talk about this as 199A
00:35:03.260 | because that's how it's reported on your tax forms.
00:35:06.740 | And really, it does exactly what you said.
00:35:09.100 | It's basically a 20% discount on that tax on the dividends.
00:35:13.860 | In fact, what it does is it really takes
00:35:15.540 | that amount of dividends, multiplies it by 0.8,
00:35:19.180 | and then applies the tax rate.
00:35:20.900 | But that has been a way that we've seen for investors,
00:35:25.660 | for taxable investors in REITs,
00:35:27.260 | they've seen a really significant reduction
00:35:29.940 | in the tax they're paying on those dividends.
00:35:32.380 | That 199A provision doesn't just apply to REITs,
00:35:35.620 | it applies to a lot of different types of real estate,
00:35:38.660 | whether publicly or privately held,
00:35:40.780 | can qualify for that 199A treatment.
00:35:43.580 | Which is, again, that goes back to that consistency
00:35:47.060 | of treatment of income and returns of real estate
00:35:50.260 | between REITs and other types of holding,
00:35:52.140 | which we think is very important.
00:35:53.700 | We really want there to be that consistent,
00:35:56.780 | even playing field between different ways
00:35:59.380 | you can hold real estate.
00:36:01.260 | - Okay, very good.
00:36:02.100 | And it does get a little complicated
00:36:03.100 | because you also, depending on your income,
00:36:05.300 | can be subject to the net investment income tax,
00:36:07.580 | not only on the ordinary income,
00:36:09.020 | but also on the capital gains,
00:36:10.500 | which is the way in which Obamacare is paid for.
00:36:15.500 | - Correct.
00:36:16.380 | - So 3.8%, but it only hits
00:36:18.220 | if you make above $250,000 a year,
00:36:21.300 | if you're filing jointly,
00:36:22.540 | or $200,000 if you're single.
00:36:24.740 | So it doesn't affect everyone.
00:36:26.860 | Well, there's also different types of REITs, right?
00:36:30.140 | There are equity REITs, mortgage REITs,
00:36:32.820 | public non-listed REITs,
00:36:34.860 | and then there's private REITs.
00:36:36.500 | And so let's go through the difference.
00:36:39.340 | Let's start with the easy one, equity REITs.
00:36:41.500 | - So equity REITs, I think, are what people,
00:36:43.780 | when they think about a REIT,
00:36:44.860 | this is probably what they're thinking about.
00:36:46.580 | This is a publicly traded company
00:36:49.260 | that owns and operates commercial real estate.
00:36:51.780 | Today, the market capitalization of listed equity REITs
00:36:55.420 | is right around $1.3 trillion.
00:36:57.580 | So it's a meaningful part of the stock market.
00:37:01.220 | Listed equity REITs,
00:37:02.460 | they comprise one of the GIC sectors.
00:37:04.700 | They're the 11th GIC sector of the stock market.
00:37:07.460 | So they're really represented as a unique sector.
00:37:10.740 | These are the companies who, through owning their stock,
00:37:13.860 | this is where you're getting access
00:37:15.820 | to the flow of rents from commercial real estate,
00:37:19.420 | with daily pricing, daily liquidity,
00:37:22.380 | the ability to buy and sell those holdings
00:37:24.860 | as frequently as you want,
00:37:26.780 | with, for most investors, effectively unlimited liquidity.
00:37:30.660 | That's the equity REITs.
00:37:32.060 | Mortgage REITs, very similar,
00:37:34.180 | publicly listed, publicly traded,
00:37:36.220 | but instead of owning and operating properties,
00:37:39.580 | they're typically going to own real estate debt.
00:37:43.380 | So that could either be in the form of home mortgages,
00:37:47.620 | owning Fannie and Freddie mortgage-backed securities,
00:37:50.740 | or it could be in commercial mortgages,
00:37:53.340 | either through commercial-curatized,
00:37:55.500 | commercial mortgage-backed securities, or direct loans.
00:37:58.780 | So when you think about the listed space,
00:38:01.100 | listed equity REITs make up about 95%,
00:38:04.460 | the mortgage REITs make up about 5%
00:38:06.580 | of that market capitalization.
00:38:08.580 | The interesting thing about mortgage REITs,
00:38:10.540 | and one of the reasons why we see
00:38:12.740 | a lot of individual investor interest in mortgage REITs
00:38:15.620 | is because of their dividend yields.
00:38:17.860 | They often pay double-digit,
00:38:20.820 | or recently have been paying double-digit yields,
00:38:23.620 | so they've been a very high-yielding,
00:38:25.980 | income-driven investment.
00:38:28.540 | - The yield is double-digit,
00:38:30.100 | but is that due to return of capital,
00:38:32.180 | or is that due to actual just interest income?
00:38:35.140 | - Most of that is interest income.
00:38:36.700 | - Wow.
00:38:38.180 | Okay, the third one is public, non-listed REITs.
00:38:42.820 | What are these?
00:38:43.780 | - These are another flavor of REIT,
00:38:46.260 | and these have grown in popularity
00:38:47.780 | over the last several years.
00:38:49.820 | And so these are public REITs,
00:38:51.780 | so they are registered with the SEC,
00:38:54.100 | they file 10-Qs and 10-Ks,
00:38:56.340 | they have all the transparency
00:38:57.780 | you associate with a public company,
00:38:59.660 | but they're not listed on the stock exchange.
00:39:02.420 | So their shares don't trade on a daily basis,
00:39:05.860 | and they have somewhat limited liquidity.
00:39:07.980 | You get liquidity in these stocks,
00:39:11.220 | typically by selling your shares back to the REIT,
00:39:14.540 | and they offer typically regular,
00:39:17.460 | typically on a monthly basis, liquidity opportunities,
00:39:21.380 | but that liquidity can be limited.
00:39:23.300 | In times when a lot of people
00:39:25.180 | wanna sell their shares back,
00:39:26.500 | they may put on restrictions
00:39:28.220 | about how much you can sell back,
00:39:29.740 | or those restrictions are set beforehand,
00:39:31.980 | but you may run into those restrictions.
00:39:34.660 | When you think about non-traded REITs versus traded REITs,
00:39:37.940 | we like to think about it as really a trade-off
00:39:41.620 | between volatility and liquidity,
00:39:44.620 | whereas with listed REITs,
00:39:46.660 | you're getting full liquidity,
00:39:48.460 | daily moment-to-moment pricing,
00:39:50.540 | the ability to exit and enter your positions
00:39:53.340 | whenever you want,
00:39:54.660 | and valuations that are stock-like valuations,
00:39:57.100 | they're estimates of future profitability,
00:39:59.340 | discounted to today,
00:40:00.940 | but you live with that day-to-day,
00:40:03.100 | moment-to-moment volatility of the stock market.
00:40:05.540 | With non-traded REITs, by contrast,
00:40:07.780 | you have limited liquidity,
00:40:09.580 | you have valuation that is more akin
00:40:12.740 | to private real estate valuations,
00:40:14.740 | which are sort of backward-looking,
00:40:16.500 | based on appraisals, more slow-moving,
00:40:19.660 | so they're not gonna price in changes
00:40:22.140 | in the economic environment quickly
00:40:24.340 | the way listed REITs will,
00:40:26.140 | so you avoid that volatility,
00:40:27.820 | but you don't have the same amount of liquidity.
00:40:30.260 | - We've also heard in the press
00:40:31.860 | that there's been some miscommunication
00:40:34.660 | between the brokers who sell these public non-listed REITs
00:40:39.620 | and the consumers who buy them,
00:40:42.420 | where there's been some recent arbitration.
00:40:45.820 | Do you wanna comment on that?
00:40:48.100 | - Yeah, I mean, it's definitely a product
00:40:49.620 | that is marketed to a high-net-worth individuals,
00:40:53.540 | sometimes sold through brokers,
00:40:55.420 | sometimes sold directly by the REITs themselves,
00:40:58.940 | and I think with all of these products,
00:41:00.660 | it's really very important for people to understand
00:41:03.500 | what are the attributes of the product
00:41:05.100 | and what's it gonna bring and what's it not gonna bring,
00:41:07.380 | and we think that's true
00:41:09.500 | across the full range of REIT products.
00:41:12.420 | - And the last one is a private REIT,
00:41:14.340 | which is for mostly institutional investors.
00:41:17.140 | Briefly, what are these?
00:41:18.820 | - So private REITs are exactly as described, right?
00:41:21.700 | They are not listed on a stock exchange.
00:41:24.180 | They don't file with SEC.
00:41:26.220 | They're really marketed individually.
00:41:28.780 | They might be used inside of a structured product.
00:41:31.780 | It might be part of another partnership.
00:41:34.500 | So most investors are not gonna run across private REITs
00:41:39.260 | in their ordinary course of business.
00:41:42.340 | - So in aggregate, you write in your reports
00:41:47.220 | that about 4 trillion in gross assets
00:41:51.500 | across the U.S. are in REITs,
00:41:54.900 | with public owning 2.5 trillion,
00:41:59.260 | which means 1.5 trillion
00:42:01.180 | would be a non-public and institutional or private.
00:42:04.660 | And then you have here that U.S. listed REITs
00:42:07.460 | have an equity market capitalization
00:42:09.620 | of more than 1.3 trillion.
00:42:12.700 | So I guess I don't understand the question here
00:42:15.980 | is public REITs own 2.5 trillion
00:42:19.180 | and equity markets are 1.3 of the 2.5.
00:42:23.540 | Am I reading that correctly?
00:42:24.860 | - We've really got two separate concepts going on here
00:42:28.420 | because what we're talking about is the valuation
00:42:32.020 | of the underlying real estate.
00:42:34.140 | So equity market capital only captures part of the value,
00:42:37.340 | right, because they're also holding debt.
00:42:39.620 | It's really hard to compare these two concepts.
00:42:41.900 | Our estimate is that the public REITs
00:42:43.900 | own about 2.5 trillion,
00:42:46.220 | could be anywhere between 2.5 trillion and 3 trillion
00:42:49.140 | in commercial real estate
00:42:50.380 | with the balance owned by private REITs.
00:42:53.500 | - So about 3% of the U.S. equity market.
00:42:57.060 | - REITs make up about 3% of most equity indexes, yeah.
00:43:00.860 | - And it's been that way for quite a few years.
00:43:03.020 | Has it not?
00:43:04.260 | - Well, it depends how far you go back.
00:43:06.580 | If you look back to say 1990,
00:43:09.980 | you would have seen a REIT market capitalization
00:43:12.500 | of just about $10 billion.
00:43:14.260 | And that has grown dramatically today to about 1.3 trillion
00:43:19.060 | as we saw a wave of IPOs in the 1990s
00:43:22.220 | and the evolution of the industry.
00:43:24.580 | Over the last three or four years,
00:43:26.220 | REITs have been in this 2% to 3% of the S&P 500
00:43:30.460 | or the Russell 1000 range.
00:43:32.780 | - So talking about the history of REITs,
00:43:34.300 | this is a little bit interesting.
00:43:35.660 | I mean, no REITs existed prior to 1960.
00:43:39.540 | That's when Congress established the ability
00:43:41.940 | to be able to do real estate pass-through.
00:43:45.900 | And it took off a little bit.
00:43:48.980 | I mean, you had some companies coming public.
00:43:52.700 | They were, you know, some shopping centers,
00:43:54.900 | even some railroads, some lodging, and so forth.
00:43:57.700 | But it really took off when the law changed in 1986,
00:44:02.100 | which gave REITs the ability to operate
00:44:05.860 | and manage real estate rather than simply owning it
00:44:09.460 | and financing it, which was the original concept.
00:44:12.820 | So could you talk a little bit about the history of REITs
00:44:15.180 | and what happened and why during the early 1990s,
00:44:19.540 | there was not a lot of REITs,
00:44:20.700 | but then now it's growing in many different areas.
00:44:23.140 | - Yeah, and just going back sort of in 1960,
00:44:26.620 | Congress passed the first REIT legislation.
00:44:29.380 | And, you know, we always think it's very interesting
00:44:31.660 | because the purpose of that was to allow everyday investors
00:44:36.460 | to get access to commercial real estate
00:44:38.220 | as part of their portfolios.
00:44:39.380 | Really, the REIT legislation was inspired
00:44:43.380 | by the mutual fund legislation.
00:44:45.620 | Same concept, let's let a broader base of investors
00:44:48.700 | get access to stocks in the case of mutual funds,
00:44:52.420 | real estate in the case of REITs.
00:44:53.980 | And it's important to sort of, you know,
00:44:55.620 | when you look at that big picture,
00:44:57.300 | I think it's very interesting that today,
00:44:59.340 | we estimate about 170 million Americans
00:45:03.140 | live in households that own REITs.
00:45:04.820 | So this has been a public policy success.
00:45:07.700 | We've gotten that broad-based ownership
00:45:09.860 | of commercial real estate through REITs.
00:45:12.220 | So it has really done what it set out to accomplish.
00:45:16.100 | Now, when we look at how it got there,
00:45:18.860 | between 1960 and 1990,
00:45:21.460 | I would say that REITs were really a niche product.
00:45:25.020 | They were generally not in the big stock indexes.
00:45:29.220 | They were not well-known.
00:45:30.740 | They were generally small cap companies.
00:45:33.220 | What we saw in the late '80s and early '90s
00:45:35.780 | was a few changes.
00:45:37.420 | One was the 1986 Act
00:45:39.140 | that allowed the internal management of REITs,
00:45:41.180 | which has been absolutely critical
00:45:43.020 | to the success of REITs in the U.S.
00:45:45.100 | We also saw what's called the creation
00:45:47.140 | of the up-REIT structure
00:45:48.740 | that actually allowed individuals who owned real estate
00:45:52.060 | to transfer that real estate into a REIT
00:45:54.540 | without it being a taxable event.
00:45:56.660 | And the confluence of those two factors
00:45:59.260 | with the commercial real estate crisis of the early 1990s,
00:46:02.860 | which resulted in a number of real estate investors
00:46:05.700 | needing to recapitalize their properties,
00:46:08.340 | that really resulted in what we call
00:46:10.500 | sort of the modern REIT era starting in early 1990s,
00:46:13.660 | where we saw a wave of IPOs
00:46:16.020 | and the creation of what are today
00:46:19.460 | some of the leading, not just listed real estate companies,
00:46:22.900 | but the leading real estate companies in the world as REITs
00:46:27.860 | because of that ability to be internally managed,
00:46:30.460 | to be organized as a corporation,
00:46:32.460 | and to build out the human capital,
00:46:34.780 | the prop tech need, the data science needs,
00:46:37.500 | everything you need to be a leading-edge company
00:46:41.460 | in real estate today.
00:46:43.140 | - And some of the properties that have become REITs,
00:46:46.740 | the list is growing.
00:46:48.260 | Imaginative, I guess you could say.
00:46:50.100 | In 1986, self-storage started to come online,
00:46:56.660 | and that's been a big player in the REIT space.
00:46:59.220 | Factory outlets, movie theaters, correctional facilities.
00:47:03.180 | I remember that wave that occurred in the 1990s.
00:47:06.620 | And then telecom towers, the cell towers that we see,
00:47:11.100 | those became REITs, and then 2004, data centers.
00:47:15.860 | And then it was pipelines.
00:47:17.620 | And later on in 2015, electric transmission lines
00:47:22.620 | and fiber optics.
00:47:24.980 | And 2019, the first post office became a REIT.
00:47:28.860 | And these have really grown.
00:47:30.220 | I mean, if you look at the industry groups
00:47:32.300 | within the REIT index,
00:47:34.260 | it's these new niche areas that have really expanded.
00:47:39.300 | Can you talk about the changing real estate market
00:47:43.020 | out there for REITs?
00:47:44.500 | - Yeah, absolutely.
00:47:45.460 | And Rick, I think this is one of the most important points
00:47:49.340 | for investors to understand about REITs
00:47:52.340 | and commercial real estate.
00:47:53.580 | I think often we think about commercial real estate
00:47:56.660 | and we think, okay, office, retail,
00:48:00.780 | maybe multifamily residential,
00:48:03.060 | possibly people put industrial on that list.
00:48:06.220 | And those are all very important components
00:48:08.540 | of the REIT marketplace today.
00:48:10.580 | Those four sectors make up about half of the market cap,
00:48:14.020 | but we've seen a tremendous growth and innovation
00:48:18.020 | in terms of property sectors and REITs.
00:48:20.620 | And one of the things we like to say here
00:48:22.220 | is that real estate houses the economy.
00:48:24.340 | That's kind of the way I like to think about it.
00:48:27.340 | And so you would expect that real estate
00:48:29.660 | would be as innovative as the economy as a whole
00:48:32.620 | and to grow with the shape of the economy.
00:48:35.060 | And REITs have really accomplished that.
00:48:37.260 | You know, if you go back to 2000,
00:48:38.820 | you'll see that 75% of the market cap
00:48:41.540 | was in traditional four property types,
00:48:43.540 | residential, retail, industrial, and office.
00:48:45.900 | Today, that's down to about 50%.
00:48:48.900 | And the balance has been taken up
00:48:50.820 | with things like cell phone towers, as you mentioned,
00:48:54.340 | data centers, which were the best performing
00:48:56.940 | property sector in 2023, driven by the AI demand wave,
00:49:01.780 | healthcare, self-storage, hotels, timber,
00:49:05.580 | and the list goes on.
00:49:06.940 | And REITs have really been a place where that innovation
00:49:11.660 | in terms of property sectors have really found a home.
00:49:15.820 | So today, one of the things that we see
00:49:17.900 | is that institutional investors
00:49:20.020 | might have a well-established portfolio
00:49:22.340 | of private real estate.
00:49:24.060 | One of the things they're turning to REITs for
00:49:26.500 | is actually access to these new
00:49:28.940 | and emerging property sectors,
00:49:30.420 | where REITs have been the innovators and the first movers
00:49:33.700 | and have really gained a leading position.
00:49:36.580 | So investors, we out here in the marketplace,
00:49:39.460 | can access REITs either directly, if they're traded,
00:49:43.660 | we can buy them through exchange-traded funds,
00:49:46.020 | we can buy them through mutual funds,
00:49:48.780 | and there are different sectors that we can buy as well.
00:49:52.380 | You also get them if you're in a target date fund,
00:49:54.620 | for example, if you're in a Vanguard fund
00:49:58.740 | or a State Street fund or T. Rowe Price
00:50:01.860 | target retirement fund,
00:50:03.260 | I mean, they're going to have REITs in there.
00:50:04.900 | So more than likely you're going to own
00:50:07.940 | what we're talking about today.
00:50:10.220 | And so we need to talk about the performance.
00:50:12.580 | And I've been watching this market since the 1980s
00:50:15.140 | when I came into the business.
00:50:16.540 | It seems to me as though in the long-term
00:50:19.860 | that you would expect REITs, property REITs,
00:50:24.420 | to perform about as well as the large cap market,
00:50:29.300 | S&P 500 or Russell 1000.
00:50:31.700 | Would you agree with that,
00:50:32.700 | that that's what we're looking for?
00:50:34.860 | Yeah, historically what we've seen,
00:50:37.060 | and there's different ways to look at it,
00:50:39.420 | but when you look at that long-term performance,
00:50:42.060 | typically you're going to see that REITs are at
00:50:44.740 | or maybe a little bit above a broad-based stock
00:50:49.140 | in terms of their performance.
00:50:51.340 | So it depends on the time period you look at.
00:50:54.180 | Sometimes when you put real estate into a portfolio,
00:50:56.940 | and I've said this,
00:50:57.780 | is that it's a different asset class than common stock.
00:51:00.980 | And the correlation between real estate
00:51:04.700 | and the rest of the market, the other 97%,
00:51:08.460 | at times you can have negative correlation
00:51:10.980 | between REITs and the rest of the equity market.
00:51:13.980 | And there are times when it's positive correlation.
00:51:16.460 | So can you speak to the diversification benefits?
00:51:19.540 | Absolutely, and I think for most of your listeners,
00:51:22.100 | this is going to be the core of why real estate
00:51:25.500 | in a portfolio is important, and I would say critical.
00:51:28.940 | It's that ability to diversify the portfolio
00:51:32.500 | while getting competitive returns.
00:51:35.060 | Depending on the time period you look at it
00:51:36.820 | and the data source you're going to look at,
00:51:39.020 | you're going to see REIT correlation
00:51:40.620 | with the broader stock market,
00:51:42.780 | anywhere between 0.55, 0.65,
00:51:46.460 | maybe up to 0.7 over some periods.
00:51:49.260 | By the way, that's on a scale of negative one
00:51:51.500 | to positive one?
00:51:52.580 | Correct, right.
00:51:53.620 | And when you look at your sort of alternatives out there
00:51:57.660 | to get diversification in a portfolio,
00:52:00.060 | if you think I could use large cap, small cap,
00:52:03.420 | value, growth, international,
00:52:05.940 | when you put those on a scale,
00:52:07.780 | you're going to see most of those stock alternatives
00:52:10.940 | are going to have correlations that are typically above 0.9
00:52:14.940 | and almost always above 0.85.
00:52:16.940 | So among those alternatives that you can use
00:52:19.980 | to get diversification in a portfolio,
00:52:21.860 | REITs really stand out.
00:52:23.380 | And that's one of the reasons why we've done studies
00:52:26.980 | with Morningstar, Ibbotson, Wilshire,
00:52:29.380 | a number of firms where we asked,
00:52:32.060 | what is the optimal portfolio look like
00:52:35.340 | and how does real estate play a role in that?
00:52:37.580 | And what we find is that those results
00:52:40.020 | are typically coming in anywhere between five and 15%
00:52:44.460 | real estate in a portfolio,
00:52:46.300 | depending on the risk tolerance of the investors.
00:52:49.300 | That five to 15, is that assuming a portfolio of all equity
00:52:52.980 | or is it a 60% equity, 40% bond portfolio?
00:52:56.820 | - Yeah, so that's an equity and bond portfolio
00:52:59.860 | and you'll see REITs taken a bit out of the equities,
00:53:03.060 | a bit out of the fixed income portion.
00:53:06.580 | - I would have thought
00:53:07.420 | that you just take it out of the equity,
00:53:08.740 | but what you're saying is if you have a 60/40 portfolio,
00:53:12.580 | 60% equity, 40% bonds,
00:53:15.300 | you may want to go to maybe 50% equity,
00:53:18.060 | 35% bonds and 15% real estate.
00:53:20.260 | Is that what you're saying?
00:53:21.660 | - That's right, yeah.
00:53:22.660 | Because what you're going to see in these optimal portfolios
00:53:26.300 | is that the REITs are providing equity-like returns,
00:53:30.780 | but because they're income providers,
00:53:32.500 | there's also some bond-like stability in there.
00:53:36.700 | - Well, you also do an Outlook, Android Economist.
00:53:39.220 | I mean, this is what you get paid for, right?
00:53:42.140 | We have to discuss the future.
00:53:43.940 | What do you see the future of REITs to be?
00:53:47.980 | - Well, we think 2024 could be a good year for REITs.
00:53:52.340 | REIT performance during the first three quarters of 2023
00:53:56.620 | was pretty tough going.
00:53:58.700 | And in 2022, REITs had pretty tough going performance
00:54:02.340 | because as Fed was adjusting monetary policy,
00:54:05.620 | REITs really bore the brunt of that
00:54:07.620 | in terms of their valuations.
00:54:10.020 | What we saw in the fourth quarter was a real turnaround
00:54:13.820 | where REITs returned 18% for the quarter
00:54:18.300 | and outperformed the broader stock market.
00:54:21.180 | And that's very consistent with one of the key themes
00:54:23.580 | in our Outlook, which is that historically,
00:54:26.900 | REITs have performed very well
00:54:29.100 | at the end of monetary policy rate rising cycles.
00:54:32.460 | Another piece of REITs that I think is important
00:54:36.020 | is that we are going to be
00:54:37.700 | in a higher interest rate environment in 2024,
00:54:40.900 | and that can be a difficult environment
00:54:42.460 | for commercial real estate,
00:54:44.420 | but REITs are coming in
00:54:45.900 | with very well-managed balance sheets.
00:54:48.820 | So REITs have been sort of low leverage players.
00:54:52.780 | They are not using a large amount of debt
00:54:55.140 | in their strategies.
00:54:56.540 | And the debt that they have is mostly fixed rate debt.
00:54:59.620 | So we think that gives REITs both the ability
00:55:02.900 | to navigate a period of higher interest rates,
00:55:05.700 | but also maybe find opportunities
00:55:08.180 | where higher leverage borrowers
00:55:10.180 | have stepped out of the market.
00:55:11.780 | So we think there's a lot of positives in 2024 for REITs.
00:55:16.420 | - As privately held real estate,
00:55:18.580 | which is more highly leveraged,
00:55:21.220 | has to refinance at higher rates,
00:55:23.740 | it becomes distressed.
00:55:26.780 | And it's the REITs that have equity, more cash,
00:55:30.220 | rather than debt that are gonna be able
00:55:31.780 | to pick up these properties at good valuations.
00:55:35.260 | - Yeah, we think there's the possibility of that happening.
00:55:37.740 | And one of the things we've seen historically
00:55:40.060 | is that as we go through the commercial real estate cycle,
00:55:43.980 | one of the periods where REITs tend to do really well
00:55:47.340 | is essentially early in recovery
00:55:50.300 | because they tend to do a good job getting out of properties
00:55:53.780 | before they're too overvalued,
00:55:55.540 | and then getting back in early in the cycle.
00:55:58.380 | As we have talked to the management teams
00:56:01.220 | who are running the REITs,
00:56:02.620 | we know that that is something
00:56:03.740 | that is very much on their mind.
00:56:05.100 | They feel like their balance sheets
00:56:06.740 | are in a very strong position.
00:56:09.660 | And when property markets open up
00:56:11.940 | and we start to see transactions,
00:56:14.300 | they feel like they can really be in there
00:56:16.980 | growing their portfolios and growing their businesses.
00:56:19.980 | - Well, John, thank you so much for joining us
00:56:21.580 | on the "Bogleheads on Investing."
00:56:22.780 | We greatly appreciate your insights.
00:56:25.060 | - Appreciate you having me.
00:56:26.500 | - This concludes this episode of "Bogleheads on Investing."
00:56:30.580 | Join us each month as we interview a new guest
00:56:33.300 | on a new topic.
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00:56:52.740 | Thanks for listening.
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