Welcome, everyone, to the 66th episode of Bogleheads on Investing. Today, we're going to be talking about real estate investing with two special guests, Jim Dawley, who created an in-depth course on real estate investing, and John Worth, who's a chief economist at NARIT, formerly known as the National Association of Real Estate Investment Trusts.

Hi, everyone, my name is Rick Ferry, and I am the host of Bogleheads on Investing. This episode, as with all episodes, is brought to you by the John C. Bogle Center for Financial Literacy. A nonprofit organization that is building a world of well-informed, capable, and empowered investors. Visit the Bogle Center at boglecenter.net, where you will find a treasure trove of information, including transcripts of these podcasts.

Before we get started today, I have a special announcement. On behalf of all Bogleheads worldwide, we wish Taylor Larimore a happy birthday. Taylor is 100 years old this month. He is the founder of the Bogleheads. Jack Bogle called him the king of the Bogleheads. Back in 1998, he founded the organization by putting the very first post on the Morningstar Forum, at the time called Vanguard Diehards.

It has since moved on to its own website, bogleheads.org. He is also the author and co-author of three Bogleheads books, and was instrumental in creating the John C. Bogle Center for Financial Literacy. Taylor was a graduate of the University of Miami School of Business. He served as a paratrooper in World War II in the 101st Airborne Division during the Battle of the Bulge, earning five combat decorations.

He's an avid sailing enthusiast, and was named the American Sailing Association's Instructor of the Year. Taylor now continues to spend his time sailing and helping others discover the Bogleheads way. If you'd like to wish Taylor a happy birthday, there will be a special post on bogleheads.org for you to add your birthday wishes and special thanks.

Today our conversation is about real estate, and it is primarily directed at people who are interested in adding real estate as an asset class, or expanding their real estate holdings into different parts of the real estate market. Our first guest is Dr. Jim Dolly. Jim is an avid Boglehead.

He is a practicing emergency room physician and founder of the White Coat Investor. Jim has developed many courses helping individual investors and professionals. And one of the courses that he recently developed is a no frills real estate investing course, where he covers all aspects of real estate investing, along with the faculty of more than a dozen highly qualified instructors.

So we're gonna be talking about that with Jim. And our second guest is Dr. John Wirth. John is the Executive Vice President, Research and Investor Outreach at NARED, formerly known as the National Association of Real Estate Investment Trust. He was a former chief economist at the National Credit Union Administration.

And prior to that, he spent nearly a decade at US Treasury, where he served as the Director of the Office of Microeconomic Analysis. And he was there during the entire financial crisis. So with no further ado, let me welcome back Dr. Jim Dolly. Welcome to the Bogleheads on Investing, Jim.

>> Thank you, it's always a pleasure to be here, and a pleasure to be with Bogleheads, especially in person at the conference. >> Yeah, we had a great conference, and thank you and your wife so much for helping out. Today, our topic is real estate. I came to you because of two reasons.

You've always talked about real estate, and you talk about it in your books. But recently, you put together a course on real estate that you call the No Hype Real Estate Investing course. First, why do you say no hype? And secondly, why do you think you needed to put together a course like this?

And thirdly, what kind of real estate investing do you do? >> One of the biggest things I don't like about real estate is it's full of hype. You pick up a real estate book, and there's all kinds of hype in it. You take a course, there's hype in it.

You go to a website, there's hype in it. I don't like it. It turns me off. I feel like I'm being sold to. And I know a lot of Bogleheads don't like that either. And so I kind of took the approach of, if we're gonna make a course, let's have it be just the facts, ma'am.

And I think people respond well to that. >> And you pulled together a lot of professionals, a lot of people in the industry. It isn't just you that's speaking in this course. >> Absolutely correct. There's a whole bunch of other people that have recorded material for the course. And I don't pretend to be an expert in every single part of real estate.

I haven't done every type of real estate investing. And so that's one of the benefits of having other faculty members in the course, is you can hear about flipping homes, for instance, from someone who's actually flipped homes, rather than me, who only knows about it theoretically. >> Tell us a little bit about yourself and your own experiences with real estate investing.

>> Sure, I have a little bit of experience with direct real estate investing, kind of an accidental landlord situation. And realized fairly early on that I prefer to be mostly on the passive side of the spectrum. I think it was Michael LaBouf who talks about investing your time actively and your money passively.

And Bogleheads obviously try to do that for the most part. And I've been a Boglehead for a long time. And so I try to invest pretty passively for the most part. And so I end up on the passive side of the spectrum. What does that mean? That means publicly traded REITs, and the holding I use there is just a real estate index fund.

It means syndications, essentially going in with 99 other people and buying an apartment complex. But for the most part, my main other holding outside of publicly traded REITs are private real estate funds. These are investments that are only available to accredited investors, but allow you to have some diversification.

So instead of getting one apartment building, you get 15 apartment buildings in the fund, for example. And that allows you to be diversified if one of those goes bad. On the debt side, these tend to be loans to developers. Typical fund might have 75 or 300 different loans to developers.

And they pay pretty good interest in order to have access to money without having to go to a bank. And so they might borrow money at 10 or 12% plus two points. And even after paying the fees in the fund, you may come out with 8, 9, 10, 12% return on that money.

So I invest in both private equity and private debt funds. Those are my main holdings outside of publicly traded REITs. If I didn't know anything about real estate, which I don't really know that much, I've only owned residential real estate plus real estate investment for us, index fund. If I was going to learn, you have a really good blog on your website called Real Estate Investing 101.

And it does give you an awful lot of information. When you first go into the blog and you start reading about it, you have this nice graph which talks about the four quadrants of real estate investing. I wonder if you could touch on that. It's pretty easy, I think, to talk about real estate to somebody who invests kind of traditional investments.

You know, if you understand stocks and bonds, it's not that hard to understand real estate. You can invest on the equity side, the equivalent of a stock investor. Or you can invest on the debt side, the equivalent of a bond investor. So if you're investing on the equity side, the simplest form of real estate might be buying the house next door and renting it out to somebody.

Your income for this equity investment is the rent. Now, it's not the only source of return. The house might appreciate in value as well. Maybe you get some tax breaks for it. And you can depreciate the house. And that gives you a substantial tax break. But for the most part, your income coming in is the rent.

And your expenses for this business you now own are things like a mortgage, property insurance, property taxes, maintenance, all those sorts of things that it takes to run the business. So that's being an equity investor. When it goes up in value, you get the benefit of that. When you're able to raise rent on it or you're able to charge other fees to the renter, your income goes up on it.

You benefit from all of that as the equity investor, the owner of the property. But there's another way to invest in real estate. And that's being the debt investor. Most people have investments in real estate that are leveraged, meaning they borrowed at least some of the money to invest in it.

And you can invest on that debt side as well. You can loan money to somebody who is the equity investor in real estate. And just as bonds are less risky than stocks, investing on the debt side is less risky than being an owner. In the event that something terrible happens with the business, the debt side typically comes out with all or most of their capital.

And when something terrible is going on and you're on the equity side, you might lose all of your capital, especially if it's highly leveraged. And so there's two ways to invest there. There's the equity and the debt. On the debt side, you split out two types of debt. There's called hard money loan.

And then there's mezzanine debt or preferred equity. Can you describe the difference between the two? This is what gets a lot of people a little bit confused. There's these intermediate types of investments. It's the same way in the stock market, right? There's preferred equity. And it's the same thing on the real estate side.

For example, there might be a debt investor that's got an 8% note on a property. Well, they're going to make 8%. But they're first in line. If this property has to be foreclosed on, they can foreclose on it, sell the property, get all their money back. And then, of course, the equity investor is at the bottom of the capital stack.

So whatever's left over, in the event things go bad, goes to the equity investor. But there can also be different types of investors in between those two. And that's usually called preferred equity or mezzanine debt. Typically pays a higher interest rate. For example, if that first note is 8%, this next note might be 14%.

And so it's a riskier position, has higher expected returns. But those come, obviously, with higher risk. I want to go through different types of properties because you list in your course class A properties, class B properties, class C properties, royal land. Could you quickly go through these different classes of properties?

Yeah, sure. Class A is the nicest thing that just got built in the last few years. It's luxury. It's got granite countertops and tile floors. And it's in a nice neighborhood and a nice school district. And you're renting it out to professionals. That's a class A property. A class B property, it's a little bit older.

It might have been built 15 years ago. Lower income tenants are in there. It's not quite as nice as it was when it was first built. Maybe there's some deferred maintenance issues that need to be done on the property. Class C properties might be 30 or more years old.

Again, they're not as nice as a class B property. The tenants in there might be working class folks. They might be on government subsidies and lower rents. You're going to have a lot more ongoing maintenance, a lot more repairs than a class C property. And a class D property, of course, is in the bad part of town.

If you've heard the term slumlord before, they own class D properties. And they're rundown. And the tenants don't have great credit. But you're also buying them at a much higher capitalization rate than you would a class A property. And so your returns might actually be better in a class D property than a class A property.

But there's just a lot more issues you're going to be dealing with to have that sort of an investment property. And who decides whether what you're buying is class A, B, C, or D? Well, that's the beautiful thing about it. It's like a climbing grade for those rock climbers out there.

It's just consensus. And of course, someone trying to sell something, they're going to try to convince you it's class B. And you as the buyer would have to really go look at it and understand it to realize this isn't class B property. This is class C property. And it's not worth paying nearly as much for.

And so there's no government agency that goes out and says, this is class A and this is class B. It's just by consensus among the investors in the market. Let's discuss your real estate investing continuum. You've put together this very nice graphic on your website, which shows on one side, you've got the direct investor in real estate who actually builds it from the ground up.

And all the way through the REIT investor at the end, who's just investing in public REIT. And you've got all of these different ways which you can invest in real estate in the middle. I'd like to just go through that list of eight different ways that you've laid out here very nicely in this chart.

Moving left to right, you start with ground up construction. This is the person that goes to the city and gets the permits and digs the hole in the ground and puts the foundation in and builds the house and puts renters in it. This is ground up construction. Of course, you don't have to do that from the ground up.

You can buy something that's already been built. You're just improving it and then selling it to somebody else who's going to rent it out. That's generally called fix and flip. A lot of people watch TV shows that talk about this and how people made money fixing and flipping up properties.

But that's one way to invest. The next most active way to invest is short term rentals. And what you're really doing here is you're running a hotel business. You're renting these out to people. Typically, they will have a stay that averages 5, 6, 7 days. Lots of people are only in there for three or four days.

Some people will stay for a month. But for the most part, short term rentals, you're renting to people for a matter of days. And so it's pretty active. Somebody's got to get in there and clean it every three or four days. You have to book a different tenant, essentially, a different guest, multiple times a month.

And you're running a business. So it's a pretty active thing. Next, you come to long term rentals. And these are people you typically rent to for a year, two years, or five years. And so it's not nearly as actively involved as short term rentals. But as you might expect, you're also not charging them hotel rates.

And so there's less revenue involved as well. That's a way a lot of mom and pop investors invest. They buy a house, or they buy multiple houses, or they buy a duplex or two, or some quadplexes, or they buy an eight-door apartment building. A few years later, they buy another 10-door apartment building, and that's how they invest in real estate.

Some people do not want to be involved in that direct management role. But they still want to own the properties themselves. They want something they can drive by and show their friends or touch physically with their hands when they go to see it. But they don't want any hassles.

And I call that category turnkey properties. This is where somebody else is building the home. Someone else is getting a renter in there. Someone else is managing the property. When it's time for you to get out of the investment, they will sell it. But you are the 100% owner of the home.

And there are services out there that will do that for you if that's how you want to invest in real estate. The next step is what I mentioned earlier. This is when you go in and take advantage of some economies of scale. You want to own a big apartment complex.

Let's say the apartment complex has got 400 doors. You can't afford this thing yourself. It might cost $10 million, and you don't have that, much less enough to diversify that investment. But if you went in with 100 other investors-- typically it's 98 other investors, because of the way the laws are written-- you could buy that apartment complex.

But as that apartment complex does well or does poorly, you're going to share in the profits or losses there. And that's considered a syndication. You're a partner in a partnership. You get a K-1 every year. Losses and gains are passed through to you on that K-1. If you want more diversification than one apartment complex that you put $100,000 into, then you might want to look into private funds.

Instead of one complex, you might own a dozen of them. They'll all be packaged together into a fund. The fund might hold them for five or 10 years or indefinitely, and then sells off the properties. And you get what you get in your share of the returns. Obviously, there's somebody putting all that together, the general partner.

If it does well, they tend to do very well, charge fees that are similar to hedge fund fees. 1% a year and 20% of profits wouldn't be unusual for what they charge to run those funds and those syndications. But the nice thing about it is once you buy it for you, it's mailbox money.

You have no role in the management after the initial due diligence period and purchasing the investment. Do those funds have a maturity date? Do they eventually dissolve, or are they just ongoing? It depends. Some are evergreen, and some-- the intent is to dissolve them. For an equity-type investment, those will typically run three to 10 years.

But they'll usually give themselves some wiggle room. So if the market's not really good for selling real estate in six years, they might hold it for eight years in hopes of getting the investors a better exit price. These are illiquid investments, terribly illiquid investments that you are locked into.

Once you sign up for the ride, you're in there. And sometimes you don't even know exactly when your money is going to come back, especially if things are not going well. And then finally, on the far right side of this real estate investing continuum is publicly traded REITs. And these are typically large real estate properties, a large number of them that have been packaged up and securitized.

And you can trade them any day the markets are open. You can buy a mutual fund that invests in 100 or more of them. And they're very liquid and very transparent, like every other company on the stock market. But you're not going to have any control over them like you might if you bought the property next door, for instance.

And so as you travel from left to right across the continuum, you will see that less experience is required, but you will have less hassle. You get more diversification and more liquidity, but you get less control. The tax benefits tend to decrease as you move left to right. And you tend to pay more layers of fees.

As a general rule, if you're not having to do anything, you should expect lower returns than if you're over there doing fixing and flipping. And so as a general rule, your returns will go down as well when you move left to right across the spectrum. My second guest is from the REIT industry, so we'll be covering that a little bit more later on.

So thank you for that spectrum. But I want to get into, why do people buy real estate? Why do they get invested? Yes, you get a good rate of return, granted as you go across your continuum from left to right, the return drops, as does your control. But what are some of the other reasons?

Well, I mean, the main reason you add anything to your portfolio is because it has solid returns and, hopefully, low correlation with the other assets in your portfolio. So the reason I invest in real estate, if you boil it all down, it's because it has high returns, similar to my stocks that I invest in through index funds, and it has lower correlation.

How low that correlation is varies over time and, of course, is somewhat debatable, but that's the reason I invest in real estate. Yes, there are some great tax breaks. The one people like to talk about the most is depreciation. And as you depreciate a property, you're basically sheltering that rental income from taxation.

And done properly, you depreciate the property for a few years, and then you exchange it into a more expensive property and depreciate that property a few years and exchange into a bigger property and depreciate that a few years, and then you die. And your heirs get a step up in basis of death, and nobody ever pays capital gains or the depreciation recapture taxes on that depreciation.

So you could have tax-free income out of this property for decades and never pay taxes on that income. And, you know, obviously you have to set it up just right to accomplish that, but that's a big draw for a lot of people to get into real estate. A lot of other people, it bothers them to invest in paper assets, right?

They don't like investing in mutual funds or stocks or bonds 'cause they don't feel like it's real. They can't drive by and see it. And some people really like that aspect of real estate investing. - So the exchange process where you exchange from one property to another, where you could, where you don't have the recapture of depreciation, and you don't have to pay the capital gain, 1031 exchange, certain rules go around that, such as having to buy a property or identify a property within a few months and then buy it within six months.

Can you elaborate on that? - Yeah, I think that's exactly it. I mean, it has to be an exchange. It's supposed to be a similar property, but keep in mind that the IRS is pretty darn lenient on similarity between the properties. But I think it's 60 days you have to identify the property and then you have to close within six months.

And so it's definitely something that a lot of people are very interested in. There are companies out there that help you to do exchanges, but obviously you don't want to let the tax tail wag the investment dog. Buying a crummy property, even if you're able to exchange into it is not a good move.

And so you've got to find another good investment to exchange into and then somehow manage to sell the old one and buy the new one within six months of each other. - I do want to cover that tax benefit though. I mean, if you're in the highest tax bracket, even if you didn't get a 1031 exchange, even if you were just selling the property, the recapture tax of the depreciation.

So you're in a 37% bracket. You're getting income that would normally be taxable, but the depreciation on the property reduces your income and you're in a high tax bracket, say 37%. But there's benefit to even those people if they sell, they don't get taxed on that recapture of the depreciation.

They get taxed on the capital gain, but the recapture of the depreciation, the maximum tax rate on that is only 25%. So there's actually even a benefit there. - Yeah, absolutely. You can tell when you look at the tax code that there's a lot of incentives in there to people to invest in real estate, to develop real estate, to make places where people can live.

This is clearly an activity that Congress and by extension, the IRS supports and they support it in the tax code. - Generally in a portfolio, you have stocks, bonds, and now we're talking about real estate. What's your view of proper diversification? Let's say, 60/40, 60% stocks, 40% bonds, just using that as a base.

How would you fit real estate into your portfolio? - Well, I think you gotta remember that real estate's a risky asset to start with. These are not treasury bonds. Even if you're investing on the debt side, there's far more risk there than a typical bond portfolio would hold. So this is a risky asset.

So when you think about stocks and real estate, they both go in the same category of risky assets. But I think a reasonable amount of real estate to have in your portfolio ranges anywhere from zero to 80%. I think it's fine not to invest at all in real estate.

You do not have to invest in real estate to be a successful investor, to be financially independent, to leave lots of wealth to your kids. Whatever your investing goals are, you don't have to invest in real estate. Some people just love real estate. It is their thing. I would caution those folks, invest at least 20% of your portfolio into the most profitable corporations the world has ever seen, i.e.

the stock market, and preferably via low-cost, broadly diversified index mutual funds, or ETFs. I think it's really silly to put everything into real estate. So even those folks, I think they ought to have at least 20% in stocks rather than everything in real estate. In my portfolio, it's 60% stocks, 20% bonds, 20% real estate.

But you don't have to match my portfolio for me to think what you're doing is reasonable. I think someone that had 40% of their portfolio in real estate would be just as reasonable as somebody that only had 10% of their portfolio in real estate. - I guess it gets down to one of the last charts I want to talk about, which you wrote about, which is, what is the best way for me to invest in real estate?

And this gets back to your spectrum of ways, or the continuum ways of, you know, you have to come up with a way of investing in real estate that suits you personally. So can you talk about that? - Yeah, that's exactly the whole point of that prior chart about the real estate continuum, is it's not that one way is better than another.

It's that you've got to match yourself and what you want out of an investment to the particular type of investment. You don't have to invest in real estate. So the first thing you have to ask yourself is do you want to add a little bit of complexity to your portfolio in hopes of getting a little bit more diversification, in hopes of maybe boosting returns?

Yes or no. And if the answer to that is yes, then, you know, you can start looking at the different types of real estate. So the next thing people need to ask themselves is are you willing to give up some liquidity and transparency and diversification? And do you qualify as an accredited investor?

Because that's going to have a big impact on what's available to you. And if you're really not willing to give up liquidity and transparency, you're going to be staying in the publicly traded markets. We're talking about buying publicly traded REITs. But if you're willing to give up some of that, then you've got to ask yourself about how you feel about fees.

Because a lot of fees get added into this real estate space, especially when you're looking at syndications, when you're looking at funds. You know, these fees look like hedge funds. You know, they're substantial fees. And if that really bothers you, again, stick with the publicly traded REITs, and you won't see those sorts of fees.

Okay, the next question you'd ask yourself is hassle. How much hassle are you really willing to deal with? And if you're willing to deal with a lot of hassle, and you love real estate, you love making deals, you love looking for properties, you don't mind working with tenants, you can go do direct real estate investing.

People have retired off nothing but their direct real estate investments. It's a very profitable way to invest. You got to learn what you're doing. There's a learning curve. But this is a very reasonable way to invest. And some people do that. They don't invest in mutual funds. They invest in properties.

But again, if you're willing to deal with some hassle, now you're asking yourself, are you an accredited investor or not? Because if you are not, then there are a very limited number of investments out there. Most of them are what I call crowdfunded investments that don't require you to have accredited investor status.

I'm not as bullish or positive about those returns. I think a lot of times those are not the most experienced operators running those investments, but it is an option. - You've mentioned accredited investor a couple of times. Could you explain that? - An accredited investor, by definition, is somebody who has at least $200,000 in income each of the last two years, or $300,000 together with their spouse, or has a million dollars in investable assets.

And there's some other requirements for trusts and businesses, et cetera. However, that's just the legal definition. The definition I think you should use when you decide if you're an accredited investor is number one, are you capable of evaluating the merits of an investment without the assistance of an attorney, an accountant, and a financial advisor?

And number two, can you lose your entire investment without it affecting your financial life in a significant way? And if those two are not both true, I wouldn't call yourself an accredited investor, even if you met the $200,000 income limitation, which by the way, hasn't gone up with inflation for years.

- This is for syndicated real estate, for private equity type real estate, not for REITs, not for building your own. - Yeah, this is for the most part, we're talking about syndication. We're talking about, you know, these private funds. But keep in mind, we say REITs, but the truth is a large number of these private funds have adopted REIT status for some various benefits.

So, you know, we throw out this term REITs, and most of the time, we mean these big publicly traded REITs, but the truth is at least half the funds I'm invested in are REITs too. - Well, that's a great place to end because my next guest is all about REITs.

Jim, thank you so much for joining us today. - Thank you, Rick. It's a pleasure as always. - Our next guest is Dr. John Wirth, Executive Vice President, Research and Investor Outreach at NARIT. With no further ado, let me introduce John Wirth. Welcome to the "Bogle Heads on Investing" podcast, John.

- Thanks for having me. - So you're the Executive Vice President, Research and Investor Outreach at NARIT. Tell us a little bit about your background and something interesting about yourself. - Sure, well, I did a PhD in economics back in the mists of time, and then proceeded to go join the U.S.

Treasury. And I spent about 10 years at Treasury between 2000 and 2010. So that included working through many aspects of the financial crisis and financial crisis recovery, which was probably the time in my life where I spent the least amount of time at home. Many more all-nighters as a professional than I did as a student.

- Tell us a little about the environment at Treasury at that time during the financial crisis. You were under Paulson, correct? - Yeah, with Hank Paulson in the Bush administration, and then there was a handover to Tim Geithner as the Obama administration came in. I would say the attitude was one of a lot of flexibility.

That response crossed two administrations. People tend to forget that. And I think that there was a degree of admirable ideological flexibility and an ability to work together. The handoff wasn't seamless, but it was as close to seamless as I think it could have been between a Republican and Democratic administration.

And I think that was a sense of common purpose that I think too often is lost today. But I would say that had a lot to do with some of the successes in those programs that we ended up with and keeping the nation out of even more difficult economic environment than what we went through.

- And after that, you went to join the National Credit Union administration. What was your role there? - I was the chief economist there, and I actually went there to create the role of chief economist and stand up in office of chief economist. And it was a great experience, a really educational experience.

I had been on the policymaking side, but not really on the regulatory side. So going over and working for a regulator, getting an appreciation for the challenges associated with bank and credit union regulation and what that means on a real day-to-day basis. - And then you decided to go to NARATE, the National Association of Real Estate Investment Trust, which is what that stands for, or used to stand for.

Now I think it's its own word, correct? - Correct. - Can you tell us a little bit about NARATE and what your mission is? - Our mission is really to represent and be the voice for REITs and listed real estate companies that have an interest in the U.S. Virtually every listed real estate company in the U.S., every REIT in the U.S.

is a member of NARATE. We represent REITs of all types. And that runs the gamut from making sure that REITs are well-represented in terms of policymaking and the political process, to what I do, which is our research efforts, but also investor outreach, getting out and making sure that investors of all types understand the attributes of real estate and how REITs can provide those attributes in a low-cost liquid form, as well as holding meetings, communications, making sure that the industry is cohesive and giving them opportunities to come together.

- Just for basics, how does a company qualify as a REIT? How does it become a REIT? - You qualify as a REIT by meeting a number of IRS requirements that are built into the law. The most basic and the most key is that you need to be owning real estate assets and you need to be paying out 90% or more of your taxable income in the form of dividend.

And that's why REITs often are thought of as income-producing stocks, because of that 90% requirement. And the quid pro quo there is that if REITs meet those requirements, then they don't pay corporate taxes on that dividend that they've paid out to their shareholders. Instead, the taxes are paid at the shareholder.

And what that does is that really aligns the taxation between owning real estate in the form of a partnership and owning real estate through a REIT. To a very close approximation, a dollar of income through a REIT and a dollar of income through a partnership are gonna be taxed exactly the same way.

- Taxation of REITs is interesting because it is not taxed at a corporate level, which makes these investments unique. And the dividends that come in is three types of income that come in from REITs. There's ordinary income, which is the income you were talking about, generally from rent or from a mortgage payment.

Capital gains, sometimes they sell properties and make a profit. And then there's a return of capital. So I can understand the ordinary income from rent. I can understand capital gains. What is the return of capital? - So return of capital is important because the portion of the dividend that is paid as return of capital is not taxed at the shareholder level, although it does reduce the basis in the stocks.

So ultimately, when that stock is sold, that will be accounted for. And return of capital is really there to account for the situation because of various sort of accounting and tax situations where essentially a REIT or any other company is doing exactly what it says. It's really returning capital that essentially hasn't been invested to the shareholders.

So that's the theory behind not having it taxed, but also reducing the basis. - Now, there's a couple of other things about real estate. The ordinary income portion of it is subject to the qualified business income deduction. This changed during the Trump administration because corporations were being taxed at a lower tax rate.

Therefore, now this income from corporations needed to be taxed at a lower tax rate. But since it was coming to us, it was gonna be taxed as ordinary income. So they said, well, we'll give you a reduction on this of 20%. Did I say that correctly? - Yeah, I think you did a great job with that, Rich.

We tend to talk about this as 199A because that's how it's reported on your tax forms. And really, it does exactly what you said. It's basically a 20% discount on that tax on the dividends. In fact, what it does is it really takes that amount of dividends, multiplies it by 0.8, and then applies the tax rate.

But that has been a way that we've seen for investors, for taxable investors in REITs, they've seen a really significant reduction in the tax they're paying on those dividends. That 199A provision doesn't just apply to REITs, it applies to a lot of different types of real estate, whether publicly or privately held, can qualify for that 199A treatment.

Which is, again, that goes back to that consistency of treatment of income and returns of real estate between REITs and other types of holding, which we think is very important. We really want there to be that consistent, even playing field between different ways you can hold real estate. - Okay, very good.

And it does get a little complicated because you also, depending on your income, can be subject to the net investment income tax, not only on the ordinary income, but also on the capital gains, which is the way in which Obamacare is paid for. - Correct. - So 3.8%, but it only hits if you make above $250,000 a year, if you're filing jointly, or $200,000 if you're single.

So it doesn't affect everyone. Well, there's also different types of REITs, right? There are equity REITs, mortgage REITs, public non-listed REITs, and then there's private REITs. And so let's go through the difference. Let's start with the easy one, equity REITs. - So equity REITs, I think, are what people, when they think about a REIT, this is probably what they're thinking about.

This is a publicly traded company that owns and operates commercial real estate. Today, the market capitalization of listed equity REITs is right around $1.3 trillion. So it's a meaningful part of the stock market. Listed equity REITs, they comprise one of the GIC sectors. They're the 11th GIC sector of the stock market.

So they're really represented as a unique sector. These are the companies who, through owning their stock, this is where you're getting access to the flow of rents from commercial real estate, with daily pricing, daily liquidity, the ability to buy and sell those holdings as frequently as you want, with, for most investors, effectively unlimited liquidity.

That's the equity REITs. Mortgage REITs, very similar, publicly listed, publicly traded, but instead of owning and operating properties, they're typically going to own real estate debt. So that could either be in the form of home mortgages, owning Fannie and Freddie mortgage-backed securities, or it could be in commercial mortgages, either through commercial-curatized, commercial mortgage-backed securities, or direct loans.

So when you think about the listed space, listed equity REITs make up about 95%, the mortgage REITs make up about 5% of that market capitalization. The interesting thing about mortgage REITs, and one of the reasons why we see a lot of individual investor interest in mortgage REITs is because of their dividend yields.

They often pay double-digit, or recently have been paying double-digit yields, so they've been a very high-yielding, income-driven investment. - The yield is double-digit, but is that due to return of capital, or is that due to actual just interest income? - Most of that is interest income. - Wow. Okay, the third one is public, non-listed REITs.

What are these? - These are another flavor of REIT, and these have grown in popularity over the last several years. And so these are public REITs, so they are registered with the SEC, they file 10-Qs and 10-Ks, they have all the transparency you associate with a public company, but they're not listed on the stock exchange.

So their shares don't trade on a daily basis, and they have somewhat limited liquidity. You get liquidity in these stocks, typically by selling your shares back to the REIT, and they offer typically regular, typically on a monthly basis, liquidity opportunities, but that liquidity can be limited. In times when a lot of people wanna sell their shares back, they may put on restrictions about how much you can sell back, or those restrictions are set beforehand, but you may run into those restrictions.

When you think about non-traded REITs versus traded REITs, we like to think about it as really a trade-off between volatility and liquidity, whereas with listed REITs, you're getting full liquidity, daily moment-to-moment pricing, the ability to exit and enter your positions whenever you want, and valuations that are stock-like valuations, they're estimates of future profitability, discounted to today, but you live with that day-to-day, moment-to-moment volatility of the stock market.

With non-traded REITs, by contrast, you have limited liquidity, you have valuation that is more akin to private real estate valuations, which are sort of backward-looking, based on appraisals, more slow-moving, so they're not gonna price in changes in the economic environment quickly the way listed REITs will, so you avoid that volatility, but you don't have the same amount of liquidity.

- We've also heard in the press that there's been some miscommunication between the brokers who sell these public non-listed REITs and the consumers who buy them, where there's been some recent arbitration. Do you wanna comment on that? - Yeah, I mean, it's definitely a product that is marketed to a high-net-worth individuals, sometimes sold through brokers, sometimes sold directly by the REITs themselves, and I think with all of these products, it's really very important for people to understand what are the attributes of the product and what's it gonna bring and what's it not gonna bring, and we think that's true across the full range of REIT products.

- And the last one is a private REIT, which is for mostly institutional investors. Briefly, what are these? - So private REITs are exactly as described, right? They are not listed on a stock exchange. They don't file with SEC. They're really marketed individually. They might be used inside of a structured product.

It might be part of another partnership. So most investors are not gonna run across private REITs in their ordinary course of business. - So in aggregate, you write in your reports that about 4 trillion in gross assets across the U.S. are in REITs, with public owning 2.5 trillion, which means 1.5 trillion would be a non-public and institutional or private.

And then you have here that U.S. listed REITs have an equity market capitalization of more than 1.3 trillion. So I guess I don't understand the question here is public REITs own 2.5 trillion and equity markets are 1.3 of the 2.5. Am I reading that correctly? - We've really got two separate concepts going on here because what we're talking about is the valuation of the underlying real estate.

So equity market capital only captures part of the value, right, because they're also holding debt. It's really hard to compare these two concepts. Our estimate is that the public REITs own about 2.5 trillion, could be anywhere between 2.5 trillion and 3 trillion in commercial real estate with the balance owned by private REITs.

- So about 3% of the U.S. equity market. - REITs make up about 3% of most equity indexes, yeah. - And it's been that way for quite a few years. Has it not? - Well, it depends how far you go back. If you look back to say 1990, you would have seen a REIT market capitalization of just about $10 billion.

And that has grown dramatically today to about 1.3 trillion as we saw a wave of IPOs in the 1990s and the evolution of the industry. Over the last three or four years, REITs have been in this 2% to 3% of the S&P 500 or the Russell 1000 range. - So talking about the history of REITs, this is a little bit interesting.

I mean, no REITs existed prior to 1960. That's when Congress established the ability to be able to do real estate pass-through. And it took off a little bit. I mean, you had some companies coming public. They were, you know, some shopping centers, even some railroads, some lodging, and so forth.

But it really took off when the law changed in 1986, which gave REITs the ability to operate and manage real estate rather than simply owning it and financing it, which was the original concept. So could you talk a little bit about the history of REITs and what happened and why during the early 1990s, there was not a lot of REITs, but then now it's growing in many different areas.

- Yeah, and just going back sort of in 1960, Congress passed the first REIT legislation. And, you know, we always think it's very interesting because the purpose of that was to allow everyday investors to get access to commercial real estate as part of their portfolios. Really, the REIT legislation was inspired by the mutual fund legislation.

Same concept, let's let a broader base of investors get access to stocks in the case of mutual funds, real estate in the case of REITs. And it's important to sort of, you know, when you look at that big picture, I think it's very interesting that today, we estimate about 170 million Americans live in households that own REITs.

So this has been a public policy success. We've gotten that broad-based ownership of commercial real estate through REITs. So it has really done what it set out to accomplish. Now, when we look at how it got there, between 1960 and 1990, I would say that REITs were really a niche product.

They were generally not in the big stock indexes. They were not well-known. They were generally small cap companies. What we saw in the late '80s and early '90s was a few changes. One was the 1986 Act that allowed the internal management of REITs, which has been absolutely critical to the success of REITs in the U.S.

We also saw what's called the creation of the up-REIT structure that actually allowed individuals who owned real estate to transfer that real estate into a REIT without it being a taxable event. And the confluence of those two factors with the commercial real estate crisis of the early 1990s, which resulted in a number of real estate investors needing to recapitalize their properties, that really resulted in what we call sort of the modern REIT era starting in early 1990s, where we saw a wave of IPOs and the creation of what are today some of the leading, not just listed real estate companies, but the leading real estate companies in the world as REITs because of that ability to be internally managed, to be organized as a corporation, and to build out the human capital, the prop tech need, the data science needs, everything you need to be a leading-edge company in real estate today.

- And some of the properties that have become REITs, the list is growing. Imaginative, I guess you could say. In 1986, self-storage started to come online, and that's been a big player in the REIT space. Factory outlets, movie theaters, correctional facilities. I remember that wave that occurred in the 1990s.

And then telecom towers, the cell towers that we see, those became REITs, and then 2004, data centers. And then it was pipelines. And later on in 2015, electric transmission lines and fiber optics. And 2019, the first post office became a REIT. And these have really grown. I mean, if you look at the industry groups within the REIT index, it's these new niche areas that have really expanded.

Can you talk about the changing real estate market out there for REITs? - Yeah, absolutely. And Rick, I think this is one of the most important points for investors to understand about REITs and commercial real estate. I think often we think about commercial real estate and we think, okay, office, retail, maybe multifamily residential, possibly people put industrial on that list.

And those are all very important components of the REIT marketplace today. Those four sectors make up about half of the market cap, but we've seen a tremendous growth and innovation in terms of property sectors and REITs. And one of the things we like to say here is that real estate houses the economy.

That's kind of the way I like to think about it. And so you would expect that real estate would be as innovative as the economy as a whole and to grow with the shape of the economy. And REITs have really accomplished that. You know, if you go back to 2000, you'll see that 75% of the market cap was in traditional four property types, residential, retail, industrial, and office.

Today, that's down to about 50%. And the balance has been taken up with things like cell phone towers, as you mentioned, data centers, which were the best performing property sector in 2023, driven by the AI demand wave, healthcare, self-storage, hotels, timber, and the list goes on. And REITs have really been a place where that innovation in terms of property sectors have really found a home.

So today, one of the things that we see is that institutional investors might have a well-established portfolio of private real estate. One of the things they're turning to REITs for is actually access to these new and emerging property sectors, where REITs have been the innovators and the first movers and have really gained a leading position.

So investors, we out here in the marketplace, can access REITs either directly, if they're traded, we can buy them through exchange-traded funds, we can buy them through mutual funds, and there are different sectors that we can buy as well. You also get them if you're in a target date fund, for example, if you're in a Vanguard fund or a State Street fund or T.

Rowe Price target retirement fund, I mean, they're going to have REITs in there. So more than likely you're going to own what we're talking about today. And so we need to talk about the performance. And I've been watching this market since the 1980s when I came into the business.

It seems to me as though in the long-term that you would expect REITs, property REITs, to perform about as well as the large cap market, S&P 500 or Russell 1000. Would you agree with that, that that's what we're looking for? Yeah, historically what we've seen, and there's different ways to look at it, but when you look at that long-term performance, typically you're going to see that REITs are at or maybe a little bit above a broad-based stock in terms of their performance.

So it depends on the time period you look at. Sometimes when you put real estate into a portfolio, and I've said this, is that it's a different asset class than common stock. And the correlation between real estate and the rest of the market, the other 97%, at times you can have negative correlation between REITs and the rest of the equity market.

And there are times when it's positive correlation. So can you speak to the diversification benefits? Absolutely, and I think for most of your listeners, this is going to be the core of why real estate in a portfolio is important, and I would say critical. It's that ability to diversify the portfolio while getting competitive returns.

Depending on the time period you look at it and the data source you're going to look at, you're going to see REIT correlation with the broader stock market, anywhere between 0.55, 0.65, maybe up to 0.7 over some periods. By the way, that's on a scale of negative one to positive one?

Correct, right. And when you look at your sort of alternatives out there to get diversification in a portfolio, if you think I could use large cap, small cap, value, growth, international, when you put those on a scale, you're going to see most of those stock alternatives are going to have correlations that are typically above 0.9 and almost always above 0.85.

So among those alternatives that you can use to get diversification in a portfolio, REITs really stand out. And that's one of the reasons why we've done studies with Morningstar, Ibbotson, Wilshire, a number of firms where we asked, what is the optimal portfolio look like and how does real estate play a role in that?

And what we find is that those results are typically coming in anywhere between five and 15% real estate in a portfolio, depending on the risk tolerance of the investors. That five to 15, is that assuming a portfolio of all equity or is it a 60% equity, 40% bond portfolio?

- Yeah, so that's an equity and bond portfolio and you'll see REITs taken a bit out of the equities, a bit out of the fixed income portion. - I would have thought that you just take it out of the equity, but what you're saying is if you have a 60/40 portfolio, 60% equity, 40% bonds, you may want to go to maybe 50% equity, 35% bonds and 15% real estate.

Is that what you're saying? - That's right, yeah. Because what you're going to see in these optimal portfolios is that the REITs are providing equity-like returns, but because they're income providers, there's also some bond-like stability in there. - Well, you also do an Outlook, Android Economist. I mean, this is what you get paid for, right?

We have to discuss the future. What do you see the future of REITs to be? - Well, we think 2024 could be a good year for REITs. REIT performance during the first three quarters of 2023 was pretty tough going. And in 2022, REITs had pretty tough going performance because as Fed was adjusting monetary policy, REITs really bore the brunt of that in terms of their valuations.

What we saw in the fourth quarter was a real turnaround where REITs returned 18% for the quarter and outperformed the broader stock market. And that's very consistent with one of the key themes in our Outlook, which is that historically, REITs have performed very well at the end of monetary policy rate rising cycles.

Another piece of REITs that I think is important is that we are going to be in a higher interest rate environment in 2024, and that can be a difficult environment for commercial real estate, but REITs are coming in with very well-managed balance sheets. So REITs have been sort of low leverage players.

They are not using a large amount of debt in their strategies. And the debt that they have is mostly fixed rate debt. So we think that gives REITs both the ability to navigate a period of higher interest rates, but also maybe find opportunities where higher leverage borrowers have stepped out of the market.

So we think there's a lot of positives in 2024 for REITs. - As privately held real estate, which is more highly leveraged, has to refinance at higher rates, it becomes distressed. And it's the REITs that have equity, more cash, rather than debt that are gonna be able to pick up these properties at good valuations.

- Yeah, we think there's the possibility of that happening. And one of the things we've seen historically is that as we go through the commercial real estate cycle, one of the periods where REITs tend to do really well is essentially early in recovery because they tend to do a good job getting out of properties before they're too overvalued, and then getting back in early in the cycle.

As we have talked to the management teams who are running the REITs, we know that that is something that is very much on their mind. They feel like their balance sheets are in a very strong position. And when property markets open up and we start to see transactions, they feel like they can really be in there growing their portfolios and growing their businesses.

- Well, John, thank you so much for joining us on the "Bogleheads on Investing." We greatly appreciate your insights. - Appreciate you having me. - This concludes this episode of "Bogleheads on Investing." Join us each month as we interview a new guest on a new topic. In the meantime, visit boglecenter.net, bogleheads.org, the Bogleheads Wiki, Bogleheads Twitter.

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