By Ralph Block

For many years, REIT investors have been suffering from an identity crisis. Are REITs “real estate” or are they “equities?” Should we regard REITs as a unique asset class, and part of the larger world of commercial real estate? Or as merely another industry group within the broad spectrum of equities—such as financial services stocks?

The label applied to REIT stocks can have a profound impact upon their acceptance as investments, as classification heavily influences some investors’ portfolio allocation decisions. I have known many financial planners and advisors who have labeled REITs “stocks,” and based upon that categorization alone have recommended REIT allocations to their clients of merely 5 percent of their equities exposure—perhaps a total portfolio allocation of just 3 percent.

If REITs are classified as common stocks, a decision to invest in REITs could be made only by the ‘equities’ investment officer of the institution or pension fund. If so, an allocation to REIT stocks would be small indeed, and the pension fund’s real estate portfolio managers would never consider them.

Advocates of both sides of this conundrum can marshal impressive arguments. Those who think of REIT stocks as merely another form of equity can claim that they are actively traded like other stocks. They can argue that REITs comply with disclosure and reporting requirements like other public companies (including GAAP accounting, albeit together with supplemental information such as FFO), and that success is often measured by short-term performance. Furthermore, REIT stocks are now represented in the major S&P equity indexes. These advocates might also argue that REIT executives themselves have claimed that REITs are engaged in active businesses, just like other public companies. If it looks, walks and quacks like a duck, it certainly must be a duck.

Yet, those who argue that REITs are really real estate are also persuasive. Unlike virtually all other equities, they don’t manufacture anything or provide services to others; rather they provide space. Only REITs mandate dividend payments and only REITs derive at least 75 percent of gross income from rents, mortgage interest and gains on real estate sales. The stocks have historically enjoyed low correlations with other equities and other asset classes and have been performing much like commercial real estate, particularly in recent years.

Finally, a notable 2003 academic paper (“Public vs. Private Real Estate Equities,” by Pagliari, Scherer and Monopoli) demonstrated the close relationship between the performance of REIT stocks and commercial real estate. (To read an interview with Joseph L. Pagliari on the paper’s findings, visit www.nareit.com/portfoliomag/03novdec/professional.shtml)

Like the legendary feud between the Hatfields and the McCoys, this titanic battle between the stock supporters and the real estate advocates is no longer relevant today. For in truth, REIT investing has now become a unique and wonderful blend of both commercial real estate and stock investing, which combines the best features of both: commercial real estate with liquidity, accountability and transparency; tangible, high-yielding assets with experienced, creative management; and predictable cash flows with significant external growth prospects.

David Swensen guided the Yale Endowment Fund to an average annual return of 16 percent over the past 21 years. He recently recommended a 20 percent portfolio allocation to real estatein the form of REITs. To Swensen, REITs are a unique and valuable species, deserving of substantial representation in every portfolio, regardless of how they are labeled.