A real estate investment trust is frequently described as a way to own property through the stock market. That is true and it obscures the more interesting fact, which is that the structure exists because of a specific tax arrangement.
The bargain
Normally, a company pays tax on its profits, and shareholders pay tax again on dividends received. Property held through an ordinary company is taxed twice.
The trust structure removes the corporate layer, on conditions.
The entity must distribute the large majority of its taxable income to shareholders, must derive most income from property, must hold most assets in property, and must have a broad shareholder base.
Meet those, and the corporate tax is avoided. The income is taxed once, in the shareholder's hands.
Why the distribution requirement matters
This is the consequence that shapes everything about how these entities operate.
Because they must distribute most of their income, they cannot retain much to fund growth.
Which means expansion requires raising external capital — issuing new shares or borrowing.
Issuing shares when the share price is below the value of the underlying assets dilutes existing holders, so growth becomes conditional on market conditions in a way it is not for a company that retains earnings.
Understanding this explains a great deal of the sector's behaviour through cycles.
The debt sensitivity
Property is capital intensive and generally financed with debt, which makes these entities interest rate sensitive on two separate channels.
Their borrowing costs rise directly.
And property valuations fall as required yields rise, since a property is valued against the income it produces relative to alternatives.
Both effects push the same direction, which is why the sector tends to move sharply with rate expectations.
The accounting measures
Conventional earnings are a poor measure here because depreciation is charged against buildings that frequently are not losing value.
The sector therefore uses funds from operations, which adds depreciation back to net income and removes gains on property sales.
A further adjusted measure subtracts recurring capital expenditure needed to maintain the properties, which is closer to distributable cash.
These are not standardised in the way statutory accounts are, so the definition used varies and the notes are worth reading.
The sectors are not one thing
Grouping these entities together as property obscures that the underlying businesses differ enormously.
Retail property, office property, industrial and logistics, residential, healthcare facilities, data centres, self-storage, telecommunications towers.
Each has different tenants, different lease structures, different capital requirements and different exposure to structural change.
The past decade demonstrated this forcefully, with logistics and retail moving in opposite directions for reasons that had nothing to do with property as an asset class.
Lease structure is the fundamental
What matters most is what the leases say.
Length, whether rent escalates and how, who bears operating costs, tenant credit quality, and the concentration of income across tenants.
A long lease to a strong tenant with fixed escalation is closer to a bond than to property. A short lease in a competitive market is closer to an operating business.
These sit at opposite ends of a risk spectrum and both are called property investment.
The listed and unlisted distinction
Listed vehicles trade daily and their prices move with equity markets, which means short-term correlation with shares is higher than the underlying property would suggest.
Non-traded vehicles do not have daily prices, which is sometimes presented as lower volatility. It is generally lower measurement of volatility rather than lower volatility.
Redemption terms on non-traded vehicles are the critical detail, and several have restricted redemptions during stressed periods, which is exactly when holders wanted out.
The tax position for the holder
Because corporate tax was avoided, distributions are frequently taxed as ordinary income rather than at dividend rates, which varies by jurisdiction and by the composition of the distribution.
Which can make the tax treatment less favourable than the headline yield suggests, and it varies with the account the holding sits in.
That is a matter for a tax adviser rather than for an article, and it is worth establishing before rather than after.
None of this is a recommendation regarding any investment. It describes a structure and its consequences.
Management structure
A detail that has produced real conflicts of interest.
Internally managed entities employ their own staff, so management costs sit within the business and scale with it.
Externally managed entities pay a separate manager, frequently on a fee based on assets under management rather than on returns.
Which creates an incentive to grow the asset base regardless of whether growth benefits shareholders, and that misalignment has been the subject of sustained investor criticism.
Several externally managed vehicles have internalised management after shareholder pressure, generally at a cost, which is itself evidence of how much the structure was worth to the manager.
Development risk
Entities that develop rather than only acquire carry an additional layer of risk.
Construction cost overruns, planning delays and letting risk on completion are different in character from the risk of holding a let building.
Which means two entities in the same sector can have quite different risk profiles depending on how much development sits in the pipeline, and the pipeline is disclosed.