Real Estate Investment Trusts (REITs): Considerations for the Federal Employees Thrift Savings Plan (TSP)
Released: 2006-04-24T00:00:00

Introduction(1)

Real Estate Investment Trusts (REITs) are mutual funds made up of real estate and mortgageassets. In recent years, their performance has been stronger than broader market indicators, leadingto calls for inclusion of a REIT alternative in the Thrift Savings Plan (TSP) for federal workers.

H.R. 1578 , the Real Estate Investment Thrift Savings Act, was introduced April12, 2005, to provide for an REIT option in the TSP. Hearings were held on the legislation April 19,2005, by the House Government Reform Subcommittee on the Federal Workforce and AgencyOrganization. Further hearings are scheduled for April 26, 2006. A companion bill, S. 2490 , was introduced in the Senate on April 13, 2006.

This report summarizes the legal and economic history of REITs and the factors that havecontributed to recent strong performances of REITs as investment vehicles. It then addresses thearguments behind their possible inclusion as an investment alternative in the TSP.

Background on REITs

Introduced in the 1960s, Real Estate Investment Trusts (REITs) applied the mutual fundconcept to real estate. By buying an interest in a REIT, an investor could own a share of a numberof real estate assets, reducing the risks and transaction costs that accompany investment in a singlepiece of real estate. Congress made the REIT concept financially viable by enacting the Real EstateInvestment Trust Act of 1960, which exempted REITs from double taxation of shareholderdividends. That is, REIT income is not taxed at the trust level, but only after it has been distributedto shareholders. (Stock and bond mutual funds receive similar tax treatment.) To qualify for thistax exemption, REITs are required to distribute at least 90% of their income in the form ofdividends.

A second piece of legislation critical to the development of the REIT market was the TaxReform Act of 1986, which permitted REITs to operate and manage property themselves. (Previously, they were permitted to be only passive investors.) The Tax Reform Act also channeledinvestment funds into REITs by restricting the use of limited real estate partnerships as tax shelters.

Individual REITs tend to specialize in certain kinds of real estate, but taken as a whole, theREIT industry invests in the broad range of commercial and residential (primarily multi-family)properties. Figure1 shows the distribution of REIT assets at the end of 2005.

Figure 1. REIT Assets by Type, December 31, 2005

Source: National Association of REITs.

There are two basic types of REITs: equity and mortgage. Equity REITs develop, own, andoperate income-producing real estate and provide tenant services, whereas mortgage REITs lendmoney to real estate owners and operators or acquire loans or mortgage-backed securities.

A few hybrid REITs operate in both modes. The investment characteristics of the two typesdiffer: mortgage REITs are highly sensitive to interest rates because their profits depend on thespread between the income from their loans and other debt assets and their own cost of funds. Asinterest rates have risen since 2004, the returns on investment in (and share prices of) mortgageREITs have fallen sharply.

Equity REITs, on the other hand, are affected by a range of economic fundamentals besidesinterest rates. For example, REITs that invest in hotels are sensitive to corporate profits and otherfactors that affect business travel. Similarly, returns on investment in hospitals, office buildings, andshopping malls depend on a host of sector-specific, uncorrelated trends.

REITs may be either private or publicly held companies. (2) Shares of publicly held REITsare traded on the stock markets like shares of any other corporation. As of the end of February 2006,there were 202 REITs listed on the stock exchanges, with a total market value of $368 billion. (Ofthe 202, 156 were equity REITs, 40 were mortgage REITs, and the remaining 6 were hybrids. Market capitalization of the classes was $335 billion, $27 billion, and $5 billion, respectively.) (3) Table 1 summarizes thegrowth of the publicly traded REIT market since 1975.

Table 1. Number and Market Capitalization of Publicly TradedREITs, 1975-2005

Source: National Association of REITs.

Recent Investment Performance

Figure 2. Standard & Poor's 500 vs. REIT Stock Index

Indices of REIT stocks have outperformed broad market indicators such as the Standard &Poor's 500 since 2000. Figure 2 compares the two indices since 1997.

What accounts for the recent performance of REIT stocks? First, the economic fundamentalshave been favorable. Following the stock market crash in 2000 and the September 11, 2001 attacks,the Federal Reserve lowered short-term interest rates to the lowest levels since the 1950s, greatlyreducing the cost of borrowed funds. Longer term rates, partly in response to the Fed moves andpartly because of a fall in post-9/11 investment demand, continued their decade-long decline,lowering the cost of funds most important to real estate funding considerably. Long rates, inparticular, have remained low by historical standards in 2006. In addition, consumer spending hasbeen strong since the end of the last recession in November 2001, which is good news for REITs thatinvest in resorts and retail structures, including shopping malls. Economic growth has been goodfor the industrial real estate sector, and improving business conditions have buoyed the hotel andlodging sectors, and are beginning to drive down the office vacancy rate in many parts of the country.

A second factor has been a wave of mergers and going-private transactions in the industry. When a publicly traded REIT is acquired by another or taken private, shareholders receive apremium above the current market price for their stock. The prospect of a merger or buyout usuallyadds to the attraction of REIT shares, and drives prices up.

A third -- and perhaps the most important -- factor behind rising REIT share prices has beenthe relatively poor performance of other investments. Since the market peak in 2000, stock yieldshave been much lower than during the 1990s. At the same time, low interest rates have meant thatreturns to fixed-income investments like corporate bonds, bank certificates of deposit, and U.S.Treasury notes have been meager by historical standards. The combination, according to a Standard& Poor's analysis, "has sent investor dollars surging into U.S. REITs in recent years." (4)

Thus, performance of REIT shares is affected not only by the fundamentals of the real estatebusiness, but also by the quality of other investment opportunities. Figure 2 shows that the REITindex was negative during several periods in the late 1990s, not just because of problems in realestate markets and earnings, (5) but also because investors shifted funds to Nasdaq technologystocks and other "hot" sectors, where returns of 30% per year were considered sluggish.

Future Prospects

Future returns on any stock market investment are, of course, uncertain. Several factors makepredictions about REITs even more uncertain than most. As Table 1 shows, the market value ofREIT stocks has grown explosively since 1990. Since 2000 alone, market capitalization has morethan doubled. This suggests two things:

(1) that publicly traded REITs have become much larger, though mergers, external debt andequity financings, as well as internally-generated growth, and

(2) that investor perceptions of REITs have changed.

The first point means that an investment fund that attempted to capture the aggregate returnof the full range of publicly traded REITs, as a TSP fund would presumably do, would in fact beinvesting in a shifting pool of firms and assets. As public REITs buy private funds or assets, or asthey are taken private, the volume and composition of the real estate assets that generate REITincome will not be constant, which implies that past behavior of REIT stocks may not be a reliableguide to future performance.

On the second point, if investors move in and out of REITs in response to factors unrelatedto the state of the underlying commercial real estate market, the behavior of REIT stocks under anygiven set of market conditions can be expected to change. In 2000, a Wall Street Journal (6) article noted that"[h]istorically, REITs have behaved like stocks. But in the last two years, they have seemed morelike bonds, diving as interest rates rose." A recent Ibbotson Associates study found that the historicalcorrelation between REITs and small-capitalization stocks has broken down:

Early in the 1990s, however, the market's perceptionof these securities began to shift as the REIT market grew along with investor understanding of thesector. In turn, shifts in the market began to alter the behavior patterns of this asset class. Since 1992the REIT market has more than quadrupled, and investors have begun to view these investmentsmore as real estate investments and less as simply domestic equity investments. Over the last 10years, correlations between REITs and more traditional asset classes have been declining, makingthem a significant source of portfolio diversification. (7)

Together, these trends suggest that the investment characteristics of the present set of publiclytraded REITs may not hold constant over the years to come.

In the short-term, the fact that REITs have outperformed the S&P 500 for several yearsrunning suggests that REIT stocks may be overvalued and due for a correction. Standard & Poor'sanalysis notes that the "cap rate," a measure of commercial property returns, was low in early 2006,suggesting that stock prices were higher than the fundamentals of the commercial real estate marketwould support. (8) Nevertheless, REIT stocks have risen by 13% since the beginning of 2006, seemingly in "defianceof common sense," according to the Wall Street Journal . (9)

A REIT Fund for the TSP?

The Thrift Savings Plan (TSP) is a tax-deferred retirement savings vehicle for federalworkers, akin to "401(k)" plans for private sector employees. Although available to all federalemployees, it is particularly important to those covered by the Federal Employees Retirement System(FERS), whose contributions are partially matched by their federal agency. At present, the TSP hasfive investment vehicles, three of which are broad stock indexes. One of the stock funds tracks theS&P 500 index of major U.S.-listed companies (the C fund). The I fund tracks international stocksand the S fund invests in stocks not included in the S&P 500, including shares of small and mid-sizecompanies. The remaining two funds invest in bonds (the F fund) and government securities (theG fund).

In addition, the TSP has five automatic "lifecycle" arrangements of investing among the fivevehicles, each geared toward a projected time frame over which accounts will remain in the TSP. At this time, the TSP does not allow for investment in individual stocks, nor in funds made up ofparticular economic sectors or industries (such as biotech, or aeronautics). The TSP hasapproximately 3.5 million participants and more than $180 billion in assets.

On April 12, 2005, Chairman Jon Porter of the House Government Reform Subcommitteeon the Federal Workforce and Agency Organization introduced H.R. 1578 , the RealEstate Investment Thrift Savings Act, which would provide for a real estate stock index investmentoption under the TSP. The subcommittee held a hearing on April 19, 2005. Chairman Porter madethe case for the legislation as follows:

What we are talking about today is a simple concept:DIVERSIFICATION. Basic economic principles dictate that investors should not place all of theireggs in one basket, but must spread their money and risk among different types of assets. A fewyears ago -- during the tech bubble collapse -- many Federal employees experienced setbacks in theirinvestment portfolio and did not have the option to invest substantially in REITs. Federal employeesshould not be left out in the cold. Adding a REIT fund option to the TSP is the next logical step.With its resilient earnings and lower volatility, real estate provides a sound investment over the longhaul. Such an investment is a valuable diversification tool, providing the possibility of strong returnsand risk reduction. (10)

Chairman Porter also noted that the TSP offered five investment options, versus 16 for theaverage corporate 401(k) plan. Investment diversification is the cornerstone of modern portfoliotheory, which holds that the inclusion of highly risky assets in a portfolio can enhance overall returnsand does not imply a high level of risk to the portfolio, as long as the risks are not positivelycorrelated. If the correlation between REITs and the stock market has declined, as the Ibbotson studycited above finds, a REIT fund would offer TSP participants a way to hedge their investments instock funds: if the stock funds fell, the REITs would rise (or at least not fall as far), easing the painof stock market episodes such as the bear market of 2000-2002. At the same time, based on theirexpectations of future REIT performance, participants could move funds into REITs in search ofhigher yields. Thus, as Chairman Porter stated, a REIT fund may offer both "the possibility of strongreturns and risk reduction." (11)

The TSP governing board and CEO, however, have recommended against the addition of aREIT fund. Their arguments, as set out at the 2005 hearing mentioned above, (12) may be summarized asfollows.

The view of REITs as a hedge against stock market declines is complicated by the fact thatREIT stocks are already included in both the large and small stock funds currently offered by theTSP. (For example, nine REIT stocks are included in the S&P 500, which the TSP's C fund tracks.) Gary Amelio, the TSP executive director, noted in his 2005 testimony that the C and S stock fundsheld over a billion dollars in REIT shares, making TSP the thirteenth-largest holder of REITs in theUnited States. Thus, the hedging value of REITs is to an extent already built into the TSP: if REITsrise when other stocks fall, the aggregate indexes mirrored by the TSP funds will fall less than theywould have otherwise. Similarly, superior returns earned by REITs over any period are captured inthe aggregate return to the TSP stock funds.

What the creation of a REIT fund would do is allow TSP participants to increase theproportion of REIT stocks in their portfolios beyond their weighting in broad indices such as theS&P 500. If their timing were right, TSP participants who chose the REIT option could outperformtheir peers who remained in the stock funds. But Figure 2 suggests that they would be choosing avolatile investment option that could lead to losses as well as gains.

By offering only a few investment alternatives, the TSP is structured in a way thatdiscourages "return chasing." Conventional wisdom in financial theory is that many investors --particularly small investors -- tend to buy the stocks or mutual funds that did well in the lastreporting period and that this is generally an unsuccessful strategy, for two reasons: return chasersare always paying top-of-the-market prices and, by frequently reallocating their investments, theyincur high transaction costs. Gary Amelio noted that educational programs to discourage suchcounterproductive investment behavior would be expensive. (13)

Another argument regarding the hedging and diversification benefits offered by new TSPfunds is that such alternatives ought to be offered (if they are needed) as part of a comprehensive,considered program, rather than piecemeal. If TSP investors would be better off with a REIT choice,observers ask why not add funds based on emerging markets, hedge funds, commodities, junk bonds,and so on?

Two general arguments against such multiplication of investment options are made. Onedeals with fund expenses. Current TSP expenses are extremely low by industry standards -- "off thecharts," according to Andrew Saul (14) -- partly because the number of funds is limited. If annualexpenses go up by even a fraction of a percentage point, the effect on total investment returns overa 20- or 30-year time frame can be dramatic. Testimony from Barclays Global Investors, whichserves as a TSP investment manager, indicated that administration of a REIT fund, while desirablefrom a "pure investment perspective," would likely incur management and transaction costsconsiderably above present levels. (15)

Second, there is some question whether a wide menu of investment choices is in the interestof TSP participants, many of whom are not (and do not care to become) expert in financial markets. Presenting unsophisticated investors with many choices may result in less-than-optimal behavior,including the chasing of returns (discussed above) or the selection of an unsuitable initial investmentallocation, which the participant may not correct later because the perceived costs of obtainingexpertise are too high. These arguments can be countered by the charge of "paternalism," and thecase for investor choice and self-direction is intuitively attractive. If, as neoclassical economicsassumes, individuals act rationally in their own self-interest, why should the government, or itsdesignees, decide where TSP participants can put their funds?

However, a growing body of empirical and theoretical research, called "behavioral finance,"throws doubt on the notion that individual investors can be expected to make the decisions that arebest for themselves. (16) Behavioral finance identifies mistakes that investors make consistently, such as reliance uponinaccurate rules of thumb and being influenced by the form in which an investment opportunity ispresented, rather than the substance. These bad habits appear to be deeply rooted and not easilycorrected by education programs.

A recent study of investment returns by defined-contribution plan participants found thatindividuals who chose an asset allocation or balanced fund (such as the TSP lifestyle options)achieved better returns than participants who make allocation decisions themselves. (17) Results like these suggestthat the neoclassical assumption that individuals can be relied upon to act rationally in their ownself-interest may be overly simplistic. This line of analysis seems to support the contention of theTSP directors that the current plan design, based on a few broad choices and low costs, "has beenrecognized by many impartial observers as an optimum approach." (18)

Recent Events

S. 2490 , a companion bill to H.R. 1578 , was introduced by SenatorNorm Coleman April 3, 2006, thus bringing the issue to the Senate as well as the House. The HouseGovernment Reform Committee has scheduled new hearings on the subject for April 26, 2006.

In March 2006, the Employee Thrift Advisory Council, an advisory panel made up of labor,management, and other federal employees, adopted a resolution opposing the addition of a REIToption to the TSP. Finally, a study has been commissioned by the Federal Retirement ThriftInvestment Board to review the existing TSP investment policy and consider the addition of moreoptions (including a REIT option), but publication is not expected until later in 2006.