 Welcome everyone to the 66th episode of Bogle Heads on Investing. Today we're going to be talking about real estate investing with two special guests, Jim Dolly, who created an in-depth course on real estate investing, and John Worth, who's a chief economist at Naread, formerly known as the National Association of Real Estate Investment Trusts. Hi everyone, my name is Rick Ferry and I am the host of Bogle Heads on Investing. This episode, as with all episodes, is brought to you by the John C. Bogle Center for Financial Literacy, a non-profit organization that is building a world of well-informed, capable, and empowered investors. Visit the Bogle Center at bogelcenter.net where you will find a treasured rover of information, including transcripts of these podcasts. Before we get started today, I have a special announcement. On behalf of all Bogle Heads worldwide, we wish Taylor Larimer a happy birthday. Taylor is 100 years old this month. He is the founder of the Bogle Heads. Jack Bogle called him the king of the Bogle Heads. Back in 1998, he founded the organization by putting the very first post on the Morningstar Forum at the time called Vanguard Die Hearts. It has since moved onto its own website, bogelheads.org. He is also the author and co-author of three Bogle Heads 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 Bogle Heads way. If you'd like to wish Taylor a happy birthday, there will be a special post on bogelheads.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 bogelhead. He is a practicing emergency room physician and founder of the White Coat Investor. Jim has developed many courses at 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 a faculty of more than a dozen highly qualified instructors. So we're going to be talking about that with Jim. And our second guest is Dr. John Worth. John is the Executive Vice President, Research and Investor Outreach at NARREAD 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 U.S. 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 Bogelheads on Investing, Jim. Thank you. It's always a pleasure to be here. And a pleasure to be with Bogelheads, especially in person at the conference. 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 Bogelheads don't like that either. And so I kind of took the approach of if we're going to 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, you know, 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, you know, kind of an accidental landlord situation, and realized fairly early on that I prefer to be mostly on the passive side of the spectrum. You know, I think it was Michael LeBouf 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. You know, and the holding I use there is just 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 trust 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, there's this nice graph which talks about the poor 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, you know, 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. You know, 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 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 there you split out two types of debt. There's called hard money loan, and then there's mezzadine 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 stock market, right? There's preferred equity. There'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. Whatever is 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. For example, there's a riskier position or mezzadine 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, raw land. How do they 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. It's in a nice neighborhood in 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 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 in 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. 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. 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. 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 it's just kind of a... There's no government agency that 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 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. 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 five, six, seven 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. 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. It's a pretty active thing. Next, you come to long-term rentals. These are people you typically rent to for a year or two years or five years. 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. They buy multiple houses. They buy a duplex or two or some quadplexes. They buy an eight-door apartment building. A few years later they buy another ten-door apartment building and that's how they invest in real estate. They don't 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 to the home. 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 ten million dollars and you don't have that much less enough to diversify that investment but if you went in with a hundred other investors typically it's 98 other investors because of the way that 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 complexes that you put a hundred thousand dollars 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 ten 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 one percent a year and twenty percent of profits wouldn't be unusual for what they charge to run those funds and those syndications 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 ten 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 standardized and you can trade them any day the markets are open you can buy a mutual fund that invests in a hundred 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 and 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 while you move left to right across the spectrum my second guess 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 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? 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 is because it has high returns similar to my stocks 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 it 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 obviously you have to set it up just right 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 they don't like investing in mutual funds or stocks or bonds 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 don't have the capture 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 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 managed to sell one and buy the new one within six months of each other I do want to cover that tax benefit though I mean you if you're in the highest tax bracket even if you didn't get a 10 31 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 of the property reduces your income and you're in a high tax bracket 37% but there's a 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 game 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 got to remember that real estate is 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 is 0-80% 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 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 what 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 have to come up with a way of investing in real estate that suits you personally so you can't 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 these fees look like hedge funds 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 the next question you have to ask yourself is hassle how much hassle are you really 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 they're 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 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 they don't require you to have accredited investor status I'm not as a bullish or positive about those returns 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 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 etc 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 and 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 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 Worth Executive Vice President Research and Investor Outreach at NARRI with no further ado let me introduce John Worth welcome to the Bogleheads on Investing podcast John thanks for having me so you're the Executive Vice President of Research and Investor Outreach at NARRI tell us a little bit about your background 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 US 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 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 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 NERIT or the National Association of Real Estate Investment Trust which is what that stands for now I think it's its own word correct can you tell us a little bit about NERIT 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 US virtually every listed real estate company in the US every REIT in the US is a member of NERIT 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 REITs to a very close approximation a dollar of income through a REIT and a dollar of income through a partnership are going to 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 is ordinary income which is the income you were talking about generally from rent or from 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 return of capital gains what is 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 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 going to 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 she 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 .8 and then applies the tax rate but that has been a way that we've seen for investors in 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 real 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 secondary 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 there are equity REITS, mortgage REITS public non-listed REITS and then there's private REITS and so let's go through the difference I mean let's start with the easy one equity REITS. So equity REITS I think are what people when they think about a REITS 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 GICS sectors they're the 11th GICS 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 puritized 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 REITS 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 10Qs and 10Ks 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 REITS 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 want to sell their shares back they may put on restrictions about how much you can sell back where 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 that are 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 going to price in changes in the economic environment quickly the way listed REITS will do 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 consumers who buy them where there's been some recent arbitration you want to comment on that 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 going to bring and what's it not going to bring and we think that's true across the full range of REIT products the last one is a private REIT which is for mostly institutional investors briefly what are these so you know 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 that might be part of another partnership so most investors are not going to run across private REITS in their ordinary course of business so in aggregate you'll write in your reports that about 4 trillion in gross assets of course the US 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 US 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 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 US equity market REITS make up about 3% of most equity indexes 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 dollars 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 3 or 4 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 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 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 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 I was growing in many different areas yeah and just going back to 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 base 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 US we also saw what's called the creation of the UPREET structure that actually allowed individuals who owned real estate to transfer that real estate into a REITS 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 REITS 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 you know they in 1986 self storage started to come online and that's been a big player in the REITS 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 REITS and these have really grown I mean if you look at the industry groups within the REITS 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 I think 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 we think okay office retail maybe multifamily residential possibly people put industrial on that list and those are all very important components of the REITS 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 in REITS and you know 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 health care 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 we 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-Row price target retirement fund they're going to have REITS in there so more than likely you're going to own what you'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? I'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 sort of depends on the time period you look at sometimes when you put real estate into a portfolio and I've said this 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 well 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 REITS correlation with the broad 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 that 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, Ibbitson and 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 5 and 15 percent real estate in a portfolio depending on the risk tolerance of the investors that 5 to 15 is that assuming a portfolio of all equity or is it a 60 percent equity 40 percent bond portfolio yeah so that's an equity and bond portfolio and you'll see REITS taking 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 percent equity 40 percent bonds you may want to go to maybe 50 percent equity 35 percent bonds and 15 percent 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 you know equity like returns but because they're income providers there's also some bond like stability in there well you also do an outlook enjoyed economists 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 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 percent 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 you know 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 going to 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 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 Listen live to Bogleheads Live on Twitter Spaces the Bogleheads YouTube channel Bogleheads Facebook Bogleheads Reddit Join one of your local Bogleheads chapters and get others to join. Thanks for listening