The Sneaky Tax Break That Reshaped U.S. Real Estate #CNBC

Many Americans don't have enough cash to play the game of real estate. But Wall Street offers an alternative way in, kind of. Investors call them REITs. A REIT is a real estate investment trust. And you can actually buy a stock of that on the stock exchange. It is publicly traded. It is a way of investing without buying a house. But REITs can cover much more than housing. Jenny, you have a ton of REITs. Here's what's in my portfolio. Government properties, storage, billboards, standalone box stores. There is enormous opportunity. Real estate investment trusts control as much as $4.5 trillion in real estate in the United States. It's why a lot of high net worth individuals like real estate in their portfolios, the tax efficiency of it. It provides diversification, provides yield, it provides inflation protection. REITs have quietly closed historic deals across the country in recent years. Estimated 150 million people in the United States alone own REITs, either in their retirement account, in their mutual funds, through their brokers, etc. So everybody's exposed to it. They just don't know it. This gives Wall Street funds a say over what gets built and how. In order to acquire the loan and to get the financing, the REIT is going to insist on certain amenities. It may insist on certain insurance coverage. And they're building in areas where heretofore it was an area that wasn't seen as, let's say, prime. I mean, this building cost, call it $150 million. I didn't actually have $150 million in my checking account and then wrote the check for it. We had to go to banks and investors and raise the money. Having REITs there as a likely exit helps the market and helps the availability of financing. The rapid growth of REITs have concerned some experts. When you build a property and then sell it to a real estate investment trust that is controlled by Wall Street, it puts a lot of pressure on the tenants. There are quarterly reports. There are profit margins that have to be met. That means most likely that the properties that they're selling off, if they're rentals, will just increasingly become more expensive. How have REITs changed the U.S. real estate industry? And are they an effective alternative to buying a house? Let's begin with the real estate part of REIT. A house is the classic way for Americans to get into real estate. You invest in a single asset and hope it goes up in value over time. REITs are a fundamentally different concept. You're not exposed to one house. You're not exposed to 20 houses. You're exposed to 20,000 of them. Most individual investors will say, well, maybe they own their house and that's their real estate. But occupied real estate serves a different purpose in one's investment portfolio versus investment properties. And so REITs are a way for individuals to get that access. You have to be very smart with your strategy. You have to know about legislation. You have to know about taxes. Because these decisions typically run five to 10 years. Over time, the number of REITs and the variety of what they offer has grown. Back in 1960s, 70s, 80s, maybe there were three or four different types. It was your office REITs, some hotels, industrial, and multifamily. Now there's, I can count at least 20 different types. Your casinos are REITs. Your single family homes are REITs. The data center where your servers are located are REITs. Digital Realty Trust is one of the big ones in data centers. And that's such an interesting area because you're seeing AI, you're seeing the cloud, so much investment in that. So you know that's going to be a big growth sector. Over the past 10 years, self-storage and industrial REIT funds have delivered big returns. By comparison, timber, retail, and office funds underperformed. When it comes to residential housing, these funds have performed well too. Most REITs focus on apartment complexes and specialty districts. That gives them some level of comfort in being able to be, you know, sort of leaders in building communities. Because ultimately what you're doing is, you know, profiting. You're also building community by developing newer assets. In the United States, home prices have increased over 18% in the past decade. Adjusting for inflation, much of that is due to limited supply. Back in 2018, when there was a lot of meltdown, a lot of real estate owned RIOs on the market from houses, individual owned houses. And REITs looked at it and they said, you know, this is an opportunity for us to fulfill a market demand that heretofore was unrecognized. And we think that we can do it at a lower price point because our expertise is in managing rental properties. There are only two residential single family rental REITs, and that's American Homes for Rent and Invitation Homes. They were landlords. That is, they would buy up homes and then they would rent them out. What they're doing a lot more though now is building these homes for rent. So you're seeing a lot of single family new rental homes. There are so many people now who because of higher interest rates can't afford to buy a home, but they still want that single family home in a community with the backyard and the good school district. So they're getting into these single family rental homes. We really expect that to be a growing segment of the rental market business going forward over the next 10 years. Many REITs are backing projects that reshape entire neighborhoods within cities and their suburbs. They do a lot of mixed use, like having grocery located near their properties. And they do that out of a concerted effort to be able to analyze the market demand to go into non-competitive sub markets. So something that you build in the villages down in Orlando may look differently if you build it in Tulsa, Oklahoma. Initially, this market was looked at to see that the boomers who were retiring really didn't want the maintenance of a home and wanted to move into a rental that has since transpired that different demographic groups are really looking at this from generation C to millennials to Xs to boomers, all like this concept. But for lower income Americans, Wall Street's preference for high-end housing could be creating issues. Properties under professional management that are owned by corporations have faster rent increases and also higher vacancy rates. They have these algorithms that tell them, you know what, we should keep prices artificially high and if we don't have a person in here for a month or two, that's okay because we're eventually going to get somebody at that higher price because people are just desperate for housing. The area where we're in a real crisis is at the low end of the market. You know, building new luxury apartments that are renting for $2,500 for a studio isn't going to fix that problem. So that's the real estate part of REIT. And now the investment trust bit. Investment trusts can deliver powerful tax benefits if they're set up well. Trusts that invest in real estate tend to pay out large dividends. REITs were meant to provide regular income as an entity, which meant that 90% of the profits needed to go back to the shareholders as dividends. In the 1960s, Congress introduced the so-called REIT rule. Key provisions? The funds need to focus on real estate and they need to send most of the profits back to shareholders. We currently pay about a 5.3% dividend yield. That, in its own right, is a nice yield. But when you look at the after-tax equivalent of that yield, it is very compelling. Real estate can be a very tax-efficient asset class because the investor gets to deduct the depreciation. The depreciation from our properties has covered 100% of the income and cash generated by those properties. And there's no tax owed on that dividend. High-dividend REIT funds grew tremendously in the low-interest rate era, which sped up debt-driven businesses and kicked off fierce rounds of housing inflation that haven't abated. In a very low-interest rate environment like we've seen, it was an alternative for investors to get a high dividend, which they weren't going to be able to do due to inflation. Some Democrats in Washington believe Wall Street REITs have too many advantages in the modern real estate market. They're making it harder for people to buy their first house because they're competing with big Wall Street firms. Second, they're making it harder for local communities to have local landlords. Now, instead of having a landlord who you can talk to down the street if you are late on a rent payment, you're basically paying rent to Wall Street. Yes, there are changes that are being requested. But I think at the same time, it's those kind of tax codes and that kind of investment that has made the commercial real estate grow since the 1980s. The Wall Street area, gauging the financial health of the nation. Experts believe REITs are becoming more central in commercial real estate, the third largest asset class in the United States. So by default, REITs being the more efficient and preferred way of owning real estate should get a lion's share of that because the amount of capital that's raised to invest in REITs or commercial real estate in general is to the tune of $300 billion. I'd say it's a matter of when, not if, that the activity picks up really fast. REITs do provide liquidity to the real estate market. For example, KKR bought this massive complex on the outskirts of Philadelphia from the Post Brothers in 2022. When it comes to multifamily investments, very focused on how attractive is this property as a place to live for individuals. And then the other thing that we look to is how attractive is a given market in terms of are people moving to that market. And Philadelphia is an example of a market that we think has great long-term prospects. The biggest sale in Philadelphia of an apartment before we sold Presidential City ever had been like $250 million. What really helped that transaction happen was that it had an assumable loan. We sold it in the fall of last year, interest rates had already moved up significantly. Today, if there's not an assumable loan on a property, people cannot pay anywhere near the pricing they would have paid two years ago because their cost of capital is so much higher. Lots of new homes for sale in the U.S. may come from this cohort, especially as many people cling to low mortgage rate homes bought in the pandemic. Policymakers in Washington hope to give families more even footing in a market increasingly filled with Wall Street's real estate trusts. Buying a house is still one of the primary factors of building wealth in the United States. But at the same time, there's a rising demographic change, especially among the Z's, that says that may not fit for us. We do have real estate developers that want to maximize their profits. But I think we need to think about how do we do equitable growth. And I think that's the key for our cities right now in America. We don't have a lot of equitable growth.