It is often said that equity markets have been said to outperformed all kinds of asset classes in the past few years where the comparison parameters/ benchmarks for equity happens to be the index level performance. This performance is mapped over varying time frames against other asset classes and a summary view after such comparisons is presented. Often the price index is used for comparison of index from time A to time B.
However, we may compare equity returns either using the price index (PI) or the total returns index (TRI). The TRI index and PI index denote two different set of figures. While the price return index only considers price movements (capital gains or losses) of the securities that make up the index, the total return index includes dividends, interest, rights offerings and other distributions realized over a given period of time.
In the case of REITs, the price index comparison is far less relevant and the TRI happens to be the correct index. This is because it is specified by REIT regulations that a substantial part (90% or more) of the NDCF (Net distributable cash flows) have to be paid out to the owners of the REIT in periodic intervals. In case of other corporations, payouts are in accordance with the decision of the owners of the company and dependent on net profits (not cash available). Unlike corporations where the net profit and growth is the key metric, REITs are essentially pass-through vehicles with focus of payouts of cash generated.
This stipulation or working style of a REIT means several things, and two most relevant ones can be highlighted here. Firstly, compared to equities, where profits are ploughed into the company, REITs are unable to use their revenues for expansion of their business. In terms of comparing this with equity, this restriction also means that the periodic payouts for equity markets in general is a fraction of the payouts that REIT vehicles offer, periodically. Secondly, since the business of REITs happens to be investing in realty assets to generate returns for the owners, the internal sources of funds cannot be relied upon. Therefore, to facilitate expansion the REIT will raise more capital from capital markets in the form of equity or in the form of debt. This means that efficiently raising finances for expansion is important for a REIT expansion rather than internal growth as in the normal equity-funded corporations. On the other hand, the equity funded corporations thus prefer to plough back profits for the equity holders since investing in their own business makes much more sense than employing the payouts elsewhere or raise capital from markets. The REIT owners are free to invest a much higher percentage of the periodic funds generated from their REIT investment. (A small note here: A deeper meaning of this action is that the IRR of a REIT investment may really not be close to the IRR of the equity investment, where the compounding impact is quite similar to lump sum investing rather than periodic cash outflows meted out for investing REIT payouts). Therefore, the scenario above stipulates that the only relevant index for comparison of equity performance with REIT performance happens to be the TRI or the total returns index. The price index is incapable of giving the correct picture of a REIT’s performance.