Real estate investment trust

Areal estate investment trust (REIT) is a fund that buys and manages real estate and real estate mortgages. REITs offer individual investors the opportunity to invest in real estate without having to own and manage individual properties. REITs were popular during the middle of the 1990s when inflation was expected to surge. In 2001–2002, when the stock market declined, investors again turned to REITs as safe-haven investments. When interest rates declined in 2005–2006, REITs were among the top-performing sectors of the stock market. A REIT is a form of closed-end mutual fund in that it invests in real estate the proceeds received from the initial sale of shares to shareholders. REITs buy, develop, and manage real estate properties and pass on to shareholders the income from the rents and mortgages in the form of dividends.

REITs do not pay corporate income taxes, but in return, they must, by law, distribute 95 percent of their net income to shareholders. Consequently, not much income remains to finance future real estate acquisitions.

Following are three basic types of REITs:
* Equity REITs buy, operate, and sell real estate such as hotels, office buildings, apartments, and shopping centers.
* Mortgage REITs make construction and mortgage loans available to developers.
* Hybrid REITs, a combination of equity and mortgage REITs, buy, develop, and manage real estate and provide financing through mortgage loans. Most hybrid REITs have stronger positions in either equity or debt. Few well-balanced hybrid REITs exist.

The risks are not the same for each type of REIT, so you should evaluate each type carefully before investing. Equity REITs generally tend to be less speculative than mortgage REITs, although the risk level depends on the makeup of the assets in the trust. Mortgage REITs lend money to developers, which involves a greater risk. Consequently, shares of mortgage REITs tend to be more volatile than shares of equity REITs, particularly during a recession.

Equity REITs have been the most popular type of REIT recently. Their cumulative performance of 55 percent total returns since year-end 1999 through August 2002 have outpaced the Standard & Poor’s (S&P) 500 Index, which declined by 35 percent for the same period (Clements, 2002, p. D1). Equity REITs derive their income from rents received from the properties in their portfolios and from increasing property values.

Mortgage REITs are more sensitive than equity REITs to changes in interest rates in the economy. The reason is that mortgage REITs hold mortgages whose prices move in the opposite direction of interest rates. Although equity REITs may be less sensitive to changes in interest rates, they too suffer the consequences of rising interest rates. Mortgage REITs generally do well when interest rates fall. Because of the different property holdings in mortgage REITs, they tend to be more income oriented in that their emphasis is on current yields, whereas equity REITs offer the potential for capital gains in addition to current income. For example, Annaly Mortgage Management, Inc. (a mortgage REIT), paid a dividend yield of 9 percent in the first quarter of 2005, which was a premium dividend rate to stock and bond yields.

REITs can have either finite or perpetual lives. Finite-life REITs, also known as FREITs, are self-liquidating. In the case of equity REITs, the properties are sold at the end of a specified period. In mortgage REITs, profits are paid to shareholders when the mortgages are paid up.

Little correlation exists in the performance of REITs and the stock market. Consequently, investors should hold a small percentage (no more than 5 percent) of their investment assets in REITs. Table 15–3 lists some of the guidelines for buying REITs.

Table 15-3
Guidelines for Selecting REITs
* Investigate a REIT before buying into it. Get the REIT’s annual report from a broker, or call the REIT directly. You also can get additional information from the National Association of Real Estate Investment Trusts, 1101 17th Street N.W., Washington, D.C. 20036.
* Look to see how long the specific REIT has been in business. How long have its managers been in the real estate business, and how well do they manage the REIT’s assets? How much of a personal stake do its managers have in the REIT? According to Byrne (1994, p. 32), insiders should own at least 10 percent of the stock.
* Look at the REIT’s debt level. The greater the level of debt, the greater is the risk because more of the revenue is needed to service the debt. If a downturn in revenue occurs, interest payments become harder to service. Look for REITs with debt-to-equity ratios of less than 50 percent (Byrne, 1994, p. 32).
* Don’t choose a REIT because it has the highest yield. The higher the yield, the greater is the risk. In some cases, underwriters raise the yields to hide poor fundamentals (Zuckerman, 1994, p. 35).
* Select REITs that have low price-to-book values (1:1 or less).
* Check the REIT’s dividend record. Be wary of REITs that have recently cut their dividends. Check the source of cash for the payment of dividends. Cash for dividends should come from operations, not from the sale of properties.
* Location is everything in real estate. Look at the locations of the properties in the trust. Avoid REITs that have invested in overbuilt or depressed locations.
Caveats
* Avoid REITs that are blind pools. These might be set up by well-known management firms that raise funds to invest in unidentified properties. Before investing in any project, it is important to see what the real estate assets and liabilities in any project are.
* Investors should not invest more than 5 percent of their total investment portfolio in REITs.

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