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
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
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
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
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.
* 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
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