This Week's Q & A

Q: I am planning to put some money into real estate and am very interested in real estate investment trusts. Can you describe the advantages (if any) of REITS over other types of real estate investments? And can you give me some advice on how to compare the various REIT offerings available?

A: I think I’ve answered this question before, but as my daughter (an all-knowing 10-year-od) pointed out recently, people my age have that feeling a lot. Anyway, it’s a good question, and I don’t mind revisiting it.

As you doubtless are aware, a REIT is the equivalent of a mutual fund for real estate, providing a mechanism through which individuals who couldn’t purchase office buildings or an entire portfolio of mortgages on their own, can purchase shares in real estate pools containing those assets.

Investors own shares of a REIT much as they would own shares of stock, and that is one of the major advantages of this vehicle – REIT shares can be bought and sold as readily as the shares of any stock; buildings are far less liquid. You can’t count on being able to buy or sell an office building or an apartment complex when you want to at a price you are willing to accept or pay.

Liquidity isn’t the only appeal. REITs offer extremely attractive yields relative to such alternatives as bank CDs, Treasury Bills and many stocks. And they offer investors the potential for geographic diversity, providing something of a hedge against regional downturns. The poor performance of properties in declining markets might be offset by the strength of properties in more vibrant areas.

REITs also offer tax advantages to investors. As long as they distribute at least 95 percent of their earnings, REITs are exempt from federal taxes; shareholders are required to pay taxes on their earnings, but they are taxed on distributions that have not been taxed previously at the corporate level – another plus for REITs relative to many other investments.

All of these advantages notwithstanding, REITs are not risk-free. Far from it, as survivors of the REIT meltdowns in the 1970s and 1980s know all too well. REIT boosters today insist that the industry has learned from the mistakes of the past and won’t repeat them. But there’s a reason real estate continues to evolve as an alternating series of booms and busts, so if I were you, I’d take these assurances with more than a couple of grains of salt, and approach REITs, as you should approach any real estate investment, with large quantities of caution and due diligence.

Experts in the field offer some general guidelines, which may help. First, although you’re buying shares in a pool of real estate assets rather than investing directly in a specific real estate project, you still need to know what you’re buying. The three most common kinds of REITs are:

	Equity REITs, which own properties and offer yields based on the income from the properties in the pool
	Mortgage REITs, which own mortgages secured by investment properties
	Hybrid REITs, which combine elements of both of the above.

You should start by analyzing the assets in the portfolio of any REIT you are considering. Don’t look only at the yield; look carefully at the properties or mortgages that are generating the income stream. You also will want to look beyond increases in the REIT’s stock price, which may be more a reflection of investor expectations than a barometer of the performance of the asset pool. You’ll find that some REITs are seriously overpriced relative to the earnings of the assets in their portfolios.

Seasoned REITs will have a track record you can evaluate. Newly formed REITs won’t have that performance history, but they will have yield projections, and odds are, those projections will be quite favorable. (Ever seen a pro forma that said, “We expect our share price to be in the sewer by this time next year?) You’ll want to consider how realistic those projections are, given the type and quality of the properties in the portfolio and the markets in which they are located.
A few other considerations to keep in mind as you are evaluating and comparing REITs:

	If you’re dealing with office buildings, look for properties with relatively high occupancy rates and long-term leases in place.
	Pay as much attention to the REIT’s management as you do to the portfolio’s contents. You want companies – not individuals – with expertise in the management of the class of properties included in the portfolios they are overseeing. And you want those managers to have a stake in the REIT -- some industry analysts recommend at least 10 percent – to ensure that they will care as much about the pool’s performance as the investors.
	Avoid REITs that have all of their investments concentrated in one market. Regional diversification is one of major advantages of a REIT, and its a feature on which you should insist.
	Diversification by asset type, on the other hand, isn’t usually as desirable, unless the management team’s expertise matches the diversity of the portfolio. It is rare to find companies that are equally adept at developing or managing office buildings, multifamily projects and hotels.
	Finally, watch out for highly-leveraged REITs. Experts say the debt ratio should not exceed 50 percent to 60 percent on the high side. At ratios much above that level, interest rate fluctuations can be devastating.