A REIT to Invest in Real Estate
By Richard P. Halverson

REIT stands for Real Estate Investment Trust.  REITs are a specialized form of investment company that, like mutual funds, make it possible for ordinary investors to participate in a diverse portfolio of investments (in this case real estate) that they could never achieve otherwise.

These companies may own manage, and/or lease commercial real estate properties.  They may also purchase real estate related securities such as mortgage-backed bonds.

Similar to a Mutual Fund for Real Estate

As already indicated, the concept is similar to a mutual fund.  Many investors can pool their assets to own a participation in a number of real estate investments.  With many pieces of real estate costing millions even hundreds of millions of dollars, most ordinary investors cannot own them by themselves. However, unlike a stock or bond, mutual fund REITs are operating companies.  They generally do more than just own the properties.  They often manage the real estate properties they own.  This means the REIT finds the tenants, receives the rents, pays the bills and handles all other matters associated with owning real estate.  Mutual funds, on the other hand, do not manage the companies they are invested in.

Tax Exemptions and High Dividends

REITs have an import tax exemption.  They do not need to pay federal or most state income taxes.  To receive this exemption the law requires that a REIT payout 90% of its earnings in the form of dividends to its shareholders.  These dividends are taxable to the individual investor. This special tax treatment allows shareholders in REITs to avoid the double taxation associated with normal corporations.

High payout leads directly to the most important investment characteristic of REITs.  They generally have yields that are well above average and are often excellent investments for investor seeking high income.

For example, publicly traded REITs currently have an average yield of nearly 6.0%, while the average yield for the stocks in the S&P 500 Index is about 1.2%.

With general interest rates hovering near 40-year lows, investments with high yields are difficult to find.  For some investors REITS may be the answer.  Another advantage is that REITs enjoy the high liquidity of publicly traded stocks.  Direct investments in real estate are not liquid.  You cannot sell that regional shopping mall that you own at a moment’s notice.

REITs are Not Growth Stocks

This tax exemption is a mixed blessing.  Most corporations retain a substantial portion of their income to reinvest in the business.  This allows them to grow.  REITs must pay out 90% of their earnings, leaving them little or nothing to reinvest.  Their growth must come from selling new shares in the company.  That allows the company to grow, but it means the ownership of the current shareholders is diluted so that the individual shareholder does not benefit from the growth in terms of stock appreciation.  Some long-term price appreciation can occur.  Dividends from a well run REIT tend to increase over time and the stock will reflect those increases.  Additionally, there are always the normal market fluctuations.  A good investor can make good profits by using the old “buy low sell high” technique.  But REITs should be considered income vehicles rather than growth investments.

How to Pick a Good REIT

REITs are easy to purchase.  They can be purchased through any securities broker just like any other common stock.

More challenging is to figure out which REITs to buy.  Perhaps the easiest way to do that is to buy shares in a mutual fund that specializes in REITs and let the professional fund manager do the work.  Many large fund management companies have REIT mutual funds.  The website listed in the next paragraph contains, among many other things, a list of REIT mutual funds.  You can get additional information about these funds from the respective websites of the fund management company.

How do you pick a good REIT?  If you are interested in making your own selections, a good place to start is a website maintained by the National Association of Real Estate Investment Trusts® (NAREIT).  <http://www.investinreits.com/>  This site contains a wealth of information about investing in REITs, including links to the websites of hundreds of REITs.  Remember that the trade association runs this site so their view of REIT investing is a bit biased.  Here are some questions you may consider.

First, you need to be clear what business the REIT is in.  REITs come in a wide variety of packages.  Many REITs invest in a broad list of commercial real estate.  Many others specialize by investing in things like apartments, shopping malls, hotels, hospitals and offices.  Some specialize in particular regions of the country.  Others invest in the debt related to real estate, such as mortgage-backed securities. Like any business you want to be in the strongest segment.  In your opinion does the environment for residential apartments look attractive?  How about the environment for temporary storage warehouses, for example?

Second, what is your opinion of the direction of interest rates?  Generally, rising rates are negative for the value of an REIT.  REITs are income stocks.  As such, they tend to fall in price as interest rates increase and vice versa.  Further, REITs borrow lots of money to purchase real estate properties.  High interest means higher borrowing costs.  However, rising interest rates can be an indication of a stronger economy including lower vacancy rates and higher rentals.  We have been enjoying the best of both worlds.  The economy is strong and interest rates are still low.

Third, you should be interested an REIT that has a history of increasing dividends.

Fourth, look for a REIT with a favorable ratio of price to FFO.  FFO stands for Funds From Operations.  With most companies, investors focus on net earnings to price.  With REITs, the most commonly accepted and reported measure operating performance is FFO. FFO is equal to a REIT's net income, excluding gains or losses from sales of property or debt restructuring, and adding back real estate depreciation.  You will not need to calculate this number yourself.  You can get information from the REIT’s websites.

Fifth, look for a REIT that has a favorable market price to the value of underlying assets.  You would like to own a REIT that could theoretically sell all its assets for more than the market value of its stock.  There are two ways to make an estimate of this.  A rough calculation is to take the FFO and divide it by a capitalization rate.  The capitalization rate is an interest rate that starts with the interest rate on thirty-year government bonds plus something for the fact that real estate is riskier than government bonds.  Generally, the number will not be too far from what the REIT must pay for financing.  For sake of example, assume the company has $14 Million in FFO and the cap rate is 7%.  A rough approximation of the theoretical value of the REIT, would be $200 million ($14 million/7%).  If the total market value of the REIT is currently $100 million, it could be argued that it is selling for 50% of its value.

A better way to estimate the value would be to perform an appraisal on each of the REIT’s properties.  This, of course, is beyond the ability of nearly all investors.  Large brokerage firms that have analysts following the industry do work on valuation issues.  You can find a list of these brokers on the NAREIT website linked above.  If you have an account with such a broker you can ask to receive their most recent research report.

Note it is typical for the total market value of the REIT to sell for less than its total liquidation value.  These discounts tend to persist over time.  However, deep discounts can be viewed as an opportunity for buying low.

A Good Concept, With Pictures of Lots of Pretty Buildings

REITs are an excellent way to participate in real estate.  They are particularly attractive for investors looking for high income.  Like all investments they have their ups and downs. Investors interested in REITs or any investment will make wiser decisions if they do their homework.  So spend time getting acquainted with the companies and their strengths and weaknesses.  But beware; all the web sites and annual reports have pictures of gorgeous real estate properties that will make you want to buy their stock immediately.