Investing in Real Estate Investment Trusts

If you're not quite ready to jump into a real estate investment as an owner or landlord, there is another option that allows you to reap the benefits of real estate investing without all of the negatives of property ownership. A real estate investment trust (or REIT, pronounced “reet”), offers investors a way to invest in commercial real estate in much the same way they would invest in the stock market. In short, a REIT lets you invest in real estate without having to actually buy property or land. There are more than 200 REITs to choose from, and shares of REITs are traded much like shares of stock. In fact, you can find REITs listed on the stock exchanges.

Less popular than stocks, funds, and even bonds, REITs are not new. They were established more than thirty years ago as a safe way to get into the real estate market. They are more liquid, and therefore more attractive, than direct investments in real estate; selling shares of a REIT is as easy as selling a mutual fund or stock. Since you don't actually own the real estate, you don't suffer the hassles that come with property ownership. On the other hand, a REIT gives you none of the rights that come with property ownership, either.

REITs share the characteristics of both stocks and mutual funds. A REIT is a publicly traded company, so owning shares is similar to owning shares of stocks. On the other hand, REITs were created to follow the paradigm of the investment companies, or mutual funds. Since most small investors cannot invest directly in income-producing real estate, a REIT allows them to pool their investment resources and is, therefore, like a mutual fund. This investment type is called a pass-through security, passing through the income from the property to the shareholders. The income is not taxed at the corporate level but at the investor level.

What's in the REIT ?

Unlike mutual funds, which purchase stock in companies, REITs focus on all types of real estate investment. These investments usually take one of two forms. An equity REIT buys actual property (with the property's equity representing the investment). A mortgage REIT invests in mortgages that provide financing for the purchase of properties. In the latter, the income comes from the interest on those mortgages. Of course, like everything else, there's always one option that fits in the gray area in between. In this case that's known as a hybrid REIT, which does a little of each.

What does all this mean to you? It means that REITs can be attractive investments. As with any investment, you must do your homework. The National Association of Real Estate Investment Trusts offers a great deal of information on REITs at www.reit.com or by phone at 1-800-3NAREIT. Many REITs have their own websites as well. Brokerage houses also have REIT information. Since REITs are not as common as corporate stocks and mutual funds, however, not all brokers have the expertise to provide you with good guidance. Be sure you choose a broker who is familiar with this type of investment.

Comparing REITs

When comparing REITs and deciding which is best for you, you need to consider several factors. Here are some important areas to look at when you start comparing different REITS:

  • Dividend yield. Review how much the REIT offers when paying dividends and how that compares to the price of the stock. Dividend yield is the dividend paid per share divided by the price of the stock. So if the price goes down, the dividend yield goes up. Dividends in 2004 averaged 4.7 percent for REITs — compared with 1.7 percent for S&P 500 companies (according to www.realestatejournal.com, run by the Wall Street Journal). And even with the highly depressed real estate market in 2008, REITs still offered better dividend yields, paying out an average 7.56 percent compared with a paltry 3.11 percent for the S&P 500 companies.

  • Earnings growth. With REITS, the magic earnings number is called funds from operations, or FFO. The FFO indicates the true performance of the REIT, which can't really be seen with the same kind of net income calculation used by standard corporations. A REIT's FFO equals its regular net income (for accounting purposes) excluding gains or losses from property sales and debt restructuring, and adding back real estate depreciation.

  • Types of investments held. Identify what properties the REIT invests in. REITs can invest in office buildings, shopping malls, and retail locations; residential property, including apartment complexes, hotels, and resorts; health-care facilities; and various other forms of real estate.

  • Geographic locations. Check out where the REIT invests. Some REITs invest on a national level and others specialize in regions of the country.

  • Diversification. There's that word again. Whether you choose a REIT that diversifies across state borders or buy several REITs with the idea of investing in everything from small motels to massive office complexes, you should always favor diversification when investing, and that includes investing in REITs.

  • Management. Much like buying shares in a mutual fund, you are purchasing an investment run by professional management. You should look at the background of the manager. In this case, you'll be looking for someone with a real estate background. REIT managers often have extensive experience that may have begun in a private company that later went public as the person continued on with the company.

  • Just as you investigate a company issuing shares of stock, you have to investigate the company behind your REIT. You must also look at the real estate market and the economic conditions in the area or areas where your REIT is doing business.

    Over the thirty-year span ending December 31, 2008, the compound annual total return for equity REITs was approximately 11.9 percent. Compare that with the S&P 500 return during the same stretch of time, which came in lower at 10.8 percent (data from www.nareit.com).

    Tracking Your REITs

    You'll see share prices for your REIT quoted daily, so you can follow your investment pretty much the same way you would track a mutual fund. The best measure of your REIT's performance is its FFO, which is often referred to simply as earnings. The FFO differs from corporate earnings mainly in the area of depreciation. For corporations that have assets like computers and tractors, all physical assets (except land) depreciate, meaning they record a decline in value. That makes sense because they really do lose value over time. However, real estate typically maintains or increases its value. A company whose main holding is real estate calculates its earnings, or FFO, by starting with the standard net income number, adding back depreciation on real estate and other noncash items, and removing the effect of some capital transactions. This way, you can see a clearer picture of what kind of cash the REIT is really generating.

    All in all, if you are a beginning investor who believes the time is right to invest in real estate, the best choice is a REIT. This form of investment provides a cost-effective way to invest in income-producing properties that you otherwise would not have the opportunity (or the capital) to become involved in. Regardless of how you get into real estate, whether through a REIT or as a property owner, it can be a lucrative and worthwhile investment strategy.

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