For most Americans, an investment in real estate begins and ends with the purchase of a home. Yet investments in commercial real estate — including shopping centers, office buildings, and hotels — may be available to investors.
Real estate investment trusts (REITs) allow individuals to invest in large-scale, income-producing real estate. REIT performance has varied historically, with a total annualized return of 11.78% over the past 10 years, and a 19.70% return in 2012
Types of REITs
There are more than 100 publicly traded REITs, according to the National Association of REITs (NAREIT).
• Equity REITs, which directly own real estate assets, make up most of the market.
• Mortgage REITs loan money to real estate owners or invest in existing mortgages or mortgage-backed securities.
• Hybrid REITs combine the investing strategies of both equity and mortgage REITs.
REITs resemble closed-end mutual funds, with a fixed number of shares outstanding. REITs are also traded like closed-end funds, offering a price per share. Unlike a closed-end fund, however, REITs measure performance by funds from operations (FFO) rather than by net asset value. FFO is defined as net income plus depreciation and amortization, excluding gains or losses from debt restructurings and from sales of properties. REITs’ growth benchmark is FFO growth, while valuation is reflected in an FFO multiple (share price divided by FFO) rather than in a price-to-earnings ratio.
The REIT Appeal
REITs offer a number of potential advantages, including the following.
• Diversification: REITs can help to diversify an equity portfolio weighted to stocks in other industries. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a nondiversified portfolio. Diversification does not ensure against market risk.
• Built-in management: Each REIT has a management team, sparing investors the effort of researching each property’s management team.
• Liquidity: Because REIT shares are traded on the major stock exchanges, they are more readily converted into cash than direct investments in properties. Like direct property investments, REITs may lose value.
• Tax advantages: REITs pay no federal corporate income tax and are legally required to distribute at least 90% of their annual taxable income as dividends, eliminating double taxation of income. Investors can also treat a portion of REIT dividends as a return of capital, although those classified as dividends are taxed at ordinary rates.
Weighing the REIT Risks
As with all investments, REITs have specific risks that are worth considering.
• Lack of industry diversification. Some REITs limit diversification even further by focusing specifically on niche developments such as golf courses or medical offices.
• Potential changes in the value of underlying holdings. These changes can potentially be influenced by cash flow of real estate assets, occupancy rates, zoning, and other issues.
• Concern about performance metrics. Critics contend that FFO could be misleading because it adds depreciation back into net income. NAREIT counters that real estate values fluctuate with the market rather than depreciate steadily over time, making FFO a realistic performance measure. Also, REITs may average the rent they will receive over a lease’s lifetime rather than report actual rent received, which critics say can further cloud performance figures.
• Interest rate sensitivity. If rates and borrowing costs rise, construction projects with marginal funding may be shelved, potentially driving down prices across the REIT industry.
• Environmental liability. Companies in the real estate industry are subject to environmental and hazardous waste laws, which could negatively affect their value.
REITs can be a way to add total return potential to a diversified, long-term portfolio. Your financial advisor can help you decide whether an allocation to a REIT could help you pursue your financial goals.
The information in this communication is not intended to be financial or tax advice and should not be treated as such. Each individual’s situation is different. You should contact your financial and/or tax professionals to discuss your personal situation.