Lessons from the Pros

Want Real Estate in Your Portfolio with No Landlord Hassles? Consider REITs, Part 2

Now that we have a better understanding of what a REIT is, let’s look at the current REIT market. Like all wise investors looking for buying opportunities in troubled markets, buy when the herd is running scared.

So if we consider that the commercial real estate market hasn’t hit the bottom, but the values of commercial real estate have already had a 40% decrease in the last two years, and REIT prices got hit very hard between 2007 and March 2009 (dropping more than 70%), aren’t these good signs to get in to the market? Yes? Well guess what, someone already caught on. We have seen REITs shoot up almost 100% according to the FTSE NAREIT US Real Estate Index Series. They are still 45% below their pre-meltdown days.

The other thing we are seeing in the markets are more institutional investors and company insiders buying up more than 80% of the REIT shares. That number is up sharply from 10 years ago when it was only 40%. So why have the individual investors moved out of this market (being that it was originally created for them)? One reasons is a drop in yield from an average of 7.4% (1990-2002) to 3.7% (2002-2009). The second reason is the allowance of the hefty cash dividends REITs are known for paying out weren’t in many cases last year. A ruling allowed the dividends to be paid in stock instead of cash; this will also be allowed this year. That makes them less attractive to the investors who depend on the dividends.

Even with the ups and downs of the REIT market, I believe it’s a favorable time to get in. I would suggest the following criteria:

1. Make a limited investment: Many money managers suggest 5% of your portfolio be in real estate securities. To keep balance, invest that 5% over the next year or two. If you already own funds (remember your mutual funds could also hold REITs), make sure you don’t get overweighed in real estate.
2. CASH IS KING: As many of you know, this is a theme in my classes – it’s no different with real estate that is a security. Remember, there are two kinds of REITs: Those that own commercial property (equity REIT) or those who own mortgages. As we know, there is a potential for still more troubled mortgages so I would stay with Equity REITs. I would look for the ones that are in the best position to buy distressed properties as the commercial real estate market continues to go through its adjustment. CASH on hand and access to more is what you’re looking for. An example of a REIT that fits this scenario would include Simon Property Group. Its tenants sign long-term leases, plus it has raised nearly $4 billion in new capital to be used for new investments.
3. Active Management: Once again, active management doesn’t mean that you are getting calls about overflowing toilets at 4 am. It means that a team or real estate professional will manage the assets and can also take advantage of opportunities because of their ability to raise funds from the capital markets.
4. Invest in Mutual Funds or Indexes of REITs: This is a good way to, once again, limit your risk. If you choose to buy REITs because you can zero in on a specific location that might have a promising upside, this can also be riskier. By purchasing Mutual Funds that hold REITs, you gain exposure to many different geographical areas and property types. You can also buy index funds. Once again, look for the ones with active management, such as T. Rowe Price Real Estate (TRREX).
5. Limit your tax liability: Because of the nature of REITs, they (in ordinary times) pay out 90% or more of their taxable income each year. You will be required to pay tax at your ordinary income tax rate. You might want to consider holding your REITs and/or funds in your 401(k) or IRA. This allows you to reap the benefit tax-free.

Remember that all the examples of REIT’s and funds in this article are to be viewed as examples only and not recommendations to purchase.

Watch in the coming weeks for an interview I’ll be doing with our very own Chief Knowledge Officer, John O’Donnell, about how the credit purge cycle really benefits our real estate investing.

Great Fortune!

- Diana Hill