Traveling the REIT route to real estate investing

Key Points

• Investing Beyond the Backyard
• The REIT Appeal
• Historical Performance of REITs
• Weighing the REIT Risks
• Shop Wisely for Your Piece of Property
• Your Piece of America
• Points to remember

For most Americans, an investment in real estate begins and ends with the purchase of a home. Yet an investment in shopping centers, office buildings, and hotels may be as close as your backyard — and as rewarding as home ownership — thanks to real estate investment trusts (REITs).

REITs invest in groups of professionally managed properties such as industrial facilities, office buildings, apartment complexes, or health care facilities. Equity REIT performance has varied historically, with a total annual return of 10.5% over the past 10 years, but a negative return of -15.7% in 2007.¹

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Investing Beyond the Backyard

There are several hundred publicly traded REITs, which the industry's trade association, the National Association of REITs (NAREIT), estimates at more than $300 billion in capitalization. Equity REITs, which own real estate assets, make up most of the market and have had a total return of 12.3% over the past 20 years.¹ There are also mortgage REITs — which loan money to real estate owners or invest in existing mortgages or mortgage-backed securities — and hybrid REITs — which 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 a tool called 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 a price-earnings ratio.

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The REIT Appeal

Today's REITs offer an array of advantages to investors, including:

• Diversification — Investors have been turning to REITs and their dividend potential for diversification against future market downturns.
• Built-in management — Each REIT comes with its own 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. Although, 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.
• Inflation protection — Since landlords are inclined to raise rents more quickly when inflation picks up, equity REITs — which obtain most of their income from rents — can be an inflation hedge.

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Historical Performance of REITs

REITs have outperformed the stock market, as represented by the S&P 500, in recent years, reflecting low interest rates and a booming real estate market.

Source: ChartSource, Standard & Poor's Financial Communications. For the 5-, 10-, and 20-year periods ending December 31, 2007. Based on total returns of the NAREIT Equity REITs index, Mortgage REITs index, and All REITs index, and Standard & Poor's Composite of 500 Stocks. Past performance is not a guarantee of future results. It is not possible to invest directly in an index. (CS000161)

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Weighing the REIT Risks

As with all investments, REITs have specific risks you should consider before adding them to your long-term portfolio. Chief among these is lack of industry diversification, as all REIT investments are confined to the real estate industry. Some REITs limit diversification even further by focusing specifically on niche developments such as golf courses, doctors' offices, or trailer parks, and/or on a single geographic region. Because of this narrow focus, experts often advise buying at least five REITs or investing in a mutual fund with broadly diversified real estate securities.

You should also be aware that REITs are subject to changes in the value of their underlying portfolios, and their prices may fluctuate with changes in their real estate holdings.

Keep in mind that the REIT industry's relatively short, untried performance record and unique accounting standards can be unsettling to some investors. The NAREIT equity index didn't begin until 1971 and had only 12 equity REITs. But as of December 31, 2007, the index had grown to 118 equity REITs.

There's some concern that REIT performance figures may be misleading. Part of the reason for this criticism is that FFO adds depreciation back into net income. (However, 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.

Finally, REITs are interest-rate sensitive — particularly mortgage REITs. If rates and borrowing costs rise, construction projects with marginal funding may be shelved, potentially driving down prices across the REIT industry.

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Shop Wisely for Your Piece of Property

There are some unique factors to consider when selecting a REIT.

Yield and debt — High yields are tempting, but REIT yields above a certain level can mean there's not enough being reinvested for development and acquisitions, which could shortchange long-term growth. Too much debt could also hinder growth capability. For a closer look at what a high REIT yield and high debt load could be in a given market, talk to your financial advisor.

Management potential — Management should have a substantial personal stake in the REIT, which should be listed in the latest proxy statement. If the REIT is new, refer to the prospectus for the management's track record (if any) in similar enterprises. For insight into management's effectiveness at cutting costs and increasing rents and occupancy, refer to same-space revenue growth in the annual report's financial analysis.

Demographic trends — In the case of apartment REITs, for example, ask about the area's direction of vacancy rates and rents, the amount of new apartment construction, and the affordability of home ownership. The higher the cost of home ownership, the more attractive an apartment REIT might be.

Opting for a REIT-oriented mutual fund is one way to manage the risks of real estate investing, and to reduce the time and research you would need to devote to investing in a diversified real estate portfolio on your own. A real estate mutual fund may invest in several properties across different sectors of the real estate industry and in several geographic areas, giving you built-in diversification at a cost-efficient price.

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Your Piece of America

Real estate remains a classic investment in America's future, and REITs make this investment a great way to add total return potential to a diversified, long-term portfolio. Talk to your financial advisor about whether REITs could help meet your financial goals and ways to incorporate these professionally managed investments into your portfolio.

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Points to Remember

1. REITs invest in groups of professionally managed properties such as industrial facilities, office buildings, apartment complexes, or health care facilities. Each REIT is diversified among several properties and is professionally managed.
2. REITS offer an opportunity to help diversify a long-term portfolio.
3. REITs resemble closed-end mutual funds in many respects, but REITs use a tool called FFO to measure performance rather than net asset value. A REIT's growth benchmark is FFO growth, while valuation is reflected in an FFO multiple (share price divided by FFO), rather than a price-earnings ratio.
4. The chief risk of a REIT investment is a lack of industry diversification. REITs are also relatively sensitive to interest rate movements.
5. Some factors to look at when selecting a REIT investment include yield and debt levels, management capability, and demographic trends in the REIT's geographic area.

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¹Source: FTSE/NAREIT index of all publicly traded equity REITs, for the period ended December 31, 2007. Past performance cannot guarantee future results. Individuals cannot invest directly in any index.