Now may be the time to move into a REIT
Many investors chase hot returns, buying assets that have recently performed well, but experts have long maintained that you’d be better off putting your money in sectors that are down in the dumps.
That’s why it might make sense to take a look at real estate investment trusts -- publicly traded investment pools that typically buy commercial properties such as shopping centers and medical buildings. Although REITs have outperformed stocks over the last decade, they have been slammed this year. One reason is that investors expect the market values of the underlying properties to go down. The sub-prime mortgage debacle and the housing downturn haven’t helped.
“With all the fear that’s in the marketplace, now would be a good time to think about getting in,” said Jeremy Glaser, an equity analyst at research firm Morningstar Inc. in Chicago. “Our strategy is to try to buy things at a discount to what we think they’re worth. And there are some excellent REITs that are selling at a pretty deep discount to their asset values.”
Shares of a REIT typically sell for a modest premium over the firm’s net asset value -- the estimated value of the real estate in the REIT’s portfolio -- said Mike Kirby, director of research at Green Street Advisors, a Newport Beach-based investment firm that specializes in the REIT industry.
Recently, REITs on average have been selling for about 20% less than their net asset values, he said. That would suggest investors believe commercial real estate prices are likely to fall sharply. Because such a decline is “already baked into the cake,” the shares are attractively priced, Kirby said.
“It may feel like a bad time, but there are some important valuation metrics that say differently,” he added.
Timing aside, some sage investors say REITs belong in every portfolio. The reason: diversification. Not only have REITs posted average annual returns comparable to those of stocks over the last 35 years, the real estate trusts “tend to zig when the market zags,” Kirby said. That means adding REITs to your portfolio can reduce the risk of a big decline in its value in any given year -- without hurting long-term returns.
The history of REITs begins in the 1960s, when Congress decided that individual investors should have a way to invest in big commercial real estate projects in the same way they invest in companies: by buying shares of stock.
But unlike most publicly traded companies, REITs were given a special tax break. By law, they must pass on at least 90% of their income to shareholders each year. But REITs pay corporate income tax only on the income they don’t pay out to shareholders. The shareholders, of course, must pay taxes on their dividends.
In practice, most REITs pay out 100% of their income, said Brad Case, vice president of research at the National Assn. of Real Estate Investment Trusts. As a result, most REITs offer a generous dividend yield, which is a company’s annual dividend divided by its stock price.
On average, REITs are paying a dividend yield of 5.4%. Historically, yields have accounted for about half of the total return on REIT shares, which has averaged nearly 11% over the last 35 years, according to the REIT trade group.
That yield can be attractive for retirees who are looking for regular income from their investments, but it can be a tax challenge for investors who don’t need the money now and would prefer to have it accumulate. For that reason, some experts suggest that younger investors keep REIT shares in tax-deferred retirement accounts such as a 401(k) or an individual retirement account.
There are various risks to investing in REITs, however.
First there’s market risk. The vast majority of REITs generate their income from two things: rents on the properties they own and capital gains from buying and selling these properties. So investors are exposed to the risk of a rotten real estate market, in which property values decline, and to economic swings that might make renters scarce or less reliable in paying their rent.
Moreover, some REITs specialize in one region of the country or one type of property, such as shopping malls. The market values in individual regions or sectors are likely to be more volatile than commercial real estate values overall. And, just as you probably have a mortgage on your home, REIT managers borrow to buy properties. That leverage magnifies market gains and losses.
Though most REITs buy actual real estate, one type invests in mortgages on commercial and, sometimes, residential properties. They get hit especially hard when the economy appears fragile, like now.
Since the start of the year, share prices of mortgage REITs have plunged 51%, more than triple the average 16% decline for equity REITs, which buy properties. The REITs’ total returns, which include dividends, weren’t quite as bad. But either way, the sector’s risk is obvious.
Experts also warn that it is extremely difficult for individual investors to do a good job of picking a specific REIT. That’s because their value depends on the worth of their real estate and skill of their management. And much of the information needed to evaluate those things isn’t available to individual investors, Kirby said.
“If you have access to a high-quality evaluation of net asset value, you have a good anchor on where a company’s stock should trade,” he said. “But most individual investors don’t have that. If you go it alone, you are at a big informational disadvantage.”
On the bright side, individual investors can invest in REITs by buying a mutual fund whose portfolio consists mostly or entirely of REIT shares. Such funds are offered by most of the major mutual fund companies -- including Vanguard, T. Rowe Price, Fidelity and Schwab. The funds’ managers almost certainly know much more about the sector than you could ever learn on your own.
“There are a group of very dedicated investors who do nothing all day but focus on this niche,” Kirby said. “This is a segment where hard work delivers benefits. An active manager can do quite well.”
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Kathy M. Kristof welcomes your comments but regrets that she cannot respond to every question. Write to Personal Finance, Business Section, Los Angeles Times, 202 W. 1st St., Los Angeles, CA 90012, or e-mail kathy.kristof@latimes.com. For past Personal Finance columns, visit latimes.com/kristof.
