Roller-Coaster REIT : Real Estate Investment Trusts Offer Big Rewards--and Risks

Spurred by picture-perfect yields, investors are pouring billions of new dollars into real estate investment trusts. But the boom may be adding new dangers to an already risky investment.

That’s because some of the new REITs are being started by industry newcomers who have little experience in this somewhat treacherous market. Meanwhile, newly formed REITs are targeting a more speculative segment of the market: “troubled” real estate they believe has appreciation potential. Troubled real estate can include empty office buildings, half-finished developments and properties that need substantial work.

These and other risks could result in losses for investors, or at least reverse recent strong gains that have made REITs one of the most popular stock investments.

REITs are publicly traded investment companies that pour their cash--obtained from selling stock to the public--into shopping centers, medical buildings and mortgages on commercial properties.

In just the first six months of 1993, 47 REITs completed public stock offerings worth more than $4.3 billion. If the pace continues, new sales of REIT shares will have grown 50% from last year’s record levels.

The market’s popularity is easily explained by recent returns. While home values fell in many parts of the country, the value of REITs soared 12.2% in 1992 and another 15.8% in just the first six months of 1993, says Christopher Lucas, director of research at the National Assn. of Real Estate Investment Trusts.

Few expect that rapid rate of growth to continue throughout 1993, but another year of double-digit returns seems nearly inevitable, some maintain.

That’s because when property prices and interest rates are low--as they are now--a well-managed REIT can bring in more in rent than it is paying in holding and management costs. REITs pay out 95% of their profits in dividends, which has caused yields to soar to more than 6%--about twice what you could earn on a money market fund. REITs are also benefiting because many experts believe real estate prices have hit bottom in many parts of the country.

If prices rise, REIT asset values could soar. And that could make today’s double-digit returns look anemic by comparison.

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“REITs have had a phenomenal run,” said Richard Wollack, chairman of the Liquidity Fund in Emeryville, Calif. “The past couple of years--particularly the past couple of quarters--have been dynamite. Can this go on forever? If there are no fundamental changes in the economy, yes.”

Wollack should know. Liquidity Fund--which manages real estate partnerships and provides analysis and investment banking services in the real estate industry--boasts some of the highest returns in the industry. The company’s real estate securities fund has posted an average annual return of 12.7% since it was formed in 1987. That compares nicely to the Wilshire Real Estate Securities Index, which returned just over 2% annually, and the NAREIT non-health care equity index, up 9.69% a year during the same period.

Still, Wollack and other experts caution new REIT investors to be aware of the risks. If the fund you’re buying is newly formed or invests in troubled properties, the risks are far greater than when you’re investing in established REITS that have performed well over time.

At the very least, investors in troubled real estate must plan to hold the investment for a relatively long time before profits start rolling in.

REIT managers traditionally have concentrated on somewhat more predictable properties: those that are already leased out and generating positive cash flow after mortgage payments and building maintenance are taken into account. Even this, of course, can sour because lessees can move or fall behind on their rent, and managers can face unexpectedly costly repair or maintenance work. That’s one of the reasons historical REIT returns can look like a heart monitor display--soaring one year and plunging the next.

Consider REIT returns over the last six years, for example. In 1987, REITs posted a 10.67% average loss, according to NAREIT. In 1988, they posted an 11.36% profit. The average REIT was negative again in 1989 and 1990 to the cumulative tune of 19.16%, before coming back with a vengeance in 1991 with an average return of 35.68%.

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Nonetheless, many experts believe investors can do exceptionally well with REITs if they know what to look for and if they diversify properly. Most experts believe you should limit REIT investments to less than 20% of your total investment portfolio. And if that leaves you with significant sums in REITs, you should diversify among REIT investments as well by choosing a few with different geographic concentrations or specialties.

Additionally, if your heart’s not up to taking “a flier” on one of the more speculative REITs, you must carefully examine the REIT’s financial fundamentals.

REIT Tips

Here’s what you should look for when investing in real estate investment trusts:

* Managers with proven experience. If the company is hiring outside managers, or has yet to specify who will handle management responsibilities, consider that a red flag. * REITs that specialize. While it’s good to diversify your overall investment portfolio, the REITs that have the best historic performance are usually the ones that specialize in just one geographic area or one type of property. Overly diversified REITs frequently have problems because the management skills necessary to handle one type of property are not necessarily the same skills that help in operating another. * Good financial fundamentals. Look for REITs that are conservatively leveraged--they shouldn’t be borrowing 90% of the money they’ve used to buy properties. They also should have good cash flow. Cash flow, which is the amount of rental income the REIT has left over after paying bills each month, will determine your dividend yield. Also consider the occupancy rate of the REIT’s properties. A REIT that has good--and improving--occupancy rates is a much less risky bet than one that’s investing in empty buildings. * Strong track record. You can’t predict the future of an investment by looking at the past, but you can certainly determine trends. If the company has a long history of increasing its dividend and providing a reasonable return, it is likely to continue to be a good investment, assuming the REIT has made no substantial changes in management or investment emphasis.