FPA Financial
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INVESTING IN REAL ESTATE THROUGH REITS
Amid the carnage of the
stock market in 2000 it was easy to spot the survivors and the winners. One
winner was U.S. Treasury securities, which as a group returned around 13.5
percent for the year. The other, a surprise many investors
may not yet realize, was real estate in the form of REITs and the mutual funds
that invest in REITs.
The over 200 REITs (real
estate investment trusts) as a whole returned 25.9 percent, according
to the National Association of Real Estate Investment Trusts (NAREIT). Real
estate mutual funds, which mostly invest in REITs, returned about the same.
This is not to argue that
REITs are or should be the next big investment everyone rushes into, just as
people rushed into large cap stocks and tech stocks in the last three to four
years, say Certified Financial Planner practitioners. What it does argue is for
the value of being diversified among many different types of assets because you
never know what’s going to do well from one year to the next. REITs, in fact,
have performed poorly the two previous years, 1998 and 1999, while stocks
boomed, losing around 25 percent.
Furthermore, investment experts
argue that the performance of REITs in 2000 attest to the value of including
real estate in some form in the portfolios of many investors. The percentage
depends upon the individual investor, but CFP practitioners like a range of 5
to 20 percent of the portfolio. The real estate component
doesn’t have to be in REITs. You can own real estate directly such as rental
property or raw land, for example, or invest in limited partnerships. (The
major of investment experts don’t consider a residence as a portfolio
investment.) However, REITs, or at least the mutual funds that invest in REITs,
make it easier for investors to own investment-quality real estate without the
headache of locating property and managing it themselves, let alone the
challenge of selling it quickly if necessary.
What are REITs? They are
corporate entities managed by skilled and sophisticated management teams who
invest either in commercial property or mortgages, or a combination.
Equity REITs both own and
operate their properties, such as office buildings, apartments, warehouses,
hotels and shopping centers. A REIT may concentrate either in a geographic
area, in a specific type of property or, have a diversified mix among
industrial, commercial and residential properties in various geographical
locations.
Mortgage REITs make their
money from interest earned by lending money to property owners, often secured
by that property. Hybrid REITs invest in both equity and mortgages.
REITs make money from rental
income, profits from the sale of the property, ancillary services provided to
tenants or a combination. Like mutual funds, REITs do not pay taxes if, under
the recent REIT Modernization Act, they pay out at least 90 percent of their net
income to their shareholder/investor.
With successful REITs, this
results in a stream of income for shareholders. According to NAREIT, current
yield for equity REITs is around 7.5 percent, while annual appreciation is
around 5.5 percent. Mortgage REITs were spinning off 11.31 percent in yield
in December 2000, along with a 2.76 percent price appreciation. This flow of
income makes REITs especially attractive to retired investors seeking current
income. Investors not needing the current income might prefer to invest in
REITs primarily through tax-deferred accounts such as retirement plans and
individual retirement accounts.
The combination of income
and growth has long made REITs a little confusing for investors to categorize—do
they act like stocks, bonds or something entirely different? However one
classifies them, many experts note that REITs—and typically other forms of real
estate investments—don’t move in lock step with large-cap stocks such as those
on the S&P 500. This negative correlation is why REITs can help diversify a
portfolio.
Choosing a good REIT takes
some research and involves transaction costs, so some investors prefer to
invest through mutual funds where professional managers can choose for them.
The mutual fund also provides greater diversification because it invests in
many REITs, which can be difficult for many investors to achieve on their own.
February
2001— This column is produced by the Financial Planning Association, the
membership organization for the financial planning community, and is provided
by Rich Chambers, CFP, a local member in good standing of the FPA.
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