Real Estate Investing Information-Commercial and Residential Property |E-Personal Finance

The Top 10 Issues in Investing in REITs

For many people, investing in real estate—other than their own home—is financially too expensive. What if you could buy real estate with other people and combine your resources for better profits? Real estate investment trusts (REITs) allow individuals to do just that—plus, you can avoid the headaches of being an active property owner (landlord).

REITs, also sometimes called real estate stocks, are simply a tax designation created by the U.S. government for corporations that invest and manage a portfolio of real estate properties, mortgages, or both. REITs involving real estate properties are called equity REITS, while those that loan money for real estate mortgages and other related matters are called mortgage REITs. Hybrid REITs do both.

In any case, they focus on reducing or eliminating corporate income taxes.

Issues in Investing

The top ten issues in investing in REITS are:

-- Accounting

-- Capital Sources

-- Current Income versus Long-term Appreciation

-- Demographics

-- Dividends

-- Leverage

-- Management

-- Performance

-- Profits

-- Risks

1 Accounting

Generally Accepted Accounting Principles (GAAPs) depreciate assets over time. However, a good quality real estate property should appreciate over time—just the opposite. Thus, the performance and valuation of REITs can be misstated, although statistics counter this problem.

For instance, “funds from operations” (FFO) calculates performance and valuation by excluding depreciation expenses from net income. Other statistics are “cash available for distribution” (CAD), “net asset value” (NAV), and “adjusted funds from operations” (AFFO). It is important to be familiar with these and other real estate statistics.

2 Capital Sources

REITs are required to distribute at least 90 percent of their taxable income to shareholders. Because of this, managers must depend on external funding for their sources of capital. Remember: the ability of REIT managers to procure debt or equity capital is a key factor in future growth.

3 Current Income versus Long-term Appreciation

Examine REITs to determine their ability to provide current income, long-term appreciation, or both. The particular structure of management determines which objective is more likely to be stressed over the other. Compensation based on asset value may necessitate that management invest for capital appreciation. Alternatively, management salaries based on current earnings or dividends may result in management increasing the dividend yield while sacrificing long-term appreciation. Decide which strategy works best for you.

4 Demographics

Not all REITs are the same. Each one generally concentrates on one type of commercial enterprise (say the hotel industry), a single geographic location (maybe southern California), or other such distinctive grouping. This similarity within a REIT could make it susceptible to downturns—thus, greater risk. Therefore, it is important to consider demographics. Ask if it invests in locations with:

-- expanding populations

-- full employment

-- desirable industries

-- strong levels of business activity

Buying more than one REIT can help to minimize overall risk.

5 Dividends

Distributions to REIT shareholders are exempt from corporate taxes. However, each REIT must distribute at least 90 percent of its taxable income to shareholders. This requirement may cause other tax consequences. Thus, most REIT dividends aren’t eligible for lower tax rates set up by the Internal Revenue Service (IRS) and investors will usually pay at higher rates.

6 Leverage

The less leverage (debt) a management team has for its REIT, the more stable it should be for the investor—and vice versa (more debt equals less stable). Total debt should generally be less then five percent of its market value—figured by multiplying share price by the number of outstanding shares. When debt is low, management can more easily borrow money, which is an important consideration when thinking about REIT investments.

7 Management

Be sure to read the REIT prospectus. The expertise of the management team is vital to the REIT’s long-term success. The amount of experience held by each member of the team, along with the combined time the management team has been together, can dramatically increase the probability of success.

8 Performance