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The ABCs of real estate investment trusts

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Highlights
  • REITs must pay out at least 90 percent of their taxable income to shareholders.
  • Individual REITs focus on one of many sectors, such as offices or retail.
  • Investors can buy a mutual fund or ETF containing many REITs.

Real estate investment trusts, or REITs, have outperformed both stocks and bonds in recent years, making this alternative asset class an essential component for any investor's portfolio, experts say.

A real estate investment trust represents the pooled funds of many investors, which are used to buy and manage income-producing properties. REITs trade on public exchanges, just like stocks. They invest directly in properties and are required to pay out at least 90 percent of their taxable income as dividends to shareholders.

"Investors should absolutely have them somewhere in their portfolio," says Philip Martin, REIT strategist for Morningstar in Chicago. "They are known for their dividends, but somewhat underappreciated is their growth component."

Some REITs, such as those that own office buildings, have cyclical ups and downs in line with the economy. In contrast, other REIT sectors, such as health care, have a more steady financial performance.

REITs offer diversification to your portfolio, as they're often uncorrelated to stocks, though they have become more correlated over the past nine years, says Mark Senseman, an investment specialist at Strategic Wealth Associates in Phoenix.

Experts recommend allocating 5 percent to 15 percent of your portfolio to real estate investment trusts, depending on your risk tolerance and time horizon.

Performance statistics, dividends

The FTSE NAREIT U.S. Real Estate index of REITs outperformed the Standard & Poor's 500 index of stocks by an average of more than 6 percentage points a year in 2009 through 2011. And REITS are outperforming stocks again so far this year.

"REITs have provided a return above the S&P over the long haul with lower volatility," Martin says. To be sure, REIT returns fell slightly more than stock returns in the financial crisis of 2008.

Much of REITs' returns come from dividends. REITs recently offered an average yield of about 3.5 percent. That compares quite favorably to the 2 percent yield for the S&P 500 and the 10-year Treasury yield of 1.6 percent.

Dividends of real estate investment trusts are growing on average at a 4 percent to 6 percent annual rate, Martin says. And if interest rates rise, REIT yields will likely rise as well. But keep in mind that REIT dividends are taxed as ordinary income, rather than at the 15 percent maximum rate for qualified stock dividends.

REITs also provide protection against inflation, Martin says. That's because many commercial leases include rent increases tied to a price index. "And real estate itself has historically been a good inflation hedge," he adds.

Martin sees real estate values increasing as the economic recovery continues. "Commercial real estate is generally not oversupplied like it was in the early 1990s," he says. "So, when demand picks up, albeit slowly, real estate values should rise. You have to believe the demand side will pick up in the next couple years."

Question of timing

Despite REITs' attractive qualities, now may not be the best time to allocate a lot of money to them, given their surge in the past 3 ½ years. REITs, on average, are priced about 15 percent above their fair value, Martin says.

REITs recently traded at 21.6 times their adjusted funds from operations, or FFO -- well above the 14.3 percent average of the last 13 years according to Merrill Lynch, says Michael Sheldon, chief market strategist of RDM Financial Group in Westport, Conn. FFO measures a REIT's cash flow.

Barry Vinocur, editor of REIT Zone Publications in Novato, Calif., doesn't believe in market timing. But you can use dollar-cost averaging to avoid initiating all your REIT investments at high prices, he points out. Dollar-cost averaging entails investing smaller sums regularly rather than a lump sum all at once.

To invest in REITs, you have to decide whether to go for individual REITs, which are diversified since they generally hold numerous properties, or you could purchase mutual funds or exchange-traded funds that hold a number of REITs.

"For most investors who aren't green-eyeshade people, you can pick a good index fund whether it's a mutual fund or ETF," Vinocur says. "You want good diversification, as there will always be some company that does poorly."

Alternatively, if you are willing to put in a few hours of research a week, you can put together a portfolio of individual REITs. Guides are available to teach you how to analyze REITs.

Investment guidelines

If you opt for individual REITs, make sure a REIT's FFO is large enough to cover its dividend payment, says Senseman.

In addition, you should make sure a REIT's debt level isn't too high. A helpful rule of thumb is that the REIT's aggregate loan-to-value rate shouldn't exceed 55 percent, with 35 percent being a good level, Vinocur says.

You can choose REITs from many different sectors -- such as retail malls, office buildings, health care buildings, apartments, hotels and more. There's even a cellphone-tower REIT.

Martin's favorite is health care. Unlike many other sectors, it's fairly valued in his eyes. Fundamentals are strong, with the industry growing amid an increase in demand for medical care. And the supply of health facilities hasn't increased much over the last decade, Martin says. "Companies (health care REITs) have strong balance sheets and proven management teams."

The apartment sector, which has soared as homeownership has dwindled since the financial crisis, is 20 percent overvalued in Martin's eyes. "We don't think that's sustainable, but fundamentals will remain strong through 2013," he says.

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