 SM
|
|
|
|
Who We Are
Money Focus Mutual Funds Insurance Mortgages Taxes Step by Step Hot Topics Contact the Editor
Featured Site AfterHourTrades.com, Inc. Featured Columnist: 
All content is © copyright (1999-2002)BonPaulProductions (all rights reserved) |
REITs Undone
REITs or Real Estate Investment Trusts is a company that buys, develops, manages and sells real estate assets. REITs allow participants to invest in a professionally managed portfolio of real estate properties. REITs act as pass through entities, which basically means that they are designed to pass profits on to investors through the purchase of income producing rental properties.
Historically, REITs have had there share of ups and downs, both from a tax perspective and from an investment standpoint. There was actually a time in their history where you could have been taxed twice for your investment, once at the corporate level, and then again at the investor level. But that changed with post W.W.II demand for these types of investments. When Eisenhower passed the Real Estate Investment Trust tax provision in 1960, the REIT became a pass through entity. Their popularity increased in the '80s with the Tax Reform Act of 1986, which allowed REITs to manage their properties directly. Several years later, pensions were allowed to invest in the income and appreciation provided by them.
REITs come in three basic flavors: Equity, which invest in and own properties, collecting rents; Mortgage, which act as lenders collecting interest from those loans; Hybrids, which are little of both. These companies are often traded on exchanges, and are a healthy source of income appreciation for not only pensions, but also insurance companies, bank trusts, and mutual funds.
REITs pay dividends, which not only add to their attractiveness, but also allow then to shine in their indexes, REITs paid an average of 7.3% over the last five years of the nineties, which was six times what the Russell 2000 index of small cap stock paid. And therein lies the rub. Many of these companies qualify as small capitalization concerns, and this makes it difficult for mutual funds to purchase. A company that is too tiny doesn't have the liquidity that a large mutual fund would like. But they do provide a steady stream of income, low volatility, and along with good returns, they provide stability.
The National Association of Real Estate Trusts reported that mortgage REITs returned 77.3% total return in 2001. So what about 2002? Many mutual fund managers have conservatively estimated that the sector will return in the 7-10% range for the year. But that may be just a little too conservative.
Or is it overoptimistic. When the bubble burst on technology, it burst suddenly, then the bad air sort of leaked out over the course the next twenty four months. But this talk of a bubble in real estate may have some merit it seems, but the bursting seems less possible. A slow leak maybe.
When most investors think of REITs and real estate, they think locally in terms of their own homes. But the companies involved in real estate trusts are more likely to have invested in commercial properties. When business is hurting, it is the properties that take the hit. First the market deteriorates followed by the amount of money landlords can charge for rental space. This has been going on for the last several years.
But when these trusts start to pull back on the amount of payable dividends, then the trouble is more evident. There is however, a break even point, which is getting closer and is becoming more worrisome.
REITs are exempt from corporate income taxes and as result pay larger dividends. When a company sees a drop in occupancy, it determines the point at which it will effect its dividend payments. For the first nine months of this year, that dividend has averaged around 7% according to the National Association of Real Estate Investment Trusts. Compare this to the dividends paid by the companies in the S&P 500, which pay just shy of 2%, and you can see why investors have suddenly taken notice.
When the market bottoms out on REITs, investors are just as panicky, if not more so than with equities.
Companies within funds that hold REITs have only three options when their cash flow is hampered by diminishing cash flow: cancel dividend payments, sell properties or borrow money to pay them.
In each of these scenarios, the investor feels the short fall first. Canceling dividends eliminates investor trust. Selling properties in an already depressed market means earning shortfalls and possibly charges taken in the following quarter. Borrowing is similar to creating debt to pay off debt in the Peter to Paul method.
If you own REITs because they have been good performers, you probably have gotten everything from them that they have to offer. If you are familiar with the companies within your fund (and owning them through a fund is the only way to go because many are small companies with limited exposure) explore the percentage of occupancy. Many of these companies will start seeing trouble when their rates of occupancy falls close to or below 90%.
Some things to look for when buying a REIT fund include: Excellent longer-term returns. This can help a fund weather sudden downturns which might be on the horizon. A talented, experienced management team is a must and the costs should be reasonably low with small investment minimums and reasonable expenses. Some funds in this category tend to be risky and the reason for this is their method of investing. Watch out for funds with concentrated portfolios that can lead to day-to-day volatility.
Although we do not as rule recommend anything to anyone, the Cohen & Steers Realty Shares (CSRSX) and the old standby Vanguard REIT Index (VGSIX).
A note about the Vanguard fund while I have your attention. This fund follows an index provided by Morgan Stanley and which is not quite the standard for benchmarks. Although it has done well, it is because of the low expenses it charges rather than the higher quality of it's holdings. Most indexed REITs follow the broader Wilshire index.
|