For many investors, real estate is an attractive option for diversifying their investment portfolios. Although real estate historically has had a low correlation with other types of investments, such as stocks and bonds, real estate investments can help reduce a portfolio's overall volatility for investors seeking attractive long-term returns. In addition, real estate is considered a good hedge against inflation, since property values typically rise as the cost of developing new real estate increases.
Despite these advantages, however, the outright ownership of real estate can be troublesome from a landlord's perspective and prohibitive from the individual investor's perspective; very few individual investors can secure the huge mortgage loans required to purchase an entire apartment complex or a shopping mall.
One way investors can invest in real estate without staking the performance of their entire portfolio on one property is through an equity real estate investment trust (REIT). An REIT is a business trust, corporation, or similar association that purchases and manages a diversified portfolio of real estate investments.
Similar to closed-end mutual funds, REITs pool the resources of investors who have similar investment objectives. These investors receive shares of the REIT, which represent a proportional interest in its assets. The shares are publicly traded, primarily on the over-the-counter market.
Equity REITs represent one type of REiT popular with investors. At least 75 percent of an equity REIT's assets are invested in properties such as apartment units, office complexes, or retail shopping outlets. (Two other types of REITs are mortgage REITs, which hold mortgage debt on properties and serve as lenders to real estate purchasers, and hybrid REITs, which hold a combination of equity and mortgage investments).
Equity REIT Performance
Since 1973, the average performance of equity REITs has been higher than that of both large-company stocks and long-term bonds, and while equity REITs have been more volatile than bonds, they have fluctuated less than stocks. Additionally, over the past 10 years, equity REITs have correlated with the Standard & Poor's 500's performance only 65 percent of the time. This means that about one-third of the time the returns of large-company stocks, long-term bonds, and equity REITs have moved independently of each other, a characteristic that helps reduce the volatility of an investor's portfolio.
The key to equity REITs' performance is their relatively high dividend yield, which averaged 7.75 percent in 1995. The reason that equity REITs yield high dividends is that they must distribute at least 95 percent of their taxable income annually to avoid paying corporate income taxes. Moreover, many equity REITs pay dividends in excess of taxable income because of the positive cash flow created from the depreciation deductions allowed on rental properties. Distributions that come from depreciation are non-taxable returns of capital.
Return-of-capital distributions reduce an investor's basis in the REIT, which creates a capital gain that is not taxed until the shares are sold. Under current law, the gains will be considered long-term and taxed at a maximum Federal rate of 28 percent if the shares are held for more than one year. This advantage is similar to the tax-deferred growth in stock prices, which also is taxed at capital gains rates when the shares are sold.
Investment Considerations
In addition to past performance, investors should consider the following factors when evaluating equity REITs as a portfolio diversification vehicle:
Quality of management. The responsibility for deciding which properties to purchase is usually made by a board of directors or trustees. Before investing in an equity REIT, investors should be sure that the portfolio's managers have a good track record in the industries in which they invest. The managers should also be part-owners of the REIT.
Portfolio composition. Investors should consider specializing in particular types of real estate - such as hospitals, hotels, apartment complexes, or shopping malls - or in particular locations. Investors also should diversify their investments geographically, so they are not tied to one region's economy.
Debt level. Most equity REITs must borrow to finance the purchase of their properties. The average debt-to-equity ratio among REITs in 1994 was about 60 percent. Some analysts recommend that investors seek out REITs that have debt-to-equity ratios of less than 40 percent so that the safety of dividend payments will not be threatened and management will have greater financial flexibility.
Moreover, investors should seek equity REITs whose portfolios are financed through fixed-rate loans, rather than variable-rate loans, since variable-rate loans expose the borrower to rising interest rates. A higher debt level means added risks for the investor, but it also provides leverage - the potential for higher returns.
Cash flow. Increasing rental income enables an equity REIT to support its dividend payments while making additional property investments. Experts recommend that potential investors evaluate an equity REIT's funds from operations (FFOs), a measure that includes net income plus depreciation allowances. Analysts recently have begun to accept this measure as a more accurate benchmark of an equity REIT's return on its investments. In other instances, prices of equity REIT shares are often evaluated based on their price-to-FFO ratio, rather than on the traditional price-to-earnings ratio considered for most stocks.
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