Money Matters: Consider REITs as alternative investment

By James Quackenbush The Daily Record Newswire With the economy showing signs of slowing down and the bull market run losing its momentum, investors have started looking for different opportunities in which they can earn a quality return on their investments while mitigating risk. However, with rates remaining low, yields on high-quality bonds and other interest bearing investment are at historic lows. Real estate investment trusts (REITs) have attracted investors as an alternative to stocks and low-yielding bonds due to their unique underlying investments, long-term performance, diversification, and attractive yields. REITs are corporations that invest shareholder capital and manage the day-to-day operations of a collection of real estate properties and/or loans secured by real estate properties. The underlying assets of a REIT are sold in shares to investors, through an IPO offering or over a stock exchange, giving owners a fractional ownership of the underlying properties. This allows the average investor the ability to invest in major real estate properties without committing a substantial amount of capital. Owners of the shares are investing in the rental income, interest, and appreciation of the properties and mortgages owned within the trust. Virtually anyone can enjoy the benefits of major investment properties with as little as a few hundred-dollar investment through REITs. Further, investor capital is pooled together allowing the trust to invest in numerous properties, reducing the risk of any single property having a substantial negative effect on the overall trust. To be classified as a REIT with the IRS, a corporation must meet the following criteria: it must distribute at least 90 percent of its annual taxable income as dividends to its shareholders, have 75 percent of its total investment assets in real estate, and derive at least 75 percent of its gross income from rents or mortgage interest. By having REIT status, the company avoids any corporate income tax, whereas a regular corporation is taxed on any profit made throughout the year and then decides how to allocate its after-tax profit between dividends to shareholders or reinvestment back into the company. REITs, on the other hand, distribute all or most of all pretax profit to their shareholders in the form of dividends. Consequently, a well-managed, diversified REIT has the potential to pay hefty dividends to its shareholders. The two most common types of REITs are equity REITs and mortgage REITs. Equity REITs own and manage income-producing real estate properties such as rental apartments, malls and commercial office buildings. Equity REITs are the most popular because the cash flows and capital gains are derived from the underlying property. Further, they tend to be more stable over the long term and are less sensitive to interest rates. Mortgage REITs, on the other hand, lend capital to owners and developers or invest in financial instruments secured by mortgages on real estate. Mortgage REITs tend to offer very high yields but carry a greater risk because of their sensitivity to interest rates. Specifically, if interest rates rise, the value of the mortgage REIT can drop in value. Lately, with investors being very yield-focused, the yields offered by REITs are attracting investors away from lower-yielding investment vehicles such as bonds and CDs. Most REITs offer sizable dividends since the trust must distribute 90 percent or more of their taxable income each year. However, all profits that are passed through to its investors are eventually taxed at the investor's ordinary income tax rate. For that reason, it is more beneficial to hold REITs in a tax-advantaged account such as an IRA where the dividends can compound over the years tax-free. Typically, yields can range from 3 percent to over 10 percent, depending on the type of REIT, which can be significantly higher than yields on the S&P 500 and Government Treasury Bond. For example, the yield on the iShares Real Estate 50 Index fund ETF (FTY) is yielding 3.6 percent and the yield on the iShares All Mortgage Capped Index Fund ETF (REM) is yielding nearly 10 percent. In terms of long-term performance, REITs have a rather impressive track record, which is measured by the FTSE NAREIT Real Estate 50 Total Return Index and tracks the 50 largest publicly traded equity REITs. The Index has a trailing five-year annualized return (since May 31) of 4.09 percent and a 10-year annualized return of 11.61 percent. This compares to stock returns (as measured by the S&P 500) of a five-year annualized return 3.32 percent and a 10-year annualized return 2.64 percent. With stocks showing signs of weakness and bonds offering nominal yields, REITs have emerged as an attractive alternative investment due to their unique underlying investments, long-term performance, and attractive yields. REITs allow investors to pool capital together to participate in large-scale real estate investments without committing a substantial amount of capital. Due to the requirement that the trust must distribute 90 percent of their income to their investors, income received can rival those of stocks and bonds. Although REITs can be a great investment, they should never constitute more than a 10 percent of an overall investment portfolio. If you think that REITs might be an attractive investment vehicle for your portfolio, consult your investment professional before making any investment decisions. ---------- James Quackenbush is an analyst/portfolio manager for Karpus Investment Management. He can be reached at (585) 586-4680. Published: Tue, Jul 12, 2011