Is it Time for REITs Again?
With many people still stinging from a housing market that, in many parts of the country, is still struggling to recover, any suggestion of adding real estate to an investment portfolio may fall on deaf ears. Unquestionably, the bloom has come off the rose in the real estate market; at least when compared with it’s heydays of the last couple of decades. These days the average investor seems perfectly content to leave whatever opportunities exist in the market to the real estate pros or institutional investors who can afford the risk and the illiquidity. The reality is that many sectors of real estate have performed extremely well in the last couple of years. However, most investors don’t have access to the capital needed or the opportunities that lie in other parts of the country, which is why it may be time to consider REITs (Real Estate Investment Trust) for your investment portfolio.
What is a REIT?
REITs are a lot like mutual funds or investment trusts for real estate. Investment managers pool the investments of investors to buy and manage a portfolio of real estate properties. Like mutual funds that target specific industry sectors or regions, REITs target specific types of properties and markets. For instance, timber properties and self-storage properties have been among the top performing categories in the last year. REITs also invest in residential properties such as apartment complexes and they also target commercial office space. The properties are often held for five to ten years depending on the market.
The REIT issues shares, or units to investors to raise the capital it needs to make property acquisitions. Most REITs issues shares at price of $10 each. From the capital REITs raises from investors, it pays selling fees, property acquisition costs, and property management fees. The balance of the capital is invested in real property and cash investments. Most REITs invest in income-producing properties, so their portfolio will generate cash dividends for investors. Dividends can be paid in cash or reinvested into additional trust shares.
There are two general types of REITs – publicly-traded and non-traded. Each holds certain advantages for investors along with disadvantages.
The shares of publicly-traded REITS are traded on the major stock exchanges much like other stocks or the shares of exchange-traded funds. Share values are determined, in part, by the valuation of the underlying real estate, and, in part, by the general movements of the stock market. Investors who have hold a favorable view of certain real estate markets can buy shares of a REIT, and if the general outlook for a certain market is perceived as favorable, investors could drive the price of the REIT shares higher regardless of the actual property valuation. Conversely, an unfavorable outlook could drive share prices down.
- Shares are liquid.
- No minimum investment if purchased on the open exchange.
- Can accumulate shares over time and benefit from dollar-cost-averaging.
- Investor pays normal broker commission rates for stock trades.
- Share prices are affected by more than the actual value of the property. Although real estate values don’t necessarily correlate with stock prices, REIT share prices can react negatively in down market cycles. REIT shares tend to be less volatile than stock shares.
Non-traded REIT shares are not traded on the major exchanges. Once issued to initial investors, they are held until the liquidation of the REIT portfolio. Non-traded REITs must allow for periodic redemption of shares, typically on a quarterly basis. Investors can redeem their shares; however, because the shares are not valued every day, as the publicly-traded REIT shares are, the redemption price is usually determined by trust management. Non-traded REITs are required to revalue their shares based on property value assessments once every three years, so future redemptions could reflect the reassessed value.
- Dividend yields are much higher than on publicly-traded REITs. If liquidity is not an issue, non-traded shares have the potential produce higher total returns over the long term.
- Not as liquid as publicly-traded REITs, although they can be redeemed through the trust. There is a secondary market for non-traded REITS but it is thin, so shares are usually sold at a steep discount.
- Share prices upon redemption are not necessarily based on actual property valuation. Management can determine both the share price and the maximum number of shares it will allow investors to redeem.
- Expenses tend to be high. Sales commissions can range between 5% and 9% of your investment amount.
Larger investors, such as institutions and high net worth investors tend to favor non-traded REITS largely due to their higher dividend yields. The drawback on non-traded funds has always been the relative lack of liquidity; however, real estate investors in general understand that real estate is a long term investment, so it is not a central issue.
For long term investors who seek broad diversification through an optimal asset allocation strategy, real estate is still considered to be strong asset class that can add the right correlation needed to counter the risks of other assets, such as stocks and some commodities. REITs offer the smaller investor an opportunity to participate in professionally managed real estate that offers long-term growth potential as well as current income.