Want to invest in real estate and not worry about late rent checks, leaky toilets or whether a tenant is trashing the place? Buy shares in a real estate investment trust.
These investments, commonly called REITs, own pools of properties, are run by professional managers and are as easy to buy and sell as stock in General Motors.
What’s more, they’ve been one of the best investments going. The National Association of Real Estate Investment Trusts’ index of 159 publicly traded REITs is up 11.4 percent in the past 18 months. By comparison, the Standard & Poor’s 500 index of large-company stocks gained 4 percent in the same period.
There’s just one problem with investing in REITs: Seventy-eight REITs have gone public the past 18 months, increasing by 50 percent the number to choose from.
How to choose a REIT? We posed that question to three investment pros who make their living choosing REIT stocks.
Here are the 10 things to look for:
– Value. As with any investment, the idea is to buy low and sell high. But for the average investor, finding undervalued REITs-those whose shares are trading at less than what the company’s assets are worth-can be a seemingly impossible task.
Most REITs own scores of properties, but few carry them on their books at market value. Unless you’re a real estate appraiser with a lot of time on your hands, it’s virtually impossible to determine the value of all of a REIT’s properties, says Jon Fosheim of Green Street Advisors, a Newport Beach, Calif., real estate research company.
If you have a stockbroker, chances are his or her company has an analyst who follows the real estate industry. If not, many public libraries carry Value Line Investment Survey Inc., which publishes weekly reports on 5,000 publicly traded companies. In addition, Standard & Poor’s Corp. sells research reports on 4,000 companies. They cost $9.95 apiece and can be ordered by calling 800-642-2858.
– Growth prospects. Pay attention to how a REIT grows. The best-run REITs expand by raising rents, paying down debt and periodically acquiring top-drawer properties. Look out for REITS whose managers are acquiring new properties constantly, or deriving fee income from properties they manage but don’t own.
What’s an acceptable rate of growth? “I’m looking for 5 to 10 percent growth in the dividend each year,” says Matt Avery, who manages $400 million in two real estate mutual funds for San Mateo, Calif.-based Franklin Resources Inc.
– Management. A REIT won’t grow unless its management team knows how to get the most out of its assets. Experts say there is no substitute for experience. How much?
“I would say 7 to 10 years is a reasonable period of time,” says Barry Greenfield, manager of Fidelity Investment’s $500 million real estate fund. “You want someone who has been through a whole real estate cycle.”
Greenfield also likes to see managers own a sizable stake in a REIT, from 7 to 10 percent, and have their pay tied to performance.
– Properties. Nowadays, there’s a REIT for just about every type of property. In addition to the old standbys-apartments, office and industrial buildings, nursing homes and hospitals-there are REITs that own mobile-home parks, hotels and factory-outlet centers.
If you’re familiar with one of these industries, put your expertise to use. If not, you may want to consider geography. Many REIT properties are focused in a particular region of the country. Some believe that California’s economy has bottomed out, making some of the nearly two dozen REITs in the state a good buy.
Also pay attention to the quality of properties in a REIT. Does it own high-profile, well-kept buildings, or junky rundown projects in dicey neighborhoods? Don’t place too much emphasis on appearance. New buildings could be suffering from low occupancy or too much debt, while well-tended older buildings with little or no debt and a stable tenant base could be cash cows.
– Cash flow. Because REITs are tax-free corporations that pass 95 percent of their earnings on to shareholders, cash flow from operations, not net income, is the most important financial measurement of a REIT.
Five years ago, cash flow was about the only thing you really needed to know about a REIT. Today, focusing solely on cash flow “can be a ticket to the poorhouse,” says Fosheim, whose clients include many of the nation’s largest institutional investors.
Cash flow has faded in importance because of the growing use of variable-rate debt. Many REIT managers use short-term, low-rate debt, which temporarily reduces borrowing costs and increases cash flow.
– Debt. When researching a REIT, sift through the company’s balance sheet and see how much of its debt is due in five years or less, then check the footnotes for the amount of variable-rate debt.
Just as in managing your household finances, too much debt can be a bad thing. Be wary if a REIT’s total debt approaches 40 percent of its market capitalization (share prices times the number of shares outstanding).
– Yield. Because REITs are an attractive alternative to bonds, many investors, especially those on fixed incomes, simply chase yields (the rate of return the dividend pays based on the share price). That strategy, however, can lead to a REIT whose fundamentals and outlook are poor.
If you can’t resist yields, “make sure it’s in line with its peer group,” Avery says. “If it’s higher, it’s not necessarily attractive.” Most recent REITs are yielding 5 to 8 percent.
– Type. There are three basic types of REITs: those that invest in properties, those that invest in mortgages and those that invest in a combination of the two, known as hybrids.
Equity REITs, which own properties, account for 85 percent of the industry’s $40 billion in market capitalization, and about 30 companies account for half of that total. These are the favorites of investment pros. Mortgage and hybrid REITs have generally lost value the past 18 months.
– Inflation. A slow but steadily increasing rate of inflation can help boost REIT returns nicely. Rising prices mean that the economy is growing and healthy and that property managers can probably increase rents without too much resistance.
But if inflation picks up steam, there’s also a big downside: interest-rate hikes. If a REIT’s borrowing costs increase, that will have a negative effect on cash flow, Avery says.
– Other income. Some REITs derive a portion of their income from outside fees, by managing properties not in the REIT, or overseeing the construction of projects not in the REIT. If 20 percent of a REIT’s income comes from such outside contracts, steer clear.
“These are very volatile businesses,” Fosheim says. “Many of these contracts have a 30-day cancellation clause.”
