The Common Sense Investor

What exactly are REITs and what advantages do they offer as an investment vehicle?

REITs have been in vogue recently with the latest real estate boom. Well-run and reasonably priced REITs can be part of the common sense investor’s portfolio. But don’t just throw your money blindly at a REIT investment for the sake of diversification.

Real estate investment trusts (REITs) are companies that own and, more commonly, manage income-generating commercial real estate. There are REITS that make or invest in loans and other obligations that are secured by collateral in the form of real estate. Most REITS are actually publicly traded.

REITs actually qualify as pass-through entities ““ that is, they are companies that are able to distribute the majority of income cash flows to investors without taxation at the corporate level. And being such entities, whose main responsibility is the passing on of profits to investors, a REIT’s business activities are generally restricted to generation of property rental income.

In 1960, the US Congress created the legislative framework for REITS that was envisioned to enable the investing public to benefit from investments in large-scale real estate enterprises. REITS, as they have come to be known ““ real estate stocks, offer a lot of diverse benefits to the institutional and retail investing communities. First of all, it provides an ongoing dividend income along with the potential for long-term capital gains through the appreciation of the share price. REITS can also serve as a powerful tool for effective portfolio balancing and diversification. Some other benefits of investing in REITS are:

• Historically, the ownership of REIT shares has increased investors’ total return and/or lowered the overall risk in both equity and fixed-income portfolios
• The dividend growth rates for REIT shares have, for the last ten years, outpaced inflation
• The business model of REIT is based largely on the value of tangible and quantifiable assets, namely large-scale commercial real estate - something that not many industries are able to claim.

Another benefit/advantage of REIT as an investment is its liquidity compared to other traditional private real estate ownership. One reason for this liquidity is that REIT shares are traded in major exchanges which makes them easier to buy and sell than the actual properties in private markets.

Now, in order for a corporation to qualify as a REIT and subsequently gain the benefits of being a pass-through entity (tax-free at the corporate level) it must be able to fulfill the following Internal Revenue Code provisions:

• The entity must be structured as a corporation, business trust or any similar association
• It should be managed by a board of directors or trustees
• Its shares must be fully transferable
• There must be a minimum of 100 shareholders
• It must be able to pay dividends of at least 90 per cent of a REIT’s taxable income
• During the last half of each tax year, five or fewer people can possess no more than 50 per cent of shares
• A minimum of 75 per cent of total investment assets should be put in real estate
• About 75 per cent of the gross income should be derived mainly from rents or mortgage interest
• Stocks in taxable REIT subsidiaries should be no more than 20 per cent of its assets

There are two facts that the common sense investor should keep in mind when investing in REITs. First, since REITs pay out a large portion of their return in dividends, they are susceptible to dividend taxation. Second, investing in REITs should only be done when an emphasis is placed on quality companies that are selling for reasonable prices.

REITs are currently seen as a sexy investment, so the common sense investor needs to be careful that he or she is not investing blindly; just throwing your money at a fad. Rather, see REITs for what they are: companies that can either be run well or poorly and which can either sell high or low.

Buy well-run REITs at reasonable prices and you’ll be investing with common sense.