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REITs Are Quite Alright

It's generally agreed that real estate investment trusts, REITs, shouldn’t occupy more than 10 percent of one's investment portfolio, except during rare times. Some say, one of them happens to be now.

A confluence of economic and market conditions make them an excellent option for diversifying a portfolio: low interest rates, a strong potential for inflation, lots of available capital and real estate bargains.

“The yields that we’re getting now are probably at a low point,” says Rose Greene, a certified financial planner who advises clients in Los Angeles. “Not next week or next month, but over the next several quarters we should see the inflation rate pick up some—and real estate does well in an inflationary environment.”

David B. Armstrong, chief portfolio strategist for Monument Wealth Management, thinks it is a smart tactical move to have higher REIT allocations for the next five to seven years, but adds, “investors have to be very careful.”

After all, the Dow Jones REIT Indexhas doubled since its spring of 2009 bottom, the culmination of a 75-percent decline that began with the recession in 2007.

Investors also need to be selective.

Wide World Of REITs

The REIT world, after all, is a varied one. Even though companies must invest 75 percent of their assets in real estate, get at least 75 percent of gross income from rents or mortgage interest, and pay out 90 percent of taxable income in dividends, their portfolios can and do differ widely.

REITs can invest in properties, mortgages or both. They can be broadly diversified or focus on a geographical area and/or particular sector, from retail to residential to hospitality to agriculture. There are privately held REITs and publicly traded ones like mall owner Simon Property Groupand Vornado Realty Trust , the brainchild of hedge fund dynamo Eddie Lampert.

Pros and cons abound, so it’s important to consider your investment goals—and even hire an advisor who knows how to find and vet opportunities.

Exchange-traded REITs are very liquid. There are no minimum investments or net worth qualifications ,as there are with private REITs. (Though some private REITs have minimums as low as $2,500.) But there are downsides.

"I consider traded REITs a real estate stock play—as goes the market, so goes those stocks,” Greg Genovese, CEO and president of real estate investment, asset management and advisory firm Pacific Valley Realty Capital. “They tend to be more thinly traded, so they have a lot of volatility."

Private REITs come with fees—generally one-time costs equal to a year’s dividends, Armstrong says. Yet shopping around for low fees isn’t necessarily smart. "I would say buyer beware of the very inexpensive managers—it's possible that the cheaper fee could be coming at the expense of a qualified management," he says.

People are paramount, Green agrees. “The ultimate value that you will see is a function of the quality of the portfolio managers. You want to see a reliable track record of beginning, middle and conclusion.”

And no matter whether you go exchange-traded or not, take a good look at a company’s borrowing history, Genovese urges. “Companies that tend to use extremely high leverage when monetary policy is loose—well, leopards don’t usually change their spots,” he says. “The same management tends to be just as risky or riskier the next time around.”

Where Opportunity Lives

An excess of leverage is why some are looking to new REITs rather than more established portfolios.

“A lot of REITs purchased property between 2004 and 2008, and they’re probably overleveraged and the property’s not performing as well," says Jeffrey Rogers, president and COO of Integra Realty Resources, the largest independent real estate valuation company in the U.S.

He’s looking at projects that are newer and therefore non-traded, he says. "They don’t have any legacy problems and they’re buying real estate at the best time in our lifetime."

Armstrong agrees, and sees freestanding necessity retail—drugstore and grocery chains—as having strong potential as well.

"CVS Caremark and Walgreen, they’re growing and building new properties all the time," he says.

The companies buy land, build a store, sell it to a portfolio manager and lease it back, he points out. That means a steady income stream—and predictable rent increases.

Even if that freestanding drugstore goes out of business, the parent company is still responsible for paying the rent. "And very long-term corporate leases run 15 to 17 years," he says.

Tayo Okusanya, REIT analyst at Jefferies & Co., is bullish on healthcare REITs—especially senior housing.

“We think over the next 12 months, there are some names that will deliver some pretty strong earnings growth,” he says. Among them are Omega Healthcare Investors , Medical Properties Trust and Health Care REIT.

The multi-family space is also a good bet, in his view. Nationwide, apartment vacancy rates are at 7.2 percent and rents are edging up, sccording to Reis. Low inflation—especially stable fuel prices—is keeping operating expenses low, Okusanya points out.

Meanwhile, good REIT managers are circling condo properties that were built on spec and now lack buyers and refinancing opportunities, Armstrong says. They can be bought at 50 cents on the dollar and converted into rentals.

“Nobody wants to buy a condo right now,” Armstrong says. “But everybody wants to rent a nice place.”

Okusanya expects growth of net operating income—property revenue minus operating expenses, without taking into account financing costs—to be in the high single to low double digits for multi-family properties. Two publicly traded companies to look at are Essex Property Trustand Home Properties.

He thinks the window of opportunity for REITs may be limited. "A year from now there will be more pressure on the Fed to raise interest rates, Financing is going to be more expensive. Cap rates are going to go up. There’s going to be an interesting call to be made in 12 months."

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