Real estate investment trusts have strong appeal to some investors

By now you should have heard the word “REIT” in the investment world, but you may be wondering what one is and how it works.

First, realize that REITs — real estate investment trusts — are not new. They’ve been around for more than 45 years. However, it has only been since the 1990s that they’ve gained popularity. From the end of 1992 to the middle of 2001, the size of the REIT industry has increased almost tenfold. Still, according to the Institute of Business and Finance, the REIT industry has only captured 10 percent of the $3.5 trillion commercial real estate market, and it still has plenty of room for growth.

So what is a REIT? REITs are corporate real estate entities overseen by financially skilled management teams. In simple terms, they are companies that run commercial real estate properties, such as business skyscrapers, apartment communities, hospitals, golf courses and shopping centers. By investing in a REIT, you can become part-owner of real estate you would probably never be able to own by yourself.

To be considered a REIT, the investment must adhere to certain rules, including:

• It must distribute at least 90 percent of its annual taxable income, excluding capital gains, as dividends to its shareholders.

• It must have at least 75 percent of its assets invested in real estate, mortgage loans, shares in other REITs, cash or government securities.

• It must derive at least 75 percent of its gross income from rents, mortgage interest or gains from the sale of real estate property, and at least 95 percent must come from these sources together with dividends, interest and gains from securities sales.

• It must have at least 100 shareholders and no more than 50 percent of the outstanding shares concentrated in the hands of five or fewer shareholders.

One advantage of REITs is that they are not correlated to the stock or bond markets – they tend to have their own up and down cycle. In fact, REIT stocks have only a 55 percent correlation with the broad market, as measured by the S&P 500 Index from 1972 to 2000. This means that when the S&P 500 goes up or down, REITs are not as likely to follow suit with the broad stock market. Since REITs tend not to perform with the market, they can be a good choice for asset allocation.

According to the National Association of Real Estate Investment Trusts, in 2006 REITs gained 34 to 35 percent – the seventh consecutive year that REITs outperformed the overall stock market. They also have had a positive performance in 28 of the past 34 years.

Even if the near-term outlook for real estate is not good, REITs can still be a good investment, since good management teams with access to capital have the potential to find opportunities in bad times as well as good.

Just like common stocks, REITs come with risks too, but they are different from other investments.

For example, shopping mall REITs are subject to the changing tastes and lifestyles of consumers; apartment building REITs are subject to overbuilding, and health-care REITs are subject to the politics of government cuts in health-care reimbursement. While typical stocks go up or down according to the market, REITs fluctuate because of changes in society, so are subject to credit risk, interest rate fluctuations and the impact of varied economic conditions.

Because REITs were not heavily marketed in the past, many people have never heard of them, but REITs are easy to buy (they’re available on the various stock exchanges), and even some money managers buy REITs. Additionally, REITs have traditionally been a U.S. stock, but now they are becoming more global. In January, Britain legalized them, and Germany is expected to come out with its version of a REIT this year. Currently, 17 countries outside the United States have REITs. As they become more global, they will likely experience more growth.

REITs often appeal to retirees because of their dividend potential. REITs also can be a good investment for people trying to grow assets, because they have historically performed well over the long term. They also can be used to diversify risk to an overall portfolio because they’re not tied to general stock market instruments.

Douglas Charney is a senior vice president-investments with Wachovia Securities in Harrisburg, Pa. He can be reached at 888-529-2973.