How can investors decide if investing in REITs is right for them?
The Right REITs
REITs do have pitfalls. Given the flood of new issues that have come to market over the past five years, many REITs’ managements are less experienced in different economic environments. In the rush to meet investor demand, some sponsors have packaged together inferior properties, any of which would have a tough time making it through a market downtown.
REITs’ biggest risk factor is a recession. Economic downturns typically express real estate prices, since fewer people can afford to buy. More dangerous is the effect of slow growth on the rents REITs’ dividends depend on.
Equity REITs with a large focus on retail properties such as shopping centers or malls are particularly vulnerable. They can be badly damaged if a retailer renter is forced to close up shop. The renters (i.e., a major store that draws shoppers and smaller stores to the mall). The demise of many retailers in the mid-1900s and their effect on mall owners is a case in point.
A regional economic slump can damage REITs whose properties are overly concentrated in one particular geographic area. Highly leveraged (high-debt) REITs are perhaps most at risk, since their margin for error is less.
These risks mean that not every REIT will prove to be a good investment in the coming years. Selectivity is crucial. Here’s a checklist for choosing the right REITs best suited for your own personal investment objectives:
The most important criterion for choosing REITs is management that has proven itself over the long pull during both up and down markets. A consistent record of dividend increases over the past decade (or at least no dividend cuts) is one good measure and indication of a strong man agent. So is a steadily rising profit margin.
Concentration In Economically Stronger Parts Of The Country
The more jobs a state adds, the more its real estate should appreciate long-term. But as the experience of real estate near-depressions in New England and California historically showed during the early 1990s, bad times can strike even the healthiest places. There’s just no substitute for some geographic diversification.
Diversification Among Several Types Of Properties
Owning a mix of residential, commercial and industrial properties allows a REIT to take advantage of the relative security of apartment rents and the faster growth of retail and other rents. Heavy weighting in one particular area- for example, retail- may not be dangerous provided management has a strong record of performance in all types of markets.
High Occupancy Rates
One of the hallmarks of a healthy real estate portfolio is a high average rate of occupancy in its properties. A REIT can’t make money unless it’s getting rents. Allowing for normal turnover, an occupancy rate of at least 95 percent is optimal.
A low level of debt (20 percent or less of capital) gives a REIT much more flexibility to expand in bull markets, and take advantage of bargain buys of quality properties in bad ones. Low debt gives REITs maximum flexibility if times get tough to cut rents, make timely sales or5 do whatever else it takes to maintain their financial strength. Low debt also makes certain REITs recession beneficiaries. As interest rates fall, their prices will rise as investors chase their high, safe yields.
Low Payout Ratios Based on Funds From Operations (FFO) With Potential For Growth
FFO takes the unique aspects of owning property into account, making it the most important measure of REITs’ profitability. The lower the FFO payout ratio (percentage of FFO paid out in annual dividends), the more a REIT can increase its payout over the long haul. FFO payout ratios under 70 percent are preferable.
Owning a basket of first-rate REITs is a sure way to diversify. Unforeseen problems can always arise, so diversification amongst three to five REITs is always a good option just in case a few don’t pan out. Additionally, many REITs offer dividend reinvestment plans so you can compound your investment free of brokerage commissions.
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