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Real Estate Investment Trusts Explained: REITs Escaped the Worst of Sandy, So Is Now a Good Time to Buy?

Nov. 14, 2012
Investing, Investments
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Is now a good time to buy REITs?  A REIT, or a real estate investment trust, is a company that invests in real estate directly either via mortgages or actual property ownership.

What are REITs?

Essentially REITs are just real estate holding companies that qualify for special tax treatment under the law. Specifically, the IRS exempts REITs from paying income taxes at the corporate level, as long as they hold at least 75 percent of their investment portfolio in qualifying real estate investments (there are also mortgage REITs which hold mortgages, rather than real estate). By law, REITs must also disburse 90 percent of their income or more to shareholders.  In turn, shareholders must claim all REIT income on their individual tax returns, and must generally pay ordinary income tax rates on the income.

What Did Hurricane Sandy Do to REITs?

Thus far, northeastern REITs got away without too much damage from Hurricane Sandy.  When the storm was closing in on the Jersey Shore, REIT investors were getting pretty nervous.  At one point, analysts were concerned that as many as 9,000 REIT-owned properties were in the path of Tropical Storm Sandy.

Alexanders, Inc. (NYSE – ALX), was in particular jeopardy. As REITs go, this 2.2 billion trust is a small one. But all six of its properties sat squarely in the path of Hurricane Sandy – right smack dab in the middle of the NYC metro area.  However, the trust escaped major damage. Its properties are set back in Manhattan. While lower Manhattan got clobbered with a 15-foot storm surge that flooded the World Trade Center site among other sites, ALX properties only suffered slight damage.  Meanwhile, Staten Island and Brooklyn sit between Manhattan and the open ocean, taking the brunt of the punishment.

Markets hardly blinked.

The stock price rose sharply on news that Alexander’s had negotiated a profitable sale of King’s Plaza, a Brooklyn mall… and it’s clear that the approach and passage of the storm was a non-event, as far as Alexander’s shareholders were concerned.

First REIT of New Jersey, (NYSE – FREVS) on the other hand, did offer a modest trading opportunity. This residential real estate investment trust has almost all its properties in New Jersey.

There was a very modest decline on greater than normal volume ahead of the storm. And when the storm passed and the damage turned out to be negligible, the stock zoomed back up even higher than it was before.  The pre-storm dip, though, wasn’t enough to take much of a risk on. It wasn’t that much bigger than the normal day-to-day variations in the stock price.

If any REITs should have seen a big panic sell immediately before the storm hit, it should have been these two. But they didn’t. Why?

Well, as we saw in this article, flood insurance only covered about 15 percent of homeowners. But REITs buy flood insurance more often than individual landowners, so that takes the sting out of things. New York is also a vertical real estate market. Floods that would utterly destroy a one-story structure are relatively minor occurrences for high-rises. And neither REIT was primarily exposed entirely to the coastline.

However, if there’s a lesson to be learned here, it’s this: REITs make sense or don’t make sense based on long-term fundamentals. Think income, price to earnings, price to book, and sensitivity of earnings to cyclical market changes. For example, some retail malls – a REIT staple – take it on the chin in slow economies when they can’t fill their store slots with paying renters. If just one “anchor” pulls out – Macy’s, JCPenneys, Sears, Bloomingdales, etc., that can tear the guts out of a shopping mall REIT.

What Role Should REITs Play in a Portfolio?

Historically, investors have held REITs as an additional asset class. They tended to perform strongly when stocks were weak. Unlike bonds, REITs also have some built-in inflation protection: They earn hard assets, rather than debt, for one thing. And REITs also benefit from the freedom – generally – to adjust their rents upward in response to inflation.

REITs have long been a favorite additive to stock and bond-heavy portfolios for asset allocation practitioners. The reason: REITs usually zigged while everything else was zagging. In mathematical terms, REITs had a reasonably low correlation coefficient compared to stocks, bonds and other assets classes. This meant that REITs provided a useful diversification benefit.

In recent years, though, the diversification benefit has begun to decline. REITs and stocks have tended to move more in tandem – in part because the recession of 2008-2009 brought a huge increase in vacancy rates for all kinds of commercial properties, from shopping malls to office buildings – both REIT staples.

Privately Held REITs: Playing a Role in the Shadows

Enter the non-publicly-traded REIT. Not every REIT is publicly traded, but lots of privately held REITs need to raise capital from time to time, or you may have an executive who wants to retire and get rid of shares or a prominent investor who needs to liquidate. When this happens, they need to find someone else to buy their interest.

If you get involved in these, go in with your eyes wide open. These are really for sophisticated, experienced investors. You can get a great yield on some of them, mostly because the seller usually has to sell shares at a deep discount. This boosts your effective return on investment – when it works as planned. But remember – you’ll probably have to sell your shares at a discount, too, due to a phenomenon financiers call “liquidity premium.” People will pay higher prices for a position they can sell easily than they will for a position they will have trouble unloading.

You can buy privately held REIT shares directly from the owners, but it’s more common for them to go through a broker who specializes in this market. That broker will add a commission to the already substantial liquidity premium – 12 percent is a pretty typical front-end load in this space, according to Blue Vault Partners, a consulting and research firm specializing in the non-publicly-traded REIT sector.  These aren’t trading vehicles:  it’s best to hold these for the long-term, and take the income. According to Blue Vault Partner and University of Texas research, about 75 percent of privately-held REIT performance is due to income, anyway.

REITs: Volatile Income Generators

After taking a shellacking, like all real estate assets, in the late-2000s recession, REITs have rebounded strongly over the last four years. And naturally, they’ve attracted a lot of capital, which tends to push up prices. REITs overall have zoomed nearly 18.5 percent per year over the past three years, on heavy inflows. The Vanguard REIT Index Fund is now spitting out a yield of 3.4 percent. There are some individual REITS, like First REIT of New Jersey, above, that will get you to between 6 and 7 percent. But investors do not live by income alone.

REITs are fine income generators – and historically generate about twice the income of the S&P 500 at any given time. But they are not reliable income generators. There’s no guarantee that you’ll receive a dividend payment. You need reliable income? Get a high-quality bond or an annuity. That said, commercial REITs tend to lock in long leases, say, in shopping malls, which helps to smooth out the ups and downs.