Real Estate Investment Trusts — Their Seven-Year Run on the Decline

Many books and articles have recommended new investors put their money into real estate. For investors just starting out, they probably do not have the backing or cash in the bank to purchase real estate on their own. The Real Estate Investment Trust (REIT) is a good way to invest in real estate with minimal funds.

REITs are mutual funds that own real property assets or mortgages, called debt-based securities. They allow even the smallest investor the opportunity to own a piece a real estate investment without going it alone.

Real Estate Investment Trusts came into their own during the housing bubble with attractive dividends, some of which paid 300 percent since the end of 1999. With the current real estate market, however, REITs are losing favor amongst investors.

According to a January 29th article in BusinessWeek, many Real Estate Investment Trusts are currently overpriced with dividend yields that are less than Treasury bills. In January, REITs were yielding only 3.6 percent. That is 1.3 percentage points lower than Treasury bills.

Current REIT investors can only hope that payouts will increase or the underlying property values rise. Real Estate Investment Trusts legally must pay out 90 percent of their taxable income in dividends; so, an increase in payouts is doubtful — cash flow does not grow fast enough to offer substantial increases within a short timeframe. Of course, the current real estate market means that property values are not steady. Where real estate values used to steadily rise year-after-year, positive value changes are no longer reliable. Many are still falling, especially in the office and apartment REIT investment arenas.

In 1997, Real Estate Investment Trusts were trading at 33 percent premium to their underlying property values, called the net asset values (NAVs). After the market bottomed in late 1999, they were discounted by 20 percent. In January, they were traded at a seven percent premium to NAV.

While market optimists believe REITs still have some running room, many investors believe the NAVs are now inflated. That means the REITs were taken out at a price significantly higher than their NAV estimates, inflating the property valuations. Some industry analysts justify the inflation, since REITs are in an asset class separate from bonds or stocks. They are considered to have matured as an asset class, making them an increasingly important part of many investment portfolios.

Though many investors and money managers are exiting out of Real Estate Investment Trusts, no one is recommending investors rid their portfolios entirely of REITs. Analysts only suggest you reconsider investing in new REITs and trim your current holdings.