Equity REITs: proceed with caution ... but proceed! (real estate investment trusts) (Personal Financial Planning)

• Author: Wollack, Richard

Equity real estate investment trusts (REITs) have boomed over the last 15 months. In 1992 underwriters raised some $2 billion for new and existing equity REITs. An additional $650 million of new capital was raised in the first six weeks of 1993, and analysts conservatively project that $3 billion will flow into REITs by year-end.

The reason for the interest in REITs is not difficult to fathom. They have substantially out-performed market averages in return on investment. They pay a dividend of approximately 6 percent, but increased share prices have been the real kicker, moving from an average discount from current asset value of some 5 percent to 10 percent in October 1992, to today's premium over current asset value of more than 20 percent. The NAREIT (National Association of Real Estate Investment Trusts) Equity Index showed a total return of 14.6 percent in 1992, of which 7.2 percent was dividends and 7.4 percent was price appreciation. REITs really took off at the end of 1992 and in early 1993. In the first 10 weeks of 1993, REIT shares rose a breathtaking 17 percent.

With so much new money pouring into REITs and such a spectacular rise in share prices, any veteran investor is likely to think it's time for smart money to start looking elsewhere. We agree that the current REIT "gold rush" will create opportunities to put good money into bad investments. On the other hand, we feel there are still compelling reasons to invest in REITs. The problem for astute investors is to separate the wheat from the chaff.

FUNDAMENTALS OF REITS

REITs are similar to closed-end mutual funds except they invest in a portfolio of real estate properties instead of stocks or bonds. The important factor distinguishing REITs from other forms of real estate investment is liquidity -- shares can be bought or sold any day the markets are open. However, unlike stocks -- where profits are taxed once at the corporate level and again as personal dividends -- profits from REITs are taxed only once, at the investor level, so long as at least 95 percent of profits are paid out as dividends. (Since all REITs want to avoid taxation at the entity level, it is extremely rare for the 95 percent pass-through not to occur.)

But liquidity and tax advantage alone do not explain the recent boom in REITs. Rather, a confluence of macroeconomic factors have created a convincing logic for using REITs as a form of real estate ownership. From the investor perspective, REITs are an...