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M any ordinary investors are still confused about exactly what a real estate investment trust (REIT) is, says Kit Case, senior equity REIT analyst for Southwest Securities, Inc., summing up the calls he receives. On the other hand, Case says more sophisticated institutional investors want to know which ones to buy.

A REIT essentially is a tax-advantaged corporation or business trust that combines the capital of many investors to acquire or finance all forms of real estate. With tax rules similar to mutual funds, REITS are pass-through entities for income tax purposes. Also like mutual funds, REITs give clients the chance to buy shares in a diversified portfolio of professionally managed real estate with the same liquidity as any other publicly traded stock. Since most public REITs are listed on the New York Stock Exchange (74%), the American Stock Exchange (20%) or the NASDAQ national market system (6%), REIT shares can be readily converted into cash. Thus, REITs give clients superior liquidity when compared with direct investments in real estate.

In 1996, REITs performance drew even more converts. The industry racked up a 35.75% total return, outperforming both the Standard & Poors 500 index and the widely used Lehman Brothers government corporate bond index.

Of course, todays REITs differ radically from their predecessors of 20 years ago. In the early 1970s, REITs were perceived as not much more than the commercial lending arm of several national banks. Numerous REITs leveraged their equity capital for borrowings to make loans to developers. This worked until the mid-1970s recession, when hikes in short-term interest rates and the souring of a number of speculative construction projects depleted REIT equity and led to some bank takeovers. Investors became disenchanted with REITs because of mismanagement, which often was attributed to the conflicts of interest inherent in external management. This structure bred conflicts of interest because management billed management fees whether the REIT made money or not.

Approaching the millennium, REITs are much more fiscally conservative than their progenitors, perhaps because management and REIT shareholders are strongly allied. The majority of REITs no longer depend on risky construction lending. For example, 83.8% of public REITs derive their income from property rents and only 10.1% from interest on mortgage loans. And if any REIT did contemplate incurring excessive debt to make an acquisition, it would risk a severe scolding from the business press and perhaps a fall in stock price.

The Tax Reform Act of 1986 helped dissolve management conflicts. Save for hotel REITs, the majority of REITs no longer were forced to depend on outside managers. They could manage their buildings themselves. The 1986 act allowed most REITs to provide general tenant services customarily furnished by buildings of comparable size in a propertys geographical market and to capture the related income for their shareholders benefit.

Additionally, managements interests are heavily aligned with those of shareholders because Wall Street prefers that a REITs top executives invest in the company they manage. Most REITs follow this guideline. For example, I have dedicated 80% of my own net worth to the success of Crescent Real Estate Equities Co. These reforms in REIT income, debt levels and management structure have greatly improved REITs approval rating in the public markets.

Today, there are also a far greater variety of REITs for investors to choose from. Roughly 22% of public REITs specialize in retail properties; another 21%, in residential. Others favor diversification (15%) or industrial/office properties (14%) and an even smaller portion, areas such as self-storage (7%) or health care facilities (6%).

According to Southwests REIT specialist Case, The risk-averse investor may be more comfortable buying in sectors that display more stable share prices, such as multifamily, retail or industrial REITs. He explains that retail REITs, for example, usually have more large diversified malls with several long-term anchor tenants in their portfolios. Rents of multifamily REITs turn over yearly regardless of the local economy, but their lease increases or decreases are in small increments. Both sectors typically exhibit the type of less volatile share prices that may suit low-risk investors.

REITs also are a match for clients who want reliable cash dividends. According to the National Association of Real Estate Investment Trusts, as of the end of the third quarter of 1997, the yearly dividend of public equity REITs averaged 5.45%. However, some investors may deem bonds a better vehicle for cash dividends. After all, bond interest rates average 6% to 8%.

But REITs provide an extra financial incentive that bonds lack. With REITs, investors have the opportunity for both share appreciation and increased dividends. Dividends have tended to grow at a rate of 5% to 10% a year. Most investors wont get that cash boost with bonds. Even though interest rates rise and fall, most bondholders are locked into the fixed rate at which they purchased their bonds because most buy and hold to maturity. Despite these potential financial bonuses, REITs shouldnt take the place of bonds in a portfolio. Rather, they should be an important component in diversifying a portfolio.

REITs have an edge on other stocks as well. Because there is no double taxation, they have a larger pool of profits from which to pay shareholder dividends than do corporations of similar size. As long as a REIT maintains its tax-qualified status by paying out 95% of its net income to common shareholders, it is not required to pay federal income taxes. Without a tax bite to reduce profits, shareholders derive more of the REITs earnings because only the shareholder pays taxes on a REITs distributions.

Moreover, REIT investors concerned about taxes receive another benefit. Depending on each REITs distribution policy and annual earnings, a portion of the dividend may be deemed a nontaxable return of capital. Not only does the investor not have to pay taxes on that part of the dividend in the year it is distributed but also that amount is not taxable until the stock is sold. So the return of capital not only defers taxes but also lowers an investors taxable income during the time the REIT stock is held, thereby increasing the aftertax dividend yield.

Depending on its investment criteria, a REITs multiple will resonate differently with different investors. A risk-averse investor may prefer a lower multiple with less downside risk. Conversely, an investor who wants an aggressive, fast-growing REIT may crave a higher multiple but will likely pay a higher price. In the current real estate market, office and hotel REITs are the most growth-oriented. In particular, as office leases turn over, such REITs will realize the growth embedded in their portfolios from recent rental spikes. This growth will support greater potential for share price appreciation in office REITs.

Before placing an order, though, investors also should assess the projected growth rate of FFO carefully for indications of the REITs earnings growth potential. In addition, investors should examine the management teams history and real estate experience. Finally, investors should scrutinize a REITs debt level. Wall Street may accept debt comparable to 50% or below a REITs total market capitalization, but most REITs currently operate at much lower levels.

Once the real estate market reaches its equilibrium and buildings can be sold at or near their replacement costs, the lower debt levels prevalent among todays REITs may protect investors against a return to the fire sale mentality of the 1980s. REITs wont be forced to sell quickly, because the discipline imposed on them by Wall Street has encouraged management to make solid, long-term decisions.

©1999 AICPA