What Investors Need to Know About REITS

As a long-time financial analyst, I know that equities can fill many roles in an investor's portfolio. For example, one way to invest in real estate without directly purchasing a property is to buy shares in equity real estate investment trusts or REITs. Before considering a REIT investment, here are 8 things that you should know about this special category of equities.

REITs own and manage real estate. A REIT's principal business is to own and manage income-producing real estate properties.

REITs come in all varieties. REIT's invest in a diverse range of property types. While some have diversified portfolios of real estate, others specialize in certain types of property, such as apartments, shopping centers, hotels, hospitals, nursing homes, golf courses, parking garages and so on. As a result, REITs provide investors with a means to invest in specific sectors of the real estate market.

REITs have a special tax status. REITs don't pay federal corporate income taxes (and, in some cases may not pay state taxes either). In order to be classified as a REIT by the IRS and, therefore, to qualify for this tax break, a real estate company must, among other things, distribute at least 90% of taxable income to shareholders.

REIT dividends are ordinary income. Currently, federal income tax rates on qualified dividends paid by publicly traded companies are favorable, ranging from 0% to 15%. However, REIT dividends are not classified as qualified dividends, since the REIT has not paid corporate taxes on the income distributed to shareholders as dividends. Therefore, for tax purposes, these distributions are classified as ordinary dividends and are taxed at the recipient's ordinary income tax rate.

Some REITs are mortgage REITs. The REITs I've been discussing are equity REITs that own income-producing real estate. However, there also are mortgage REITs. This is a special category of REITs that, instead of owning real estate, make loans secured by real estate. Since mortgage REITs have the characteristics of finance companies, they must be analyzed differently than equity REITs . Therefore, when you consider a REIT investment, be sure that you understand the company's business strategy and whether it is an equity REIT or mortgage REIT.

Investors should focus on a REIT's funds from operations. For REIT investors, a company's funds from operations (or FFO), which is calculated by adding back depreciation (a non-cash charge) to net income and deducting gains on property sales, generally is a more telling measure than the better-known earnings per share (EPS) figure. Some investors make additional adjustments to FFO, most notably by deducting capital expenditures, to arrive at adjusted FFO (or AFFO). The reason that FFO or AFFO generally are considered more relevant financial measures for REITS than EPS is that they provide a better indication of the company's ability to maintain or increase dividend payments to shareholders.

REITs are not without risks. Given the nature of their business, REITs are exposed to a variety of risks, including the ups and downs of real estate markets and changes in interest rates. Also, REITs often are highly financially leveraged since they may borrow to purchase real estate properties.

Quality assets and effective management are critical to success. A REIT is only as good as its properties and its management. Therefore, before investing in a REIT, it is important to research its business, with a special focus on asset quality and the experience and capabilities of the management team. If you don't have the time, ability or desire to do the analysis yourself, but want to invest in REITs anyway, an alternative to individual REIT stocks is to invest in a REIT mutual fund.

More from this Contributor:
First Person from an Equity Researcher: 10 Tips for Doing Your Own Equity Research