With REITs, Caution Is Byword for Investors

During the past several years, many investors in commercial real estate have seen their property values plunge. But even as individual properties fell, the value of some real estate investment trusts, which typically buy and finance commercial real estate, have soared.

These trusts, commonly called REITs, posted an average total return of 33% during 1991, according to the National Assn. of Real Estate Investment Trusts in Washington, D.C. Returns have been much lower this year, amounting to only 3.23% during the first six months of 1992, NAREIT said.

Those returns include dividends and appreciation. But dividend yields alone on many REITS exceed 8%, industry experts say. That has made REITs a popular alternative for investors looking for higher-than-average current income in today’s low-rate environment.

How have REITs outperformed real estate generally? Well, their performance is tied to rental income as much as asset values.

However, like other potentially high-yielding investments, REITs can also be risky. Investors should beware if they don’t want to get burned.

REITs are publicly traded investment companies that pour their cash into shopping centers, medical buildings and mortgages on commercial properties.

They resemble closed-end mutual funds. After they’re launched through public stock offerings, their shares usually trade on major U.S. stock exchanges and are bought and sold through stockbrokers. The shares can sell at a discount or a premium to the company’s net asset value. REITs also distribute 95% of their taxable earnings to investors each year.

But in other ways, REITs can resemble bad limited partnerships. Some REITs, for example, have been plagued by questionable insider deals that have drastically increased management costs, reduced share value and eliminated dividend payouts to investors--events similar to abuses found in the limited partnership market.

It is also hard to tell what a REIT is worth. Where the net asset value of a mutual fund is often readily apparent, the net asset value of a REIT is so hard to figure that even experts often are stymied.

Nonetheless, industry experts say REITs can be ideally suited to small investors--if investors are able to recognize both the positive signs and the signs of danger.

Positive signs:

* Balance sheet strength. Look at the company’s assets, liabilities and cash flow. Cash flow may be particularly important because it determines whether the REIT has enough to pay its bills and give investors a hefty dividend to boot.

* Historic performance. Like mutual funds that have been around a while, both the REIT and its management should be able to provide investors with information about how they’ve performed in the past. Past performance is never an assurance of future profits, but it can give clues to the effectiveness of the management team.

* Investment mix. Although it is usually a good policy to diversify, REIT experts say that some of the best REITs specialize in just one or two types of properties. A good REIT might invest solely in small shopping centers, or just in medical office buildings, for example. Overly diversified REITs often have trouble because the management skills necessary to handle one type of real estate may not translate well when investing in another.

* A significant stake by management. If managers also own REIT shares, it can show that they have shareholders’ interests at heart.

Investors should also realize that some kinds of REITs are more volatile than others. REITs that specialize in making mortgage loans on commercial properties are subject to bigger swings in both market value and dividends than those that buy and manage properties directly.

Danger signs:

* External management. One of the biggest abuses in the REIT market has been from outside managers who have exacted huge fees, draining the company of its profits and robbing investors of dividends. In many cases, these outsiders would claim separate fees for providing administrative services, brokerage services and for securing loans on REIT properties. Although not all external managers participated in the abuses, many institutional investors will invest only in REITs that are managed by an in-house staff.

* Conflicts of interest. Another disastrous problem for REIT investors has come from managers who would sell their own land to the REIT at inflated prices, steer lucrative consulting contracts to their cronies and otherwise make big profits at the REIT’s expense. The best REITs prohibit insider deals. Such prohibitions are usually spelled out in the prospectus.

Investors who don’t feel comfortable weighing the pros and cons of specific REITs can still participate in the market by investing in mutual funds that invest in REITs, noted Jon Fosheim, principal at Green Street Advisors, a Newport Beach firm that analyzes REIT investments for institutions.

Several mutual fund companies, including Fidelity Investments in Boston and United Services Advisors in San Antonio, offer no-load REIT mutual funds.