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REITs grow in popularity, offer regular income

More and more investors have turned to real estate investment trusts for regular income streams and an opportunity to diversify their portfolios. But that could change—at least in the short term—if interest rates rise.

“You can find good quality REITs out there,” says Doug Hendee, chief sales officer for Brighton Securities. “They’ll offer you good return on your dollars.”

REITs are companies that own or finance income-producing real estate. While individual firms might limit their investments to specific types of properties, a REIT’s portfolio could contain a variety of properties.

“Generally, speaking, any listed REIT that you would be involved in is going to include multiple properties,” Hendee explains.

Investors generally purchase stock in REITs the way they would in other industries.

“The profile would be an investor looking for cash flow, looking for income, at the same time willing to take on some risk,” Hendee says.

Most REITs can beac categorized by whether they are public or private, and by the means they use to generate revenue. Public REITs give all types of investors, from individuals with relatively little to spend to huge institutions, access to the market.

“Because they’re publicly listed and publicly registered, they can be bought or sold like any other stock,” says Jason Garlock, director of investments for Cobblestone Capital Advisors LLC.

Public REITs must be registered with the U.S. Securities and Exchange Commission. Many are traded on stock exchanges, though they need not be, and all are subject to financial disclosure requirements. According to Garlock, such companies tend to be large, and thereby could enjoy economies of scale and access to cheaper capital.

On the downside, public REITs often have to invest in highly priced, large properties or collections of properties in order to make effective use of their capital.

“When you are a large company that has to buy very large properties, you’re limited in what you can buy,” Garlock says.

Unlike their public brethren, private REITs do not have to register with the SEC—though many do.

“They’re generally registered securities, but they’re not publicly traded on the exchange,” Garlock says. “I can’t just go out and buy a private REIT on the New York Stock Exchange.”

Though that limits the private REIT’s liquidity, it could also reduce the effect that market conditions can have on it.

“(A) private REIT does not have daily liquidity, but it also does not exhibit daily volatility,” says Christopher Brodhead, vice president of investor relations for Broadstone Real Estate LLC, which manages a private REIT Broadstone Net Lease Inc.

Private REITs also are usually smaller than those held publicly, according to Garlock, and tend to focus on relatively smaller investments.

“There’s less institutional money chasing that, and potentially greater returns,” he says. “Generally speaking, at Cobblestone we believe the opportunity for better returns in real estate exists in smaller properties.”

Whether publicly or privately traded, REITs generally fall into one of three categories, depending on the ways in which they generate revenue. Equity REITs, which constitute about 90 percent of the U.S. market, make their money by acquiring or investing in commercial properties that are leased to tenants.

“If the value of the property goes up while you own it … you’re getting that appreciation,” Hendee says. “At the same time, you have a renter paying, so you’re getting cash flow from the property as well.”

Mortgage REITs, which take up most of the remaining 10 percent of the market, gain their revenue through purchasing or issuing residential or commercial mortgages or mortgage-backed securities.

“If you borrow money at a low rate and you lend money at a higher rate, the spread between the borrowing rate and the lending rate is where you make your money,” says Brad Case, senior vice president at the National Association of Real Estate Investment Trusts.

Hybrid REITs invest in both commercial rental properties and mortgage-based assets. Such REITs are very rare, Case says.

Investors have grown increasingly interested in REITs over the years.

“The REIT market has grown tremendously, and that growth has really been concentrated among equity REITs,” Case says.

Many factors have contributed to that growth, though the historically low interest rates of the last few years have added fuel to the fire. Those rates led some investors who were seeking better returns to eschew stocks and bonds in favor of REITs.

“Pension plans have shown substantially greater use of REITs over the past five years,” Case notes.

While the prime rate has remained at 3.25 percent for at least the last year, the dividend yield for REITs was 4.18 percent as of June 12, he says.

Investors might have gained by adding REITs to their portfolios, but those who own stock in some private REITs could have faired particularly well. According to Garlock, those investments generally produce dividend yields of 6.5 percent to 7 percent. Broadstone Net Lease’s current dividend yield is 6.7 percent, for example.

Higher yields can also translate into higher stock prices. For instance, from Dec. 31, 2007, to June 14, 2015, the determined share value of stock in Broadstone Net Lease rose from $50 to $73.

REITs also offer investors an opportunity to diversify, and a greater chance of riding out market upheavals.

“There are four fundamental asset classes all investors should have: cash, stocks, bonds and real estate,” Case says. “You can’t predict the future, so you want to have exposure to different return drivers.”

Attractive though they might be, REITs do present some difficulties for investors, starting with the rates at which the income they provide is taxed.

“That income that’s being distributed to you is taxed as ordinary income,” says Mario DiLuigi, a partner in the tax and businesses services department at EPF Rotenberg LLP. “If you’re investing in equities—individual stocks like IBM and Apple, or so—those dividends that you receive are taxed at lower rates.”

In addition, the tax rate for REIT income can run higher than that for equities. According to DiLuigi, the rate for REITs tops out at 39.6 percent. By contrast, that for equities has a ceiling of 20 percent.

Some REIT investors might be able to avoid being taxed to that extent.

“For accredited investors, we provide risk-adjusted tax-sheltered yields,” Brodhead says. “Last year, we sheltered about 57 percent of the income from current income taxes.”

Attractive though REITs might be these days, their gleam might fade if the Federal Reserve Bank raises interest rates.

“The people who manage these REITs are putting together deals at low interest that they might not otherwise be able to do,” Hendee says.

A boost in the prime rate could also drive up stock and bond yields, and draw investors away from REITs. Case cautions that REIT investment levels are cyclical, and encourages investors to take the long view of the effects of higher interest rates.

“When interest rates go up, it’s because the economy is strengthening,” he says. “Real estate is becoming more valuable, rent growth is getting stronger, occupancy rates are getting stronger, so that properties are worth more, and they’re throwing off more income … that tends to drive up REIT stock prices.”

Mike Costanza is a Rochester-area freelance writer.

6/26/15 (c) 2015 Rochester Business Journal. To obtain permission to reprint this article, call 585-546-8303 or email rbj@rbj.net.

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