REITs can add to portfolio diversity

Now more than ever it's quite clear that diversification is the key to growing your investment dollars. Along with CDs, stocks, money markets, and bonds, you might want to consider another addition to your diversified portfolio an REIT.

Real estate investment trusts, better known as REITs, are publicly traded trusts which hold title to real estate assets and pass the income stream from those assets along to the trust holders (the equivalent of shareholders).

REITs allow investors to add real estate exposure to a portfolio while retaining the liquidity of a publicly traded common stock.

REITs are often the easiest way for individual investors to invest in real estate. They provide the benefits of investing in real estate without many of the downfalls. These downfalls include daily management of the property, putting a large portion of your assets in one investment, and perhaps difficulty in selling your investment.

As to other benefits, REITs may have more. First, due to their attractive dividend yields they are an excellent source of income from an investment portfolio. Second, as the REIT raises rents and acquires more investment properties, the REIT can increase the dividend. As a result, REITs can be a good source for investors to increase their income over time. Third, as the dividend grows over time, the stock price will likely also grow.

Often REITs are considered to be attractive investment conduits. They pay no income taxes at the corporate level as long as they pay out 95 percent of the taxable net income in dividends.

This requirement was mandated by Congress and it allows an investor to avoid the double taxation of investment returns that occurs with ordinary common stocks. Yet, do be aware that the dividends paid are after depreciation expense. So, the typical REIT will pay out only 65 percent to 80 percent of its cash flow, or funds from operations.

The manner in which analysts review REITs is through FFO. FFO is essentially net income prior to depreciation expense. Unlike buying a computer, which declines in value quite quickly, well maintained real estate tends to appreciate over time. As a result, analysts look at earnings prior to depreciation to determine the amount of cash flow available for the company to pay dividends.

There are three types of REITS: equity, mortgage and hybrid.

Equity REITs are like landlords. They invest in real estate and make money from rental payments received from the tenants. Most equity REITs manage the properties themselves and tend to specialize in specific property types.

Mortgage REITs are similar to banks. Mortgage REITs make money by lending to borrowers to purchase real estate.

Hybrid REITs are simply a combination of mortgage and equity REITS.

Of the aforementioned REITS, remember that mortgage and mortgage-related REITs typically use large amounts of debt to finance their operations, and mortgage REIT earnings are sensitive to interest rate movements.

(Betty J. Neal, CFP, is an investment representative with Edward Jones in Springfield.)