Higher gains for specialty REITs investors

Real estate investment trusts (REITs) have performed better than most investments during the recession. Furthermore, specialty REITs have performed even stronger than their traditional REIT counterparts in these tough economic times.

At the end of last year, REITs showed a year-to-date return of 3.2%, and specialty REITs showed a return of 7.94%, according to the Dow Jones U.S. REITs index. [For more information on recent trends in REIT investments, see the January 2012 first tuesday article, REIT investment: playing the real estate game from the sidelines]

REITs are a way for investors to invest in income-producing real estate without having to manage the property themselves. Specialty REITs are trusts that are placed in the “diversified” sector of the National Association of Real Estate Investment Trusts (NAREIT). In contrast to the standard REIT groups, which are office, retail, residential and industrial, specialty REITs typically contain an operational element. Businesses with operational elements include movie theaters, timberland where wood is harvested, self-storage businesses and data storage centers.

Specialty REITs have yielded a significantly higher return than standard REITs in response to the distressed economy. For instance, during the economic downturn and Plateau Recovery, self-storage facilities are booming due to the increase in home foreclosures and the associated need to temporarily house personal property after a displacement. Additionally, as the internet becomes an increasingly dominant force for conducting business, data storage centers are also thriving.

However, since few investors know anything about the operational elements of these types of businesses, many are cautious about investing in them.

first tuesday take: REITs can be a good investment for those willing to do their homework. These instruments have just begun the slow traipse back from the post-boom drop in all stock prices and occasionally still show negative returns.

Investors in REITs need an understanding of how their REIT’s property investments are managed, as their return on investment (ROI) depends on it. However, no property management by the investor is actually necessary, and ROI more closely resembles stock in terms of risk and return.

They provide shareholders the opportunity to diversify their portfolios without purchasing or operating property themselves, thus spreading the risk associated with owning real estate. REITs offer limited liability and avoid the double taxation of distributed corporate earnings by passing at least 90% of their earnings on to investors as dividends rather than passive real estate income.

Investing in standard REITs is similar to investing in a mutual fund, compared with specialty REITs which may be better described as cherry picking individual stocks based on careful research and projections. Investing in a mutual fund (standard REIT) is simpler and less risky, but the greater potential for return lies with those carefully researched individual investments (specialty REITs). Like a rising or ebbing tide, a greater risk of loss assumes a tandem greater potential for a large return.

Specialty REITs rely on consumer trends, which can be more fickle than housing trends, as housing could be said to be currently outpacing the gross domestic product (GDP) in terms of recovery. first tuesday considers a standard residential REIT focused in an urban center a solid, long-term investment in line with the trend in urban growth. [For more information on the rise of urban centers, see the January 2012 first tuesday article, From city to suburbia then back.]

Important research when considering investment in a REIT includes:

1. The strength of the REIT’s management. An investor must consider how responsibly cash and property will be used by analyzing the REIT’s income reports.
2. The location of the property owned by the REIT. The property’s physical market position will help determine the size of the risk. Remember the mantra: location, location, location.
3. The type of property owned by the REIT. Generally, hotels and self-storage units are considered riskier investments than apartment buildings.

Potential investors can gather details from the REIT’s annual reports made to the Securities and Exchange Commission (SEC), which describe the number and type of properties owned, those under construction, and the amount invested.

Re: “Specialty REITs, Exploiting Niche Categories, Outperform the Mainstream Players” from The New York Times