The REIT stuff?

The best REITs offer strong management, top-shelf properties, and high yields But unfortunately, risk may be high, and bombs abound Here's a map to negotiate the minefield--and counsel on more conservative real estate plays. In the 1980s, the chief executive of a major home building products manufacturer bought the REIT stock of New York's Rockefeller Center. In the rough-and tumble world of equity REITs, this was the bluest of blue-chip holdings: The stock was yielding about 8 percent, and its underlying assets comprised practically the epicenter of the city's vibrant real estate market. Bucking conventional wisdom, however, we advised the CEO, a client of Karr & Babush, to bail out of the investment and to purchase instead higher-coupon convertible REIT bonds. Soon after, the REIT took a header, torpedoed by the 1987 stock-market crash and a recession. Other issues followed it down the tubes. Today, the stock sells for 60 percent less than its initial offering price.

REITs are booming once more: Fresh cash pouring into the market could reach $10 billion this year. Many analysts might argue there's no lesson to he learned from the Rockefeller Center episode. Things are different now, they maintain, the battered real estate market is on the mend, and REITs--shareholder-owned entities that earn and distribute profits from real property ownership and lending--offer the best way for an individual investor to ride the rebound.

Though again counterintuitive, we disagree: There's no sure thing in real estate, and we're never comfortable when our more conservative investors have a significant exposure to REITs. If they're dead-set on real estate, we introduce them to investments that are first cousins of REITs, as we did with the building products CEO. If pushed to the wall, we'll craft a REIT strategy--though with about as much enthusiasm as square dancers on a minefield. While tiptoeing around, however, we insist on outlining a number of critical caveats and guidelines.

CHECKERED FLAGS, YELLOW LIGHTS

Why are REITs so popular? For one thing, the 6 percent to 7 percent annual yield on equity REITs beats that of bank CDs and T-bills hands down. New generations of REITS abound, including MegaREITs (with an initial capitalization of $500 million or more), "roll-up" REITs (the conversion of limited partnerships into REITs), and umbrella partnership REITs (the REIT serves as the general partner in a limited partnership). Perhaps most important, unlike partnership investments, REITs are relatively liquid: Shares can be sold at any time. Investors are free to pick issues that specialize in apartments, shopping malls, strip centers (mini-malls), or various health-care properties.

Even so, REITs lack flexibility. Because they are legally bound to invest only in real estate, they lack the ability to sidestep a downturn in the market. REITs also are required to pay out at least 95 percent of untaxed earnings to shareholders. Provided it meets this distribution criterion, a REIT is exempt from federal taxes, although shareholder dividends are fully taxable. In contrast to equity REITs, mortgage REITs earn money from making loans against properties. Investors in this older form of real estate trust, however, reap no gain from asset appreciation.

Another drawback: With banks and insurance companies still tightfisted on real estate lending, particularly for commercial and multifamily residential properties, the equity REIT has become a lender of last resort. As a result, most hold a fairly illiquid portfolio and are unable to sell assets or upgrade portfolios quickly. Increasingly, too, REITs are used by institutions and developers to pare debt and raise inexpensive capital. (REITs yield a maximum 7 percent, while the private property market requires a return of 10 percent or more.) Major players in this arena include Tauhman, Kimco, Carr, and IRT Property, but as the market heats up, less experienced operators will move to fill the funding vacuum, increasing investor risk.

Cautious investors also must learn to distinguish between the yield on a REIT's assets and that from increases in its stock price, which may reflect growth expectations. Many REITs are tremendously overpriced--some apartment issues in the Southeast and Southwest are selling at premiums to net asset value as high as 75 percent. Think twice before purchasing shares with a premium above 15 percent.

RULES OF THUMB

In a conservative REIT investment strategy, income protection is paramount, though such an approach may sacrifice short-term returns. If you're ready to take the plunge, consider these guidelines:

* Avoid REITs with leverage above 50 percent to 60 percent. While large amounts of low-interest, short-term debt allow for greater earnings, fluctuations in interest rates may undermine a REIT's ability to pay steady dividends.

* Seek REITs with tenants locked into longer-term leases. These can reap the benefits of asset appreciation while offering protection against cyclical volatility.

* Scrutinize management Look for REIT managers with a minimum 10 years experience buying, developing, owning, or operating the type of properties held by the REIT. Good examples are REIT managers such as Kimco and Weingarten, which specialize in strip centers, and Property Trust of America, which specializes in apartments.

* Avoid individual managers. Even those with years of experience generally have little staff and shallow pockets.

* Skip hodgepodge vehicles. REITs that oversee a variety of property types in different locations are risky, because it's unlikely that management expertise extends across the board.

Meanwhile, in contrast to diversification by property type, regional diversification may negate the effects of a downswing in particular markets. Areas expected to post strong growth over the next four years include the South, the Southwest, and the Northwest. Solid fundamentals and continued emigration from California should continue to drive growth in the Southwest and Northwest, and the demand for apartments and retail goods should be strong.

Other hot REITs include those with holdings in shopping malls and strip centers with either national or local concentration. These may become more attractive as national retail sales improve. However, since the recovery of markets for urban office space and hotels remains on the horizon, steer clear of REITs in these areas.

INVESTMENT ALTERNATIVES

As an interesting option, consider investing in mutual funds that invest in REITs. The double layer of liquidity provides an important safety net. Fidelity Real Estate, Cohen & Steers Realty Shares, and PRA Real Estate have chalked up returns so far this year of 13.3 percent, 12.6 percent, and 16.2 percent, respectively.

An added advantage: Not only can the shares of the fund be redeemed, but the fund itself can sell its REIT shares as markets and submarkets change, increasing adaptability. There is also the comfort that a professional fund manager is carefully watching the market. On the downside, management fees run between 1 percent and 1.5 percent. This takes a hefty bite out of an investment earning 6 percent.

Convertible subordinate bonds or any bonds with a convertibility feature are another alternative. The income from such vehicles is more secure than that from REIT stock, yet they also allow investors to pocket the proceeds of asset appreciation. Convertible subordinate bonds have been fairly common in the past as a financing vehicle for REITs. As the market expands, a greater variety of these products will come into play.

Driven by expectations about inflation, aggressive investors are positioning themselves to cash in on a 1970s-style real estate boom. But with low inflation likely to continue, at least in the short- to medium-term, it's doubtful we'll see spike in values. In real terms, real estate may even depreciate.

Some investment counselors recommend that their clients board the REIT bandwagon now. We say if you can't find another means of transportation, travel with care, and maintain as much diversity and liquidity as possible. In a highly cyclical industry, this is the best way to go.

Jerome S. Karr is a partner in Karr & Babush a New York-based financial and real estate consulting firm that analyzes commercial and residential projects for lenders, investors, and owners. He previously served as a vice president at Citibank and Lehman Brothers.