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Real estate in the portfolio.

To anyone who watches the six o'clock news, it's no secret that real estate investments are experiencing tough times in the Lower 48: vacancies are high, construction is low and foreclosures are common. This all sounds familiar to Alaskans who lived through the state's 1980s real estate market, when investors suffered three years of declining property values and rents. Vacancy rates soared, and so many properties were abandoned and foreclosed that many banks and savings and loans went bankrupt.

Since then, local real estate has made a dramatic turnaround. For those who were smart or lucky enough to purchase Alaska property at the bottom of the price decline, the last few years have been very rewarding. Not only have values risen sharply, but rents also have increased. According to local experts, vacancies in the Anchorage market have hovered at 1 percent for more than a year, providing a near ideal environment for property owners.

In addition, competition from new properties is almost non-existent as financial institutions maintain overly conservative lending standards. As long as the local economy remains healthy, property owners will continue to make profits.

Now many Alaskans are looking south and wondering if history might not repeat itself. Prices in many markets have been declining for more than two years and developed real estate sells for less than replacement cost, just as it did at the bottom of the Alaska market. Lenders in some regions report declining rates of foreclosures, and an end to the current recession would bolster many markets.

While you never can be sure you have reached the bottom of any market until you look back, there are tantalizing indications that the end of the real estate decline may be near. The problem for Alaskan investors is finding an effective way to invest in properties thousands of miles away while avoiding the problems of absentee ownership. For these investors, the securities markets may provide an answer.

The REIT Stuff

A real estate investment trust (REIT) is a corporation formed for the purpose of investing in real estate, either property or mortgages. Investors buy shares, which entitles them to a proportionate interest in all the assets of the corporation. The REIT hires professional managers to buy and sell the properties and to provide day-to-day management.

As long as 90 percent of the net income is distributed to shareholders, the REIT is not subject to taxation. In essence, a REIT is a closed-end mutual fund that invests in real estate instead of stocks or bonds. Like closed-end funds, a specific number of shares, which are traded on major stock exchanges, are issued when the REIT is formed. If you want to buy shares of a REIT, you must purchase them from an existing investor who wants to sell. This means the price is determined by the supply and demand for the shares, not by the underlying value of the real estate.

This is an important point to understand, because it means that it is possible to buy shares at a premium or discount from what they are worth today. In other words, in today's market, when real estate already sells for less than a few years ago, a patient investor might realize a further discount by purchasing REIT shares for less than their current depressed value.

Today's conditions could provide REIT shareholders with the chance to sell shares at a premium in the future. This premium, coupled with a rebound in the real estate market, adds up to hefty profit potential. And while investors wait for the market to rebound, they can expect generous dividends from rents.

Consider Risks/Options

These potential returns come with some real risks, just as Alaska markets of the late 1980s, not every REIT will prosper. If the timing of your purchase is too early, or the quality of the properties is poor, or if the REIT is using debt and defaults, investors could lose a substantial portion of their money. To reduce risk, consider these factors when choosing your REIT investment.

First is the type of properties or mortgages in which the REIT invests. Some REITs are broadly diversified, owning shopping malls, office buildings and rental units all over the country. Others specialize in only one type of property or only own properties in one geographic region. The most highly specialized would be the REIT whose only asset is Rockefeller Center in New York, or the one that owns a horsetrack in California!

Most REITs own only property or mortgages, but a few invest in both. A wide variety of possibilities exists and investment results will vary greatly. As a rule of thumb, the greatest potential risk and return comes from the specialized REITs, while the more widely diversified are considered safer investments.

The second factor to consider is the use of debt. Here again, you will find wide differences. Obviously, REITs that use little or no debt will be less risky than those with high mortgage levels. In fact, highly leveraged REITs probably represent investors' greatest risk of losing all of their money.

The third factor is critical, but also is very difficult to evaluate. Quality of management can make or break any company, and this is especially true of REITs. Look for successful companies whose management owns a significant amount of shares themselves and who foresaw the current difficulties and took effective steps to minimize the damage.

Information on REITs is readily available. The Valueline Investment Survey, available at the library, carries investment research on several companies. Also at the library, Standard & Poor's company profiles will have extensive information on most publicly traded REITs. In addition, most brokerage firms have an analyst who follows the real estate investment trust industry.

REIT Advantages

A big advantage of investing in developed property through trusts lies in their affordability and availability. Those who tried to take advantage of the depressed Alaskan market can attest to the frustrations and complexity of actually obtaining the property they wanted. Often, the real estate was sold by auction, and in some cases, the winning bidder was required to pay cash because financing was extremely difficult to obtain. Some investors were forced to try several times before purchasing, and all too often had to settle for their second or third choice. Properties owned through foreclosure by a federal agency often were encumbered by frustrating regulations and paperwork.

REITs have none of these problems. Shares, traded on the major stock exchanges, are almost always available. You need only open an account with a brokerage firm, then place an order to buy. The shares are usually inexpensive and you can buy as little as a single share, making real estate ownership available to virtually everyone.

In addition, shares are equally easy to sell. All it normally takes is a phone call to your broker, and the shares can be sold that day. This is in marked contrast to investors in actual property, who sometimes find it nearly impossible to sell at any price. Liquidity has always been one of the key attractions to the securities industry.

REITs also provide convenience of ownership. Unlike direct ownership, there are no phone calls in the middle of the night from tenants with leaky plumbing, no hosting an "open house" when you would rather be fishing, and none of the time-consuming bookkeeping that comes with managing an investment property. If suddenly transferred to another state, a REIT investor is not faced with the tradeoff between selling his investment or becoming an absentee landlord.

There are disadvantages, of course, including the loss of control over your investment. Although REITs are convenient to own because someone else manages the property, unfortunately, not all managers are equally skilled, diligent or honest. The cost of these professionals' services are deducted from your gross cash flow, reducing your potential return. And if you should discover you have invested in a poorly managed REIT, you have little recourse but to sell your shares, as the cost and complication of removing management is impracticable for the average investor.

Despite these disadvantages, a well-chosen real estate investment trust could prove a very worthwhile investment when the Outside real estate markets make their turnaround.

Robert Green is a Chartered Financial Analyst and a portfolio manager with Shearson Lehman Brothers in Anchorage.
COPYRIGHT 1992 Alaska Business Publishing Company, Inc.
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1992 Gale, Cengage Learning. All rights reserved.

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Title Annotation:Financial Planning; real estate investment trusts
Author:Green, Robert
Publication:Alaska Business Monthly
Date:Nov 1, 1992
Words:1379
Previous Article:Managed futures: the ugliest duckling.
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