Should You Consider Investing in Real Estate?

Headwinds face the real estate market, but investors can still benefit from investing in Real Estate Investment Trusts (REITs) this year.

If you ask most people, they will probably tell you that their real estate investments over the last two years have not performed well. Some have questioned whether or not real estate will ever be the cash cow it once was. But if you look at the actual returns of real estate over the last two years, a different picture appears. In 2009 and 2010, the FTSE NAREIT Index, which measures the performance of all real estate investment trusts listed in the NYSE, NASDAQ, and American Stock Exchange, returned more than 25 percent. That’s not too shabby, and probably a bit surprising to the average investor.

How is it possible that the real estate index performed so well?

First, understand that you are comparing two completely different investments: your home, which is one residential property, and the index, which measures a group of publicly traded companies, called real estate investment trusts (REITs), all with multiple properties in various sectors of the market. The big difference is that public REITs generally invest in commercial properties, such as malls or office buildings, not one or two houses in your neighborhood.

Public REITs give average investors the opportunity to participate with the “big guys,” while still allowing them the liquidity to get their money back when they need it. However, while REITs have been around for a long time, the opportunity to make money with them depends on several factors. Here are some things to consider before you invest in real estate:

Timing is everything.

Historically, REITs have only had four bear markets since 1973: 1973 to 1974; 1987 to 1990; 1998 to 1999; and 2007 to 2008. These relatively short periods of negative performance were followed by one 12-year run of positive returns with an average return of 23 percent and two 7-year runs with positive returns of 20 and 22 percent respectively.

Understand the economic backdrop.

The economic backdrop includes the amount of available capital, the state of the economy, and the amount of new construction in the market. At present, access to capital is back and investors have injected millions into new and add-on offerings in both public and public non-traded REITs. This influx of fresh capital has allowed these REITs to purchase many properties at discounted prices from distressed sellers such as banks, insurance companies, and pension plans. Combine these low-cost buildings with increasing rents and minimal new construction and you have a fairly good outlook for investing in Real Estate Investment Trusts.

Choose your sector wisely.

When investing in Real Estate Investment Trusts, there are several sectors to choose from, such as health care, shopping centers, office buildings, apartments, and hotels. These sectors tend to perform differently depending on where we are in the economic cycle. The length of a typical lease for the sector also plays into how volatile or sensitive the sector is to the economic cycle. Hotels and apartments have a typical lease arrangement of one day to one year. Thus the cash flow to the owner is impacted almost immediately when there is a change in occupancy rates. Health care, malls, and shopping centers tend to require leases of 10 to 20 years. This provides a more stable cash flow to the owners.

The longer the lease the less volatile the share price may be—the first movers in the sector are generally the ones with the shortest leases.

Monitor the net asset value (NAV).

Public REITs tend to trade at a discount to their NAV in an economic downturn, and at premiums during an economic recovery. The current premium to NAV as of the end of the first quarter was about 13 percent, according to Green Street Advisors. A possible reason for the premium is that investors anticipate further appreciation in the value of the underlying real estate.

Understanding the valuations of public-traded REITs and non-traded public REITs can help investors decide which type is most appropriate for them. Liquidity and dividend yields are also big differences between the publicly traded and the public non-traded REITS. The dividend yields of the non-traded REITs tend to be higher than the traded REITs, but investors should consider the lack of liquidity of non-traded REITs. An investment in a non-traded REIT usually requires a commitment of several years.

But the trend is still your friend: Investors should reconsider real estate upside potential, but not at the same 20-plus rate of the last two years. The economic backdrop is improving, financing is becoming more available, prices have been moving higher, rents are increasing, and valuations are still below historic levels. There are some headwinds on the horizon, but as long as we see the economy continue to strengthen, there is money to be made in real estate in 2011.

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The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendation for individual. To determine which investment is appropriate please consult your financial adviser prior to investing. All performance references are historical and are not a guarantee of future results. Strategies involving asset allocation and diversification do not ensure a profit or protect against a loss.