Real Estate Investment Trusts (REITs)

Real estate investment trusts (REITs) are funds which buy and manage real estate and mortgages. They provide individual investors the opportunity to invest in real estate without having to actually own and manage properties. REITs were extremely popular in 2001 and 2002 when the stock market declined, and investors turned to them as safe-haven investments.

A REIT is a type of closed-end mutual fund, in that it invests the proceeds received from an initial sale of shares. The proceeds are used to buy, develop, and manage real estate properties; the income from rents and mortgages is passed on to the shareholders in the form of dividends. REITs do not pay corporate income taxes; they must, however, by law, distribute 95 percent of their net income to their shareholders.

There are three basic types of REITs: equity REITs, mortgage REITs, and hybrid REITs. The investment risks are not the same for each form of REIT, so great care should be taken when evaluating the different types before investing. Equity REITs buy, operate, and sell real estate such as hotels, office buildings, apartments, and shopping centers. They generally tend to be less speculative than mortgage REITs, although the risk level depends largely on the makeup of the actual assets in the trust. Mortgage REITs make construction and mortgage loans available to developers, which involve greater risk. Consequently, shares of mortgage REITs tend to be more volatile than those of equity REITs, particularly during periods of recession.

As the name implies, hybrid REITs are a combination of equity and mortgage REITs; they buy, develop, and manage real estate and provide financing through mortgage loans. Most hybrid REITs typically have stronger positions in either equity or debt; there are very few equally balanced hybrid REITs.

REITs can have either finite or perpetual lives. Finite-life REITs, also known as FREITs, are self-liquidating. In the case of equity REITs, the properties are sold at the end of a specified period of time. For mortgage REITs, profits are fully paid to shareholders when the mortgages are paid up.

Mortgage REITs tend to be more sensitive than equity REITs to changes in interest rates in the economic market. This is due to the fact that mortgage REITs hold mortgages whose prices move in the opposite direction of interest rates. Although equity REITs are less sensitive to interest rate changes, they too suffer from rising rates. Mortgage REITs generally do well when interest rates fall. Because of the different types of assets held in mortgage REITs, they tend to be more income-oriented in that their main emphasis is on current yields.

Conversely, equity REITs offer the potential for capital gains (in the form of increasing property values) in addition to current income. For this reason they've generally been the most popular type of REIT in recent years. Their cumulative performance of 55 percent total returns from the of end 1999 through August 2002 easily outpaced the Standard and Poor's 500 Index, which declined by more than one-third during that same period of time.

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