Why invest in REITs?

Investing in income-generating real estate can be a great way to increase your net worth. But for many people, investing in real estate, particularly commercial real estate, is simply out of reach financially. But what if you could pool your resources with other small investors and invest in large-scale commercial real estate as a group? REITs (pronounced like "treats") allow you to do just that. A REIT is a company that mainly owns, and in most cases, operates income-producing real estate such as apartments, shopping centers, offices, hotels and warehouses. Some REITs also engage in financing real estate. The shares of many REITs are traded on major stock exchanges. They offer the benefits of real estate ownership without the headaches or expense of being a landlord.

A company must distribute at least 90 percent of its taxable income to its shareholders each year to qualify as a REIT. Most REITs pay out 100 percent of their taxable income.

How do REITs operate?

At least 95 percent of a REIT's gross income must come from financial investments i.e rents, dividends, interest and capital gains. Most importantly, at least 75 percent of its income must come from certain real estate sources including rents from real property, gains from the sale or other disposition of real property, and income and gain derived from foreclosure of property.

Publicly traded REITs collect funds via an initial public offering (IPO).Remember the Bora Capital KES 700 million private placement?!!!! These funds are used to buy, develop and manage real estate assets. Income is generated through renting, leasing, or selling the properties and is distributed directly to the REIT holder on a regular basis. When a REIT pays out its dividends, they're equally distributed among shareholders as a percentage of paid-out taxable income.

REITs have a board of directors elected by its shareholders. Typically, these directors are real estate professionals who are highly respected in the field. They are responsible for selecting the REIT's investments and hiring the management team, which then handles day-to-day operations.

Next, we'll look at what you need to know before you invest in a REIT.

Investing in REITs

Because many REITs are publicly traded, they offer investors a powerful tool for portfolio balancing and diversification. They also provide investors with ongoing dividend income, while offering the potential for long-term capital gains through share price appreciation.

REITs have an advantage over other types of stocks. Because of their pass-through taxation, REITs have greater profits from which to pay shareholder dividends than similar sized corporations. As long as a REIT maintains its tax-qualified status by paying out 90 percent of its net income to common shareholders, it doesn't have to pay federal income taxes. Without a tax bite to reduce profits, shareholders get more of the REIT's earnings.

REIT investors receive value in the form of dividend income and potential share value appreciation. Because REIT income often comes from commercial properties with long lease periods, REITs can offer a relatively predictable revenue stream. They also are somewhat resistant to inflation. Unlike bonds with pre-determined rates of interest, which lose relative value in times of high inflation, REITs with rental incomes adjust themselves in line with the cost of living. This makes them less vulnerable to inflation-related devaluation.

Another benefit is the potential for a nontaxable return of capital. Depending on the REITs distribution policy and annual earnings, a portion of the dividend may be deemed a nontaxable return of capital. Not only does the investor not have to pay taxes on that part of the dividend in the year it is distributed, that amount is also not taxable until the stock is sold. So the return of capital defers taxes as well as lowers an investor's taxable income during the time the REIT stock is held, increasing the after-tax dividend yield.

So how do you go about choosing a REIT? Even though REITs are somewhat diversified by definition, it is still important to determine whether or not a specific REIT focuses on one type of commercial development or one geographic area that could leave it vulnerable to a downturn. For this reason, many investors invest in more than one REIT. Consider demographic information such as population growth, employment growth and the level of economic activity for the particular area or industry. These will have a direct impact on rent levels and occupancy rates -- which in turn affect cash flow and dividends.

Most investors know that past performance is no guarantee of future performance. With REITs, however, you should look at past dividend payments. Be wary of high yields. If there have been excessive capital gain distributions, this can be a sign that the income is coming from nonrecurring events and will not continue for long. Make sure the REIT is not selling off properties to provide income, because future rental income will be affected.

Evaluate your own needs. REITs can provide both current income and long-term appreciation. Depending on what you're looking for, examine how the REIT management and trustees are compensated. If compensation is based on the value of the REIT's assets, management is usually concentrating on investing in additional properties for capital appreciation. If the basis for determining compensation includes dividends or current earnings, the REIT's management may be motivated to increase dividend yield, possibly at the expense of long-term appreciation.

Study the REIT's management. Before investing, make sure the management has a personal stake in the company. This information should be available in their latest prospectus.

What Should I Look for When Investing in a REIT?

The market usually rewards companies that demonstrate consistent earnings and dividend growth with higher price-earnings multiples. Thus, investors should look for REITs and publicly traded real estate companies with the following characteristics:

• A demonstrated ability to increase earnings in a reliable manner. For example, look for companies with properties in which rents are below current market levels. Such properties provide upside potential in equilibrium markets and downside protection when economic growth slows.

• Management teams able to quickly and effectively reinvest available cash flow. The ability to consistently complete new projects on time and within budget. Creative management teams with sound strategies for developing new revenue opportunities.

• Strong operating characteristics, including effective corporate governance procedures, conservative leverage, accepted accounting practices, strong tenant relationships and a clearly defined 

The Kenyan Quagmire?

REITs can only operate in Kenya as CIS and the pitfall is that our legislation only permits CISes to hold 25% of their assests as real estate. Clearly this locks out Property firms that want to issue  REITs.