This past week marked the one year anniversary of last year’s market low. Since that dismal day, the stock markets have staged a rebound (at least for now). So, too, has the market for REITs. That’s great news, right? It would be great news… if it were justified by market fundamentals. 
Real Estate Investment Trusts [REITs] are similar to mutual funds: capital is pooled and invested in real estate opportunities. REITs invest in commercial real estate: apartment buildings, shopping centers, office buildings, hotels. These products make the commercial real estate market easily accessible to investors. The good thing: by law, REITs are required to distribute 90% of their taxable income as dividends to investors. The problem: REITs, as an investment idea, are great… but that’s not a reason for investors to pile on board when the market doesn’t warrant it. The commercial real estate market is on anything but stable ground. How bad is it? At the end of 2009, commercial real estate mortgage defaults doubled to 3.8% (according to Real Capital Analytics Inc). This equals $4.5 billion in loans in default just in the last quarter. How bad is it going to get? Try defaults of 5.4% by the end of 2011. Banking officials have already said that losses from commercial real estate loans will be the greatest threat to banks this year. The banks in danger are the small, community and regional banks that hold the bulk of these mortgages. Tight credit will continue to weigh on the economic recovery; as banks absorb losses, lending will be reduced. In spite of economic reality, REITs have continued to gain ground (albeit shaky ground). Since the market low last March, REIT indexes have seen a 90% rise… yet property values are falling. This tells us that what is driving REITs is not an improvement in commercial real estate, but investors jumping into the market looking for dividends. The issue here: these dividends are not necessarily what you think. The IRS has made a temporary concession in response to conditions in the real estate market; rather than paying cash, REITs can issue additional shares as dividends. If this continues, expect prices to drop, because income investors won’t stick around for long after being paid in stock. If you are compelled to invest in commercial real estate, avoid non-public REITs. Why? Non-public REITs put you in a very inflexible position compared to publicly-traded REITs. Here’s how: non-public REITs are developed and marketed by the brokerage firm that sells them to you, and the internal cost structure is often as high as 16%. Even worse, once you buy into a non-public REIT, you are locked in. These REITs are entirely illiquid because you can’t sell them in the market if you don’t want to carry them anymore. Tying yourself into an investment with zero liquidity that is centered on an industry bound for trouble isn’t going to do any good for your portfolio. Because market fundamentals are not fueling the activity in REITs, they are a speculative investment, and should be treated as such by investors. So, if you decide to plunge in, be very careful. Commercial real estate is going to be a drain on the recovery… don’t let it drag your portfolio down.
Author’s Disclosure: none
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