By
msnbc.com contributor
updated 9/27/2007 5:50:46 PM ET 2007-09-27T21:50:46

Here’s a thought for the bold: Take the subprime mortgage meltdown as a buying opportunity and plunge into REITs.

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But only if you have a cast-iron stomach.

A REIT, or real estate investment trust, is stock in a company that’s something like a mutual fund but specializes in buying office buildings, malls, apartment houses, mortgage-backed bonds or other real estate holdings. There are about 180 REITs of various types, plus a string of mutual funds and exchange-traded funds that invest in them.

Although investors can and do make money when REIT share prices rise, REITs also are known for their healthy dividends. This year the average dividend yield — annual dividend divided by share price — is about 4.7 percent. That’s about three times that of the average stock in the Standard & Poor’s 500.

But let's be clear up front: REITs are not a sure bet.

Like stocks in home builders and other real estate companies, REITs have been hammered by the ripple effects of the subprime mess involving high-risk mortgages for people with poor credit or low incomes. Rising interest rates have pushed up monthly payments on these adjustable-rate loans, leading many borrowers to fall behind in payments and causing huge losses for some lenders.

Video: Has housing hit bottom? This has made many lenders, even those not involved in the subprime market, more cautious about approving loans. With money harder to come by, there are fewer home buyers, home prices are falling and not as many are being built. Even non-residential real estate companies are affected because investors worry those firms too may find loans harder to get, or may suffer losses from investments in bonds backed by home mortgages.

All this has been hard on REITs. Despite the healthy dividends, the average REIT has lost nearly 10.5 percent this year through the end of August because of share-price declines, according to the National Association of Real Estate Investment Trusts, a trade group. That’s a stunning reversal from gains of 38.5 percent in 2003, 30.4 percent in 2004, 8.29 percent in 2005 and 34.4 percent in 2006.

Mutual funds specializing in REITs and other real estate investments have lost nearly 8 percent this year, while the average diversified U.S. stock fund has gained about 6 percent, according to Lipper, the fund-tracking firm. The Vanguard REIT Index Fund, an ETF, is trading at about $69 a share, down from $87 in February, for example. (Over the past five years, real estate funds have gained an average of 19.6 percent a year, vs 13.4 percent for those diversified funds.)

All REIT types have racked up losses this year, but the worst has been the 45.4 percent decline in those which invest in mortgage products such as bonds backed by home loans. When borrowers fall behind in payments, the bonds lose value.

For example, shares in RAIT Financial Trust, a mortgage REIT that finances commercial real estate, are down about 76 percent from their all-time high in February. American Home Mortgage Investment Corp., a REIT that had specialized in home mortgages, filed for Chapter 11 bankruptcy in August, making its shares virtually worthless. A similar fate befell New Century Financial Corp., another mortgage REIT, which went Chapter 11 in April. It’s trading at about 10 cents a share, down from more than $42 a year ago.

So why would anyone invest in REITs now?

Two reasons. First, some speculators are betting that most of the damage has been done and that it’s a good time to grab bargains, especially in REITs that specialize in office buildings, industrial and health care properties, since those should have less exposure to the home-mortgage troubles. Some REIT companies are buying back their own shares, showing that their managers feel the shares are cheap. Many investors focus on the fact that some REITs are trading at deep discounts — when the total value of a REIT’s shares is less than the value of the properties it owns.

While this may be the case, it does not guarantee a rebound. The property valuations are just estimates, as it’s hard to know what any apartment building or strip shopping center is worth in today’s tumultuous market. Many may be worth less than they were a year or two ago, meaning the REIT discounts aren’t as big as they seem.

Also, this is a highly emotional period and we’re still a long way from knowing which real estate companies are the most deeply invested in bonds tied to subprime loans. Many experts are now admitting that the ripple effects of the subprime problem have been much rougher than they’d expected a few months ago. So long as there’s a perception that things could get worse, there’s a real risk that REIT prices could fall further.

The second reason to invest in REITs is probably the better one: They help diversify a portfolio, allowing long-term investors to spread their eggs among more baskets.

The economic factors driving real estate prices are often quite different from those governing prices of stocks, bonds, currencies or commodities. Earlier in this decade, for example, investors enjoyed healthy gains in REITs while stocks were sinking. Reducing a portfolio’s volatility improves compounding because losses are smaller in the downturns.

Many financial experts therefore suggest that small investors put 5 to 10 percent of their portfolios into REITS.

A study by the respected investment consulting firm Ibbotson Associates Inc. looked at how sample portfolios with and without REITs would have performed from 1972 through 2004.  A REIT-free portfolio of 50 percent stocks, 40 percent bonds and 10 percent Treasury bills would have returned an average of 10.9 percent a year. One with 45 percent stocks, 35 percent bonds, 10 percent treasuries and 10 percent REITs would have returned 11.2 percent. With 20 percent REITs, 40 percent stocks, 30 percent bonds and 10 percent Treasuries, returns would have averaged 11.6 percent.

At the same time, risk, measured by the average size of each portfolio’s up and down swings, would have fallen.

Federal law requires REITs to pass at least 90 percent of their annual income from rents and other sources to shareholders each year. REITs are thus exempt from federal corporate taxes paid by other types of corporations. (There are exceptions to this rule, so look closely at the tax implications before investing in a REIT or REIT fund.)

Unfortunately, REIT shareholders must pay tax on most dividends they receive at income-tax rates as high as 35 percent, compared to a maximum 15 percent for dividends from non-REIT corporations. Consider using a tax-advantaged account such as an IRA or 401(k) to invest in REITs, so you won’t be taxed on dividends until money is withdrawn.

Start your search at the trade group’s Web site. While it is unashamedly pro-REIT, it does have some good primers, loads of performance data and a list of REITs and REIT funds. The funds can be researched at morningstar.com. Be sure to look at the data on fund fees and after-tax returns.

Unless you’re an experienced, risk-loving speculator, invest in REITs only for the long-term benefit of diversification.

And think about getting in gradually rather than all at once. That way you won’t have a nasty surprise if the real estate market turns out to be shakier than you expect.

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