An often-overlooked investment opportunity: Non-traded REITs

Residential properties are one great way of owning a piece of real estate for investors, but it is certainly not the only way. Investing in commercial real estate such as malls, medical office buildings, large properties, and hospitals - may provide investors with an income stream, potential tax benefits, protection against inflation, and substantial growth opportunities. In addition, real estate is a great way to add diversification benefits when combining it with other types of non-correlated investments such as equities and fixed income securities. Therefore, commercial real estate can provide investors with a way to shield against volatile market conditions.

An investment opportunity
Years ago, commercial real estate investments were only attainable by institutional investors, wealthy individuals, and trusts with significant financial resources. Today, with the advent of products such as real estate investment trusts (REITs), many investors now have access to commercial real estate investments and opportunities that were once available to only the cream of the crop.

How it works
The most often used vehicle for investing in commercial real estate is the REIT. Although investing in commercial real estate was restricted to wealthy individual and corporations 50 years ago, since the REIT was created, the real estate market has attracted a much broader and much larger group of investors because it allowed regular investors to participate. REITs are like most other funds in the way they get capital for their operations. They raise money from investors and pool all the funds to acquire properties such as hospitals and office buildings. As long as REITs closely adhere to the laws applicable to them, most notably distributing at least 90% of all their taxable income to investors, they avoid double taxation of its income at the REIT level. This distribution is the major source of the income that REIT investors receive.

When investors place their money in any REIT, they are putting their money in the hands of real estate professionals that monitor changes and trends in the real estate market, mortgage rate movements, regional trends, and other factors. In addition to all the external factors, the REIT's success will also be affected by the fund manager's skills, experience, and talent.

REITs come in two forms: traded and non-traded fashions. Each has its own advantages and risks. However, this article concentrated on non-traded REITs.

Potential benefits

Non-traded REITs may offer:

• Steady income streams. Non-traded REITs may provide a revenue stream in the form of monthly or quarterly distributions. This gives fixed-income investors with a steady cash flow.
• Protection of principal. Although the economy's ups and downs can affect real estate values, REITs that invest in high-quality real estate assets can maintain their values.
• Capital appreciation. With a sufficiently long time horizon, real estate can provide investors with back-end appreciation which can translate into significant rates of returns.
• Inflation protection. Real estate typically withstands the erosive nature of inflation.
• Tax advantages. Many investors benefit from holding real estate investments because the investor's taxable income is reduced by taking advantage of depreciation deductions. When the asset is sold, the income that was protected by the deductions is taxed at potentially lower capital gains taxes.

Potential risks

The following risks are possible with non-traded REITs:

• Some of the property holdings in the REIT may have been purchased at a highly appreciated price which can restrict the overall growth of a REIT portfolio because the REIT may run the risk of not being able to sell the property at a more appreciated price. These types of properties may or may not be providing cash flows to the REIT.
• Non-traded REITs are typically appropriate for long-term investment horizons of 5-10 years making them more illiquid investments.
• Investment objectives stated in the REIT's prospectus are target not guarantees. Clients may see a difference in the distributions they receive and the expected level of distribution rate.

Commercial real estate investment strategies
Carefully consider what risks you are looking to take on in order to justify the expected return. Higher returns generally go hand in hand with higher risks. Individual investors need to feel comfortable with the degree of risk they are willing to tolerate and then maximize their returns to their unique risk level without leaving your comfort zone.

REITs typically fall into three principal categories each with its own advantages and risks:

1. Core investment programs concentrate on long-term property holdings in order to generate steady income streams for their investors and potentially some back-end appreciation. Investors that find these programs appealing are typically focused on receiving an income stream to supplement their current income.

REITs that fall under this category of core real estate investments invest their funds in well-established real estate markets focusing on high-quality, stable, well-maintained properties that are not too leveraged. They buildings generally have minimal upkeep necessary such as repairs.

Managers select properties in diverse markets and look at the financial stability of tenants in their chose properties.

2. The value-added group invests in properties that potentially may provide investors with significant back-end capital appreciation. Therefore, these properties carry with them a higher level of risk and are generally financed with some amount of leverage. Investors seeking greater asset appreciation rather than current income in their investment plans may find this group of REITs more appropriate for their investment goals.

When buying these types of real estate properties, managers are willing to purchase properties that may have had some operational or management problems such as average or below average occupancy rates. In hope of turning these investments around, the REIT may look to improve or reposition troubled areas in the property in some way often by finding higher-quality tenants. Once their attempts have increased the value of the asset, the manager may consider selling the property to capture gains.

3. The opportunistic REIT strategy seeks to invest in properties that will capture the highest possible returns and therefore may accept a significant amount of risk to get to their goals. Investors in these types of REITs have a minimal need for current income and are looking for substantial short-term capital appreciation.

Such investments are generally not appropriate for individuals seeking a steady income stream, but rather those seeking to increase total returns in their portfolios via capital appreciation. REIT managers create value by finding properties in geographically diverse markets where growth potential is high. Fund managers invest in properties for a short period of time are generally ready to recapitalize certain holdings to increase returns.

You don't have to do it alone
REITs can be complicated investments to evaluate and even more complicated to integrate into your current portfolio and investment goals. Your Financial Advisor can help you determine if REITs makes sense for you.