Thursday, July 30, 2009

What Are REITs?

As an investment class, real estate offers several major advantages. Real estate is a great inflation hedge, meaning when inflation is high, the value of real estate investments usually increases dramatically. Second, real estate offers several unique tax advantages, such as the ability to deduct interest expense and depreciation. Third, few investors pay 100 percent cash when they buy real estate. Rather, they use leverage (borrow money to fund the investment). This provides the investor the opportunity to benefit from investment gains utilizing borrowed funds. Lastly, real estate investments are often relatively uncorrelated with stock market gains. Thus, owning real estate is a great way to further diversify a portfolio.

However, owning real estate directly has its disadvantages. First, real estate is illiquid, meaning it is difficult to convert into cash quickly. Second, even if the majority of dollars required are loaned to the investor, investing in real estate requires a high minimum investment. Third, investing in real estate involves a large amount of personal liability. Lastly, real estate investments have significant transaction costs, such as commissions, appraisals, and closing fees.

Real estate investment trusts (REITs) provide investors a way to invest in real estate without being exposed to the above disadvantages. REITs are publicly-traded investment corporations that are traded on major stock exchanges such as the NYSE. Being traded on public exchanges provides liquidity to the investment. Further, REIT shares can be purchases with relatively small amounts of money. Also, the investment corporation bears most of the liability, making individual investors’ assets secure from creditors. Lastly, REITs generally purchase many individual properties, providing diversification within a real estate portfolio.

REITs are a great addition to many portfolios. However, keep in mind that for most investors a home is their largest asset. Consequently, investors should be careful not to overweight the real estate portion of their portfolios. In most cases, investors shouldn't invest more than 15 percent of their portfolio in real estate (excluding the home).

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