4 Trusty Tips When Investing in REITs

Over the past 10 years, real estate investment trusts, or REITs, have been stock market darlings, outperforming Standard & Poor's 500 index.

But there are signs REITs may be overheating as investors pile in, according to some experts. The average price-to-earnings ratio in the bellwether MSCI REIT Index was 41.5 at the end of July versus just 17.86 last year. And, once-hefty dividend yields have fallen.

"Most REITs in our coverage have dividend yields well below their historical norms," says Todd Lukasik, a senior equity analyst at Morningstar.

With that in mind, advisers are counseling investors to be picky when buying REITs, given their fast run-ups.

High valuations

"These valuations aren't sustainable," says Geoffrey Dancey, a portfolio manager at Cutler Capital Management LLC in Worcester, Mass. And they can lead to lower stock prices down the road, he adds, translating into losses.

Examples of unusually low REIT yields and high prices aren't hard to find. Simon Property Group, which mainly invests in malls, was trading at $145 in early August and sports a 3.2% yield.

"Persistently low (interest) rates are still driving REITs," says Lukasik. "It's hard for investors to get that."

Lukasik worries that once interest rates rise, REITs could tumble. The reason: REITs rely on borrowed money to make acquisitions. When interest rates go up, so do the borrowing costs of REITs.

In addition, investors may seek safer returns in risk-free Treasuries, which could cause a run for the exits, according to a Morgan Stanley research report.

REIT hunting

Caveats aside, REITs have a place in investors' portfolios. They pool capital to buy diversified real estate that investors normally couldn't afford. And, shareholders also benefit from their structure. REITs must distribute at least 90% of their taxable income annually.

But, the key to REIT hunting is doing your homework, says Karl Romero, a Certified Financial Planner professional with Karl Romero & Associates, a wealth management firm in Santa Ana, Calif. "Take it sector by sector," he says.

Here are some key ways to protect yourself when REIT hunting.

Avoid newly issued REITS. A host of new REITs, including single-family residential REITs, is coming to the market this year. However, these freshly minted stocks lack track records, so investors can't scrutinize their success.

"These new REITs are signs that this niche is getting pricey," says Stephen Mauzy, a principal at the Colorado-based investment analysis firm S.P. Mauzy & Associates. "Stay away from the new stuff."

Mauzy says he prefers to see how a REIT maintains its payouts and navigates market troughs over time.

Stick with publicly traded REITs. There are two types of equity REITs -- nontraded and ones that trade on a stock exchange. According to Morningstar research, publicly traded commercial equity REITs consistently outperform nontraded ones over time. They also recover faster during downturns, have lower fees than nontraded REITs and are stronger performers in bull markets.

The Financial Industry Regulatory Authority also has a warning. The independent financial watchdog says nontraded REITs have several drawbacks, including lack of transparency. They must often be held for eight years or more, since there are limited secondary markets, and front-end fees can run up to 15% of the REIT's share price.

FINRA's recommendation: Short-term investors should look elsewhere. Longer-term investors should know their capital needs if they do invest in nontraded REITs.

Don't overload your portfolio to chase REIT yields. Typically, REITs compose 5% to 10% of investors' portfolio assets. However, these days, investors are tempted to nab high yields by shifting more money into REITs rather than reaping the low yields of the bond market. Resist this urge, says Joe Davis, head of Vanguard's investment strategy group. He says REITs tend to mimic stocks rather than bonds.

"The final result is a more aggressive and more stock-heavy strategic asset allocation," Davis wrote in a commentary for Vanguard. He warns that an income-focused strategy of buying dividend-paying stocks, including REITs, is not risk-free.

Avoid REITs that use borrowed capital. REITs that use borrowed capital to spike returns can get pummeled when interest rates rise since their borrowing costs shoot up. And mortgage REITs, which mainly invest in real estate debt, are usually highly leveraged. That makes them more risky, Mauzy says. Conversely, equity REITs, which own properties, tend to be less rate sensitive.

The upshot: When interest rates go up dramatically, the mortgage-backed securities that the REIT owns plummet in value as its borrowing costs go up. This isn't a good scenario for investors and quickly can lead to dividend cuts and even bankruptcy for the REIT, Mauzy says.

Some equity REITs have significant debt, too. For example, CommonWealth REIT, which invests in office and industrial buildings, has more debt than its entire market capitalization. In June, S&P cut the REIT's rating to junk status. However, Lukasik says a lot of equity REITs that were once debt-heavy have improved their balance sheets.

That's why it pays to be picky with REITs.