iome financial planners take a strategic approach to S REITs while others use them tactically, with some seeking

the best of both worlds. - ^

'X

l-'^^rtl!

FOR REAL ESTATE INVESTMENT TRUST ( M E I T ) INVESTORS,

the 2ist century has been kind. Even after a 2007 to 2008 crash, the FTSE Equity REIT Price Index has doubled since early 2000. Through the first quarter of 2011, Morningstar's category of real estate fundswhich largely invest in REITsposted a 10-year annualized return of 10.43%, more than twice the return of the average domestic stock fund.

THIIVKING STRATKGICALLY

But like many investments, REITs aren't always on the upswing, such as during the late 1990s when they underperformed compared to the market. So how do advisors approach REITs as an asset class, maximizing the potential upside while minimizing the potential downside? One method is to think strategically, setting an allocation and rebalancing when appropriate. "As a general rule, we might allocate 10% to 15% to real estate," says Mark Bass of Pennington, Bass & Associates, a financial planning firm in Lubbock, Texas. Bass uses both traded and non-traded REITs for the real estate asset class. "The liquidity of traded REITs is a plus," he says. "We typically hold them through mutual hinds as opposed to individually listed REITs." Most traded REITs focus on one property type (office buildings or shopping centers), while a fund might hold REITs across the real estate spectrum. "We prefer to hold funds with traded REITs in a qualified account, such as an IRA, because of the dividends," says Bass. Equity REITs now yield around 3.5%, on average, while real estate fiands pay 2.7%, trailing only precious metals (4.0%) and utilities (3.2%) among the Morningstar fund categories. Inside an IRA, taxes on

"Historically, the pricing of non-traded REITs has not fluctuated as much as the pricing of traded REITs, which are subject to the daily ups and downs common to publicly traded securities."
TOM LARKIN
WELLS REAL ESTATE FUNDS

those relatively robust distributions can be deferred. Tim Seneff, group president, CNL Capifal Markets in Orlando, Fla., says that nearly half of the money raised by CNL for its non-traded REITs is qualifiedheld in some type of taxadvantaged retirement account. Bass reports that his clients have received good returns from some nontraded REITs that have gone fuU cycle. "Frankly," he adds, "the rather static values of non-traded REITs have been more comforting to clients in those periods of time when the traded REITs and other financial assets declined." Indeed, such "static values" may be a source of comfort in a financial panic when virtually all asset classes are skidding. "We suggest that advisors not oversell redemption plans on non-traded REITs," says Tom Larkin, chief sales officer at Wells Real Estate Funds in Norcross, Ga. "Those plans may not always be open or available. Instead, they should emphasize the fact that non-traded REITs are illiquid. This can be a virtue because, historically, the pricing of non-traded REITs has not fiuctuated as much as the pricing of traded REITs, which are subject to the daily ups and downs common to publicly traded securities."

A3

For non-traded REITs, where investors may learn about the sponsor's plans up front, Bass prefers low to moderate leverage. "That's particularly true in a low-interest-rate environment," he says. "I'm not a fan of all-cash deals." Using leverage (and having to pay mortgage interest) may reduce cash flow to investors but might ultimately pay off if the properties are sold at a profit. When asked why he keeps a significant allocation to REITs, Bass responds that high yields, historic performance and portfolio diversification all play a role. "However," he says, "diversification is the most important factor. We've seen studies about the use of REITs and their impact on returns and portfolio volatility." As mentioned, REITs'lack of correlation to U.S. stocks hurt in the late-1990s bull market. However, REITs had positive returns in 2000 to 2002, while stocks crashed, and REITs continued to lead stocks for the next several years. Large REIT losses in 2007 to 2008 were surrounded by banner years, before and after, leading to results that bolstered overall portfolio returns for the last decade.
TACTICAL PLAYS

A COMBINED APPROACH

Yet another approach to investing in REITs is to use both strategic and tactical planning. "Clients who have at least S500,000 to investwhich is most of our clientswill usually hold 10% to 20% of their portfolio in non-traded REITs," says Steve Hutchinson, who heads a wealth management firm in Greensboro, N.C. "In addition, we'll invest tactically in traded REITs. Responding to shifts in the economy, we might invest in commercial, retail or multifaniily housing REITs, for example." Hutchinson says that he has had clients invest in nontraded REITs for more than 20 years, with good results. "We like those REITs because you can get in at the beginning of capital formation, so there's more potential for substantial returns. Sponsors can cherry-pick the best opportunities as money comes in. Recently, we've seen sponsors of non-traded REITs diversify their offerings, even including some international properties."

Of course not every advisor views REITs as an all-weather allocation. "As far as REITs' role in our portfolios, we do not have a strategic allocation," says Jack Chee, senior research analyst at Litman/Gregory Asset Management in Larkspur, Calif "We gain REIT exposure via a tactical allocation when we are confident that the asset class offers attractive returns relative to competing asset classes under the economic scenarios we consider possible or likely." Currently, Chee lacks such confidence. "We believe that fundamentals have improved," he says. "We are seeing rents increase, occupancies stabilize or improve and dividends increase. REITs' access to capital is strong. At the same time, a lack of supply from new construetion is helping to fuel demand from tenants. However, REIT valuations appear to be pricing in many ot these positives. In our view, REIT valuations are rich by just about every measure we look at." Chee adds that his firm doesn't accept the "conventional wisdom" that REITs can be expected to have a low correlation with equities. "The REIT declines we saw in 2008 run counter to the generally perceived belief that REITs are low beta [less volatile] and not highly correlated with the broader equity market,"-he says. "We have always believed that correlations will vary depending on the facts and circumstances of each market cycle. Factors likely to influence correlations over any period include initial valuations for equities and REITs, as well as the real estate cycle and the underlying fijndamentals and macroeconomic forces that may be specific to either or both."

A4

If a client has, say, a S 1.5 million portfolio, around Among the firms offering structured notes pegged to $250,000 might be invested in non-traded REITs, REITs are Barclays, Credit Suisse and Morgan Stanley. according to Hutchinson. "We wouldn't invest all with Terms vary, but the notes inight last from 13 to 24 one sponsor," he says. "Instead, we'd spread the money months. Investors' results can be pegged to the Dow over different types of offerings from several sponsors, Jones U.S. REIT Index, with the downside capped at including CNL, Inland, Cole Capital and Hines Real around 10% and the upside capped anywhere from 15% Estate. We tell these clients to expect that money to be to 40%. Assuming the index moves up during the term locked up for at least five years, and probably longer, so of the note and the cap isn't triggered, investors would they should plan on holding for the duration." get twice the index gain: a 10% return if the index is 5% higher, for instance. In terms of specific investments, Hutchinson says, "We see opportunities in lifestyle properties, which "The only way you can lose with these notes," says offer drive-to vacations. The best locations are within 75 Balcom, "is if there is a huge rally and you don't participate miles of major metropolitan areas. We also like REITs fuUy. My clients are willing to take that risk in return that own senior housing properties. If the housing for the downside protection." Such structured notes have market improves, older people will be able to sell their other drawbackslack of liquidity, lack of cash flow from homes and move into [an] assisted-living real estate operationsbut Balcom says the [facility]. Then those REITs will do well." main concern is the issuing bank's financial The key to any type of healthcare or stability. "You don't want another Lehman medical REIT, according to Hutchinson, Brothers. For safety, we spread our structured is to find private-pay facilities, rather notes among several different banks." than those dependent on government In general, advisors are asking more outlays." Seneff, another proponent of questions about REITs, no matter what senior housing investments, adds that the their strategies might be. "We're seeing lodging businesshotelsmay also offer more interest from advisors on sophisticated attractive buying opportunities now. topics," says Larkin. "For instance, has a REIT's distribution been covered from Regarding clients with fewer assets to "Advisors and its cash flow? Some REITs are not earninvest, Hutchinson says that relatively ing enough from operations to cover the small accounts get exposure to REITs clients are distribution. That's essentially the same as through mutual funds. Tom Balcom, interested in taking on more debt. We tell advisors to founder of IBIS Wealth Management in look over a REIT's public filings. Examine Boca Raton, Fla., also uses mutual funds as tangible assets the income statement to see if the distriwell as exchange-traded funds (ETFs) for bution has been covered. Broker-dealers exposure to REITs. "Even if a client has that can do well in also have been helpful in educating advilarge holdings of investment properties," inflationary times. sors about this." he says, "I'll still want about a 10% allocation to REITs. The client probably Income and low-correlation to stocks are REIT sponsors can owns local properties while REITs make also on advisors'minds, according to Larkin. up a national asset class." structure leases And Seneff adds inflation protection as a prime concern: "Advisors and clients are to get rent bumps D O W N S I D E PROTTECTIOIV interested in tangible assets that can do well in inflationary times. REIT sponsors can For many of his clients, though, Balcom to keep up with structure leases to get rent bumps to keep turns to structured notes for participation up with inflation." in REITs. "They can provide downside inflation." protection as well as upside potential. AdWhether they take a strategic, tactical visors generally can access these structured or combined approach, advisors are using a notes through the trading desks of major TIM SENEFF variety of categories of REITs to diversify investment banks." CNL CAPITAL MARKETS portfolios and provide potential upside to clients.

A6

Copyright of Financial Planning is the property of SourceMedia, Inc. and its content may not be copied or emailed to multiple sites or posted to a listserv without the copyright holder's express written permission. However, users may print, download, or email articles for individual use.