Real estate is pricey these days but is still a valuable commodity, says Linda Stern, writing for Reuters, and one alternative to buying a house for investors is purchasing shares in a real estate investment trust that owns commercial or apartment real estate (REIT). Another alternative offered by the Chicago Mercantile Exchange (Merc) is commodity-style trading on housing futures and options in select cities.
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The Merc’s housing index, designed by Standard & Poor’s, according to bankrate.com, covers 10 metropolitan markets and a U.S. Composite. Contracts are worth $50,000 each, with an initial buy-in of $2,500. Investors can purchase contracts with durations of 3, 6, 9 and 12 months and decide whether they think the market is going to go up (trading long) or whether it will go down (trading short).
The Chicago Board Options Exchange (CBOE) is also planning to enter the real estate hedging action, bankrate.com reports. CBOE has announced plans to introduce a futures exchange based on the National Association of Realtors’ existing home sales figures, broken out into four regions and a U.S. composite.
“It isn’t really intended for individuals,” says financial adviser, Lew Altfest of L.J. Altfest & Co. in New York, according to bankrate.com. “No question, people are afraid that they’re buying now at a high price and they’re going to be stuck with something that is going to go down 20 percent. The machinations of hedging are not exactly the same as owning, but it can offset declines.”
Investing directly in REITs or in real estate mutual funds offers steady income from dividends based on rents paid to the real estate companies from the commercial and apartments properties the trust invests in. The average REIT has a 4.4 percent yield, according to USAToday.
Data on commercial and apartment properties are positive, according to both the New York Times and Reuters. “There is very little correlation that I’ve ever seen between residential real estate and commercial real estate,” Don Wood, CEO of Federal Realty Investment Trust, told Reuters.
There are three types of REITs, according to the National Association of Real Estate Investment Trusts (NAREIT) sponsored Web site, investinreits.com. Equity REITS own and operate income-producing real estate, mortgage REITs lend directly to real estate owners and operators and Hybrid REITs own properties and make loans to real estate owners and operators.
REITs are corporations, not partnerships, but they are required by law to distribute 90 percent of their taxable income to shareholders each year. REITs do not pay corporate income tax, and REIT income is taxed as ordinary income rather than dividend income, a disadvantage for some investors.
REIT income will, however, qualify for a lower tax rate, according to investinreits.com:
- When the individual taxpayer is subject to a lower scheduled income tax rate;
- When a REIT makes a capital gains distribution (15 percent maximum tax rate);
- When a REIT distributes dividends received from a taxable REIT subsidiary or other corporation (15 percent maximum tax rate); and
- When permitted, a REIT pays corporate taxes and retained earnings (15 percent maximum tax rate) ).
Investors who are considering buying shares in a REIT should keep in mind some of their unique financial reporting features, investinreits.com says. The REIT industry uses net income as defined under generally accepted accounting purposes (GAAP) as the primary operating performance measure, supplemented by Funds From Operations (FFO). FFO is defined as net income, excluding gains or losses from sales of property and depreciation of real estate.
Because many professionals believe that real estate does not depreciate in the same way as machinery and may in fact appreciate, FFO excludes real estate depreciation from periodic operating performance.
Shares in REITs are expensive these days, according to many analysts who recommend investing only a small percentage of a portfolio or a 401(k) in this asset group. “It should be a small percentage of a very well-diversified portfolio,” says David Lee, who manages the T.Rowe Price Real Estate Fund, Reuters reports.