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As Sub-Prime Woes Spike, REIT Income May Dip

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Several financial advisors contacted by Income Planning say that for those who use real estate investment trusts (REITs) to fund regular income, there is a real risk of diminished income.

Three of 4 financial advisors contacted say that sub-prime woes may take a dent out of regularly anticipated REIT cash flows. One says his clients will not suffer, but this is because of how the REIT he uses for clients is invested.

“Yes, it sure does matter what sort of REIT a person owns these days, and yes, I would say that most of them, whether they deserve it or not, have been swept up in the current trouble surrounding financial services and real estate businesses,” says Michael Martin, chief investment officer with Financial Advantage, Inc., Columbia, Md.

As an advisor, there are a few actions that can be taken to protect a client, according to Martin. One step is to diversify, he says. Diversifying sources of income “is of top importance,” he says, because of “the humbling reality that we are always unsure about the future! Diversifying is our admission of a certain amount of ignorance!”

Once the REIT market returns, he says, the choice of REIT is important. Martin says that when the market was better, he selected a REIT that owns and lends against buildings that are occupied under long-term lease agreements–usually 10 years or more–and are contracted by investment grade tenants. Consequently, Martin continues, there is greater confidence in the “sustainability of a dividend.”

As an asset class, REITs have become overvalued and their yields are not what is needed to meet clients’ income needs, he adds. And, there is a “good possibility” that “some kinds of commercial real estate may join the ranks of residential investments with some bad debt troubles.”

Don Martin, a certified financial planner with Mayflower Capital, Los Altos, Calif., also says he believes that the current drop in the residential real estate market can affect REIT income.

Although there may be no impact initially, Martin reasons, in the long term, if owners cannot sell their homes, they may be forced to rent them out. Or, if people foreclose on a property, then a “new, more solvent investor” may rent out the property after picking it up at a fire sale price.

If the economy goes full throttle into a recession, he adds, the loss of REIT income could become worse. He cites the 1990 recession and its impact on the market in southern California. For those who bought at the top of the market, it took the entire decade to break even, and even longer if factoring in the time value of money and realtors’ fees, he says.

Don Martin also raises concerns that lending “errors” in the commercial real estate mortgage market have yet to surface. These will put downward pressure on income from commercial REITs, he predicts.

For those who are invested in REITs, Martin says it should be a “modest amount” of a total portfolio. Within the REIT category, it is probably not possible to diversify domestic REITs, he allows, but he says it may be possible to diversify with Asian real estate. However, because such real estate is generally not publicly traded, such diversification is “not cheap,” Martin adds.

David Zumbusch, a certified financial planner with Sportsmen Dream Financial, Buffalo, Minn., says that he has clients in REITs with constant income of 7+% but the underlying investments in these REITs are commercial real estate with high occupancy to high credit worthy tenants.

As a percentage of a total investment portfolio, Zumbusch says that 15% is “plenty” in income producing REITs, although it is all right to hold up to 20% in them, he adds. As an alternative, for high net worth clients, Zumbusch has used secured notes with 10% annual interest. But again, he recommends holding no more than 15% for diversification purposes.

Jim Holtzman, a certified financial planner with Legend Financial Advisors, Pittsburgh, says that his firm made a decision to switch clients out of REIT investments about 2 years ago. The performance is poor, he continues. While REITs are better priced than they were, they are not yet selling at attractive enough discounts to consider for clients, he says. Furthermore, he says, looking at historical valuations may not give a totally accurate reading on value, since the sub-prime problem is a “rare event” that may alter the usual way to look at valuations.

At Legend, according to Holtzman, a client’s cash flow needs are evaluated and capital gains and dividend distributions are harvested both at the end of the year and at points during the year to provide income. Among the benefits of this approach, he explains, are tax efficiency and the freedom of not having to rely on a particular investment and its performance during difficult economic times.

While the principle of diversification would in general also apply to REITs, as it would for any investment, now is just not the time to invest in them, Holtzman says, noting that it will be at least 6 months to a year before this investment type starts to become more attractive.

Another investment type that can produce income, he says, is foreign money market funds. These funds offer good dividend yield and a bump up because of currency rates but they need to be put into a tax-qualified retirement account because they produce tax inefficient non-qualified ordinary income, Holtzman continues.

The National Association of Real Estate Investment Trusts, Washington, maintains that the bottom might be near and that it might actually be a good time for advisors to start looking at REITs again. During the 12-month period ending Jan. 31, 2008, REITs delivered a negative 24.03% total return, according to NAREIT. But, it also notes, that the FTSE NAREIT All REIT Index, a major benchmark for measuring REITs, declined 0.3% in January 2008 while other benchmarks “took steep hits to start the year (the Dow Jones Industrials down 4.63%, the S&P 500 down 6%, the Russell 2000 down 6.82%, and the NASDAQ Composite down 9.89%.)

And, NAREIT pointed to data indicating that the FTSE NAREIT All REIT index “accelerated” in the second half of January. The Index was up 8.43% in the week ended Jan. 25 and 6.56% in the week ended Feb. 1.


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