The Run-Down on REITs

If you're an investor looking for income, REITs are a great way to go. The average REIT sports a 5.13% dividend yield, according to the National Association of Real Estate Investment Trusts. The Standard & Poor's 500-stock index, by comparison, yields 1.8%.

How can REITs afford such a hefty payout? It's all in the way they're structured. The Real Estate Investment Trust Act of 1960 set up three key provisions when it created REITs:

• Companies that operate as REITs pay no tax on corporate income.
• In order to get that tax break, REITs must pay out at least 90% of every dollar in income to shareholders in the form of a dividend.
• Companies can pass on the tax savings from the dividend deduction to shareholders, making REITs an attractive investment.

REITs are companies that generally own, and in some cases operate, income-producing real estate, such as apartments, office buildings, shopping centers and hotels. Most fall under the equity REIT category. Some REITs are in the business of financing property and are called mortgage REITs. Hybrid REITs own property and make real estate loans. REITs trade on the major exchanges, just like stocks.

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Risks to REITs

Given all the different stripes of REITs -- from retail to residential to health care -- it makes sense that each has its own inherent set of risks. "So it's crucial to understand what type of risk you're taking on," says Leo Wells, president of Wells Real Estate Fund.

Hospitality, or hotel, REITs have the problem of near 100% vacancy every morning. And they're particularly sensitive to economic downturns when fewer people travel. But because of that sensitivity, says says Art Havener, vice president and analyst for A.G. Edwards & Sons. They're also the first to come back in a rebound.

Apartment REITs are also at risk in a soft economy, because it's more difficult to command top-of-the-line rents. "But there's an interesting dynamic at play right now with apartment REITs," says Havener. "Property income has gone down, but property values have increased." And actually all types of REITs have benefited from this phenomenon, he says, since property values are what tends to drive REIT share prices.

But there are other downsides. Retailers and retail REITs can face cyclical slumps. Occupancy can sometimes be an issue for commercial REITs that own office buildings. Risks also vary by geography. For instance, real estate in certain parts of California isn't nearly as hot as it used to be, and in some cases has run cold.

Interest rates aren't too much of a concern unless the Fed is furiously raising them to cool an overheated economy. If the economy starts going gangbusters, investors could be tempted to pull their money out of REITs and put it into something sexier, such as a growth stock. That's why it's far better to invest in REITs with a long-term view.

But which REITs?

If you're going to invest in REITs, buy several and make sure they're from different sectors -- even different geographic regions. Wells cautions investors to limit them to 20% or 30% of any given portfolio and recommends having a financial adviser pick the specific REITs. "Sometimes it's hard to know exactly what the REITs are investing in, and it's hard to do all the research yourself."

Do-it-yourselfers should avoid mortgage and hybrid REITs, Havener says, because they often bet on the spread between their borrowing costs and mortgage rates -- and that can get dicey, since interest rates factor in more heavily. He recommends four comfortably diversified equity REITs:

Capital Automotive (CARS, recent yield 5.1%) Owns and leases property to car dealerships and mechanics.

EastGroup Properties (EGP, 5%) Focuses on acquisition, ownership and development of industrial properties in California, Florida, Texas and Arizona.

Eagle Hospitality Properties Trust (EHP, 7.5%) A hospitality REIT that invests in primier full-service and all-suite hotels.

Extra Space Storage (EXR, 6.7%) Owns, operates, acquires, develops and redevelops professionally managed self-storage properties.