What are the Risks of Investing in Real Estate Investment Trusts

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Of course, nothing in this life is guaranteed, and that includes real estate investment trusts.

REITs are more than just a pile of properties, they are active businesses, and subject to business risks. It's a testimony to the industry, however, that over the years only a handful have gotten into deep financial trouble.

According to Ralph L. Block in Investing in REITs, those real estate trusts that have gotten into trouble have done so primarily due to excessive debt leverage, poor allocation of capital resources, and questionable transactions with directors or major stockholders.

That's for individual REITs. As an industry, their businesses are subject to two particular risks no matter how well managed they are (though good management can succeed despite these dangers).

One Risk of Real Estate Investment Trusts is Overbuildin or Excess Capacity, or Overdevelopment.

Real estate property typically goes through a boom to bust cycle. When demand for offices/apartments/malls is going up, developers rush in to build more of these properties. It's difficult to know when enough is enough, and within a few years, too many offices/apartments/malls are on the market, and rents go up and occupancy rates go down.

Sometimes the problem is not with the amount of new properties put on the market, it's with the local economy. When it goes bust, for whatever reason, the local commercial real estate market goes down.

One good example is the San Francisco Bay Area during the late 1990s. During the dot com/high tech bubble, people in Silicon Valley were renting out their couches to computer programmers for hundreds of dollars a month. After the dot bomb crash of March 2001, when many high tech companies closed their doors, the market for office space in that area went downhill with it.

Such periods are known as renters markets, and are therefore bad for property owners.

It's simple economics. When supply goes up too much and/or demand goes down too much, the price of the product must go down.

High interest rates

Interest rate increases affect REITs in a number of ways.

Since their value as an investment is for their income, higher interest rates in the overall economy makes bond yields higher, driving some money from REITs to bonds and preferred stocks.

In operating their businesses, higher interests rates makes it harder and more expensive for Real Estate Investment Trusts to borrow the money they need to expand.

Also, higher interest rates put pressure on the businesses they're renting to (by increasing their cost of borrowing money, and from reducing consumer income to spend), making it harder for those businesses to pay rent, or to pay higher rents.

Also, reduced sales in stores reduces the amount of overage rents that mall REITs can collect from the stores.

There is a risk in using current rental income to value a REIT. What current tenants are paying may be more or less than current market rents. When the current leases expire, the company will have to negotiate current market rents.

When current rents are below market rents, that's known as embedded rent growth or loss to lease, because when the lease is renewed, rents will have to go up.

When current rents are below market rents, that's known as rental roll-down, because when the lease is renewed, rental income will have to go down.

In a commercial lease, one year is used as a reference against which revenues or expenses are measured in later years. This is known as the base year.

The total leasable space in a commercial property is known as the Gross Leasable Area or GLA.

The risks of real estate investment trusts can be managed, resulting in large profits for investors.

Next: How do Real Estate Investment Trusts grow -- the ways REITs can grow their businesses

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