In Defense of REITs

While surfing on WallStraits Forum, I came across a post criticising REITs:

Originally posted by ocean21
During an economy downturn, i believe REITs will have the hardest impact, because:

1) Its fundamental business is very narrow and specific. When times are bad, pple spend less $$. Shops will not have business and cannot afford the high rental and they will go bust. Once REITs cannot continue to have their regular flow of high rental, they will not meet their expected yield. Its gonna have downward spiral effect.

2) Most REITs acquired their properties at pretty high prices (and at premium) from their "owners". When times are bad, valuation of these properties will fall and their NTA will be greatly affected since properties account for almost their entire balance sheet.

While these may sound like valid points to stay away from REITs, I feel they stem from a misunderstanding of how to invest.

These 2 reasons are insufficient by themselves to stay away from REITs. Every investment has its own pros and cons and advantages and risks.

What is important is to have a good understanding of the business and never to pay too much for it. Purchasing a REIT at a suitable margin of safety will mitigate against the risk of loss during an economic downturn.

with regards to point (1), this criticism can be made of the entire consumer brands sector as a whole. Every retail outlet and consumer brand has a particular niche and focus in their respective markets. Quality commercial REITs acquire shopping centers in good locations and fill them with quality tenants.

While this does not gaurantee that every tenant will stay in business during a downturn, a quality selection of tenants will still attract a reasonable clientele during a recession. Furthermore, REITs are at liberty to negotiate lower rents during times of economic difficulty - this prevents unnecessarily high rates during recessions and keeps their tenants in business.

With regards to criticism (2), again, this could be made of the entire property sector as a whole. Every investor who buys real estate will see market valuations of their property fall during a time of economic downturn. The trick is not to stay away from property, but to purchase assets only at reasonable valuations. If you look at the market now, you can find REITs that are priced very reasonably after the stock market pullback.

Like any investment, REITs should be evaluated while taking into consideration the business risks involved while remembering never to pay too much. If an investor keeps these factors in mind, he can profit by purchasing REITs when the market underprices them and selling when the market overvalues them. The solution is not to make a blanket condemnation of any asset class.