For real estate investment trust (REIT) investors, the 21st century has been kind. Even after a 2007 to 2008 crash, the FTSE Equity REIT Price Index has doubled since early 2000. Through the first quarter of 2011, Morningstar's category of real estate funds-which largely invest in REITs-posted a 10-year annualized return of 10.43%, more than twice the return of the average domestic stock fund.

Thinking Strategically

But like many investments, REITs aren't always on the upswing, such as during the late 1990s when they underperformed compared to the market. So how do advisors approach REITs as an asset class, maximizing the potential upside while minimizing the potential downside? One method is to think strategically, setting an allocation and rebalancing when appropriate. "As a general rule, we might allocate 10% to 15% to real estate," says Mark Bass of Pennington, Bass & Associates, a financial planning firm in Lubbock, Texas.

Bass uses both traded and non-traded REITs for the real estate asset class. "The liquidity of traded REITs is a plus," he says. "We typically hold them through mutual funds as opposed to individually listed REITs." Most traded REITs focus on one property type (office buildings or shopping centers), while a fund might hold REITs across the real estate spectrum.

"We prefer to hold funds with traded REITs in a qualified account, such as an IRA, because of the dividends," says Bass. Equity REITs now yield around 3.5%, on average, while real estate funds pay 2.7%, trailing only precious metals (4.0%) and utilities (3.2%) among the Morningstar fund categories. Inside an IRA, taxes on those relatively robust distributions can be deferred. Tim Seneff, group president, CNL Capital Markets in Orlando, Fla., says that nearly half of the money raised by CNL for its non-traded REITs is qualified-held in some type of tax-advantaged retirement account.

Bass reports that his clients have received good returns from some non-traded REITs that have gone full cycle. "Frankly," he adds, "the rather static values of non-traded REITs have been more comforting to clients in those periods of time when the traded REITs and other financial assets declined."

Indeed, such "static values" may be a source of comfort in a financial panic when virtually all asset classes are skidding. "We suggest that advisors not oversell redemption plans on non-traded REITs," says Tom Larkin, chief sales officer at Wells Real Estate Funds in Norcross, Ga. "Those plans may not always be open or available. Instead, they should emphasize the fact that non-traded REITs are illiquid. This can be a virtue because, historically, the pricing of non-traded REITs has not fluctuated as much as the pricing of traded REITs, which are subject to the daily ups and downs common to publicly traded securities."

For non-traded REITs, where investors may learn about the sponsor's plans up front, Bass prefers low to moderate leverage. "That's particularly true in a low-interest-rate environment," he says. "I'm not a fan of all-cash deals." Using leverage (and having to pay mortgage interest) may reduce cash flow to investors but might ultimately pay off if the properties are sold at a profit.

When asked why he keeps a significant allocation to REITs, Bass responds that high yields, historic performance and portfolio diversification all play a role. "However," he says, "diversification is the most important factor. We've seen studies about the use of REITs and their impact on returns and portfolio volatility."

As mentioned, REITs' lack of correlation to U.S. stocks hurt in the late-1990s bull market. However, REITs had positive returns in 2000 to 2002, while stocks crashed, and REITs continued to lead stocks for the next several years. Large REIT losses in 2007 to 2008 were surrounded by banner years, before and after, leading to results that bolstered overall portfolio returns for the last decade.

Tactical Plays

Of course not every advisor views REITs as an all-weather allocation. "As far as REITs' role in our portfolios, we do not have a strategic allocation," says Jack Chee, senior research analyst at Litman/Gregory Asset Management in Larkspur, Calif. "We gain REIT exposure via a tactical allocation when we are confident that the asset class offers attractive returns relative to competing asset classes under the economic scenarios we consider possible or likely."

Currently, Chee lacks such confidence. "We believe that fundamentals have improved," he says. "We are seeing rents increase, occupancies stabilize or improve and dividends increase. REITs' access to capital is strong. At the same time, a lack of supply from new construction is helping to fuel demand from tenants. However, REIT valuations appear to be pricing in many of these positives. In our view, REIT valuations are rich by just about every measure we look at."

Chee adds that his firm doesn't accept the "conventional wisdom" that REITs can be expected to have a low correlation with equities. "The REIT declines we saw in 2008 run counter to the generally perceived belief that REITs are low beta [less volatile] and not highly correlated with the broader equity market," he says. "We have always believed that correlations will vary depending on the facts and circumstances of each market cycle. Factors likely to influence correlations over any period include initial valuations for equities and REITs, as well as the real estate cycle and the underlying fundamentals and macroeconomic forces that may be specific to either or both."

A Combined Approach

Yet another approach to investing in REITs is to use both strategic and tactical planning. "Clients who have at least $500,000 to invest-which is most of our clients-will usually hold 10% to 20% of their portfolio in non-traded REITs," says Steve Hutchinson, who heads a wealth management firm in Greensboro, N.C. "In addition, we'll invest tactically in traded REITs. Responding to shifts in the economy, we might invest in commercial, retail or multifamily housing REITs, for example."

Hutchinson says that he has had clients invest in non-traded REITs for more than 20 years, with good results. "We like those REITs because you can get in at the beginning of capital formation, so there's more potential for substantial returns. Sponsors can cherry-pick the best opportunities as money comes in. Recently, we've seen sponsors of non-traded REITs diversify their offerings, even including some international properties."

If a client has, say, a $1.5 million portfolio, around $250,000 might be invested in non-traded REITs, according to Hutchinson. "We wouldn't invest all with one sponsor," he says. "Instead, we'd spread the money over different types of offerings from several sponsors, including CNL, Inland, Cole Capital and Hines Real Estate. We tell these clients to expect that money to be locked up for at least five years, and probably longer, so they should plan on holding for the duration."

In terms of specific investments, Hutchinson says, "We see opportunities in lifestyle properties, which offer drive-to vacations. The best locations are within 75 miles of major metropolitan areas. We also like REITs that own senior housing properties. If the housing market improves, older people will be able to sell their homes and move into [an] assisted-living [facility]. Then those REITs will do well." The key to any type of healthcare or medical REIT, according to Hutchinson, is to find private-pay facilities, rather than those dependent on government outlays." Seneff, another proponent of senior housing investments, adds that the lodging business-hotels-may also offer attractive buying opportunities now.

Regarding clients with fewer assets to invest, Hutchinson says that relatively small accounts get exposure to REITs through mutual funds. Tom Balcom, founder of IBIS Wealth Management in Boca Raton, Fla., also uses mutual funds as well as exchange-traded funds (ETFs) for exposure to REITs. "Even if a client has large holdings of investment properties," he says, "I'll still want about a 10% allocation to REITs. The client probably owns local properties while REITs make up a national asset class."

Downside Protection

For many of his clients, though, Balcom turns to structured notes for participation in REITs. "They can provide downside protection as well as upside potential. Advisors generally can access these structured notes through the trading desks of major investment banks."

Among the firms offering structured notes pegged to REITs are Barclays, Credit Suisse and Morgan Stanley. Terms vary, but the notes might last from 13 to 24 months. Investors' results can be pegged to the Dow Jones U.S. REIT Index, with the downside capped at around 10% and the upside capped anywhere from 15% to 40%. Assuming the index moves up during the term of the note and the cap isn't triggered, investors would get twice the index gain: a 10% return if the index is 5% higher, for instance.

"The only way you can lose with these notes," says Balcom, "is if there is a huge rally and you don't participate fully. My clients are willing to take that risk in return for the downside protection." Such structured notes have other drawbacks-lack of liquidity, lack of cash flow from real estate operations-but Balcom says the main concern is the issuing bank's financial stability. "You don't want another Lehman Brothers. For safety, we spread our structured notes among several different banks."

In general, advisors are asking more questions about REITs, no matter what their strategies might be. "We're seeing more interest from advisors on sophisticated topics," says Larkin. "For instance, has a

REIT's distribution been covered from its cash flow? Some REITs are not earning enough from operations to cover the distribution. That's essentially the same as taking on more debt. We tell advisors to look over a REIT's public filings. Examine the income statement to see if the distribution has been covered. Broker-dealers also have been helpful in educating advisors about this."

Income and low-correlation to stocks are also on advisors' minds, according to Larkin. And Seneff adds inflation protection as a prime concern: "Advisors and clients are interested in tangible assets that can do well in inflationary times. REIT sponsors can structure leases to get rent bumps to keep up with inflation."

Whether they take a strategic, tactical or combined approach, advisors are using a variety of categories of REITs to diversify portfolios and provide potential upside to clients.