Holding real estate trusts can add stability to your investments without reducing your returns.

Kathleen is an investment newbie who has started digging into financial statements to do a better job of analyzing stocks. But she was flummoxed when trying to assess a company that was similar to one I had written about in the May issue. When she sent me the symbol, I understood why. She wasn’t looking at an ordinary stock; she was looking at a real estate investment trust.

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But REITs are different from regular com­panies, and that makes them trickier to analyze. REITs invest in real estate or loans on real estate. Some 90% of REITs own properties, generating most of their income from rents. Moreover, all REITs are required by law to distribute 90% of their earnings to shareholders.

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To be sure you’re buying a REIT at a good price, compare its share price to its funds from operations, or FFO. FFO is calculated by adding back depreciation deductions to earnings. Tax law allows a company to write off the value of long-term assets to recognize their diminishing value over time. That’s a nice tax break, but it doesn’t cost a REIT any cash, nor does it affect the value of a com­pany’s assets. And unlike, say, computers, real estate tends to gain, rather than lose, value over time.

You can also compare a REIT’s share price to its net asset value (NAV)—that is, the value of all of the properties it owns. Assuming that the assets are valued accurately, buying at a discount to NAV means you’re getting a bargain.

But what Kathleen was asking about, and what I hold, are mortgage REITs. Instead of owning properties, these REITs invest in the mortgages on those properties. Lending on commercial property is risky, especially in a dicey economy. But I think it’s worth taking a chance on mortgage REITs because I believe the economy is improving and because I am more worried about inflation than a new recession. Mortgage REITs benefit in two ways from an improving economy: Their clients, commercial landlords, collect more rent, improving their creditworthiness. And a rising economy can boost the value of the real estate that serves as collateral.

But even when I gamble, I gamble carefully. So I consider a mortgage REIT’s cash flow and asset value, just as I would with a traditional REIT. I also scour recent financial reports for other investment clues.

With Starwood, two things give me comfort. The company projects that earnings will grow 3% to 12% in 2012 based on its existing mortgage portfolio; but it says the projection doesn’t account for deals in the works, which could increase revenues by nearly 25%. The company also brags that its borrowers have a lot of equity in the deals, providing a measure of safety.

As for Apollo, the price I paid for the shares ($16.02) represented a slight discount to its NAV, which makes me think I got a relative bargain. Apollo also restructured its debt. That should lower its costs and improve profitability.

I rushed to buy both REITs so that I’d be able to collect the rich dividends. Sure, I knew the price would drop to reflect the payout, but I think investors have a visceral, positive reaction to dividends that tends to buoy the stock. It doesn’t make great logical sense. But we are the market and we are not infinitely logical.

Kathy Kristof is a contributing editor to Kiplinger’s Personal Finance and author of the book Investing 101. Follow her on Twitter. Or email her at practicalinvesting@kiplinger.com .

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