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Put the real-estate boom in your portfolio
Real-estate investment trusts have been flying high, and will remain a value as long as interest rates remain low. I'll be adding a REIT fund to my model ETF portfolio.
By Timothy Middleton
It's a familiar story. Like everything else having to do with property, real-estate investment trusts have been on fire. Even with an early-year pause, the stocks are up 20% a year over the past five years.
Despite those gains, the REITs should continue to climb, so long as interest rates stay low. And the best-informed buyers -- industry insiders -- don't appear to think the shares are too pricey. Twice in the last week, major real-estate investment trusts have been taken over or taken private, each time at a premium to market prices.
"Clearly the private market (sees) real value in these assets," says Martin Cohen, co-manager of Cohen & Steers Realty Shares (CSRSX), one of the largest mutual funds that specializes in property stocks.
The value they see could make mutual funds that specialize in REITs a valuable addition to your portfolio. They yield more than bond funds, and they can appreciate like stock funds as the value of their holdings increase over time.
The current regime of low and stable interest rates is friendly to REITs. Landlords can finance cheaply, and tenants can afford higher rents as the economy improves. The bond market, moreover, is predicting this favorable climate will remain in place for years.
So most investors can benefit from having 5% to 10% of assets invested in REIT funds. The model portfolio of exchange-traded funds I maintain will be adding a REIT fund when I rebalance later this month.
Competition keeps yields high
REITs are real-estate companies that pay out virtually all of their income as dividends to investors. Tax law allows them to avoid paying corporate taxes on these dividends, and those tax savings boost yields. At the end of May, the average REIT was yielding 5.2%. By comparison, the 10-year Treasury yields 3.9%.
About one-quarter of the $300 billion domestic REIT market is invested in industrial and office buildings, and another quarter in retail stores. Apartment buildings account for 15% of the industry's market capitalization, with the balance distributed among hotels, hospitals and other niche markets.
REITs were beaten down in the late 1990s because their single-digit returns looked miserable compared with technology stocks. When that bubble burst, however, REITs soared.
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"We've seen a repricing of the real-estate market," says Samuel Lieber, manager of Alpine U.S. Real Estate (EUEYX), one of the best performers in this sector. Bond yields are falling and stock prices are going up in single digits. "Investors have ratcheted down their expectations for returns over the next several years," he says.
And investors have also decided long-term interest rates are not going to rise, even though short rates have tripled in the last year. REITs are income-producing securities and compete for investor attention with bonds, so they have to pay higher yields when rates go up.
Bond king Bill Gross of Pimco put his imprimatur on low and stable rates in his most recent market commentary. Gross is manager of the largest bond mutual fund, Pimco Total Return Fund (PTTRX), and he had been concerned about higher rates until recently.
Now, however, he sees the threat of inflation diminishing and the demand for Treasury bonds increasing. "We believe a range of 3% to 4.5% for 10-year Treasurys will prevail during most of our secular time frame," which is the coming three to five years.
That yield was 4.25% when short rates began to rise one year ago. Last week it was 3.9%. Until recently, many forecasters had been expecting it to rise to a range of 5% to 6%.
Real-estate industry insiders are voting in favor of stable rates with their pocketbooks. Last week, ProLogis (PLD, news, msgs) agreed to acquire another REIT, Catellus Development (CDX, news, msgs), for $3.6 billion, a 16% premium over the share price before the deal was announced.
Also last week, a Dutch group announced a deal to buy Gables Residential Trust (GBP, news, msgs) for $2.8 billion, a 14% premium, and take it private. It is the largest public-to-private conversion of a residential REIT.
One way to own property in Europe
My colleague Jim Jubak last week likewise came out for lower interest rates in the wake of "no" votes on a European constitution by France and the Netherlands.
The REIT structure was only recently allowed in France, and isn't expected to be recognized in Germany and the United Kingdom until next year, but already the foreign REIT market is nearly as big as the domestic one.
Domestic REITs are not strongly correlated with the stock market, and foreign REITs are even less so, owing to factors like currencies and regional economic growth.
For investors seeking diversification, there are several choices. Lieber also manages Alpine International Real Estate Y (EGLRX). Fidelity Investments launched a new fund, Fidelity International Real Estate (FIREX), last September. The manager, Stephen Buller, has managed other real estate portfolios since 1998. In 2003, the only full year he managed a public portfolio, Fidelity Advisor Real Estate A Fund (FHEAX), it went up 32.4%.
In my ETF portfolio, I use iShares Cohen & Steers Realty Majors (ICF, news, msgs), and that's the fund I'll be adding at the end of this quarter. There are three other REIT ETFs, but this one tracks elite companies and has done much better than, for example, iShares Dow Jones U.S. Real Estate Index (IYR, news, msgs).
According to Leuthold Group, some REITs are trading in the market for 10.8% more than the value of the property they own. Thomson Financial reports that while insider selling in the REIT industry has contracted this year, insider buying has shrunk even more, from an average of $7.5 million monthly last year to just $1.4 million per month this year.
Despite Cohen's optimism, therefore, REITs could be overvalued. Certainly no one expects 20% annual gains from property stocks going forward. But I expect them to beat Treasury bonds in the second half of this year, so they have a place in the fixed income portion of my portfolio.
At the time of publication, Timothy Middleton didn't own any securities mentioned in this article.
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