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4 reasons to take shelter in real estate
Real estate investment trusts have sheltered their investors from the worst of the market's declines. They're great diversifiers and risk relievers, but outsized returns may be a thing of the past.
By Timothy Middleton
Real estate mutual funds have gone through the bear market like Tiger Woods through the Buick Invitational, but that's not the only reason you ought to take a look at them.
Real estate, long associated with blowhards like Donald Trump, is suddenly cool with professional money managers, because in addition to making money, its doing double duty as a risk reliever.
Money has cascaded into real estate investment trusts, or REITs, and into the mutual funds that invest in them. Property funds had net inflows of $2.89 billion last year, according to Financial Research, up from only $82.7 million the year before.
4 reasons REITs look attractive
Exhibit A: In the bear market for stocks, when the Vanguard 500 Index Fund (VFINX) tumbled an average of 13.9% in each of the three years ended Jan. 31, the average mutual fund investing in REITs shot up 12.2%.
Exhibit B: Unlike bonds, which have done better than stocks lately but face inevitably higher interest rates, property stocks march to their own drummer. REITs have virtually no correlation to any index of fixed-income securities, and almost zero correlation to any equity benchmark, says Robert Steers, co-manager of Cohen & Steers Realty Shares (CSRSX), one of the largest funds in the industry. With REITs you get true diversification (away) from both stocks and from bonds.
Exhibit C: It isnt just their diversification benefits that make REITs stand out. A study by Ibbotson Associates published last year found that between 1972 and 2001, a portfolio with 20% of its assets in REITs outperformed traditional asset blends, and did so with less risk.
Exhibit D: Income returns currently run about 7.5% -- far more than you can confidently expect to get from any other asset class.
Is the party over?
Unfortunately, REIT returns in the three years to come arent likely to match the double-digit gains of the three years just past. REITs are economic laggards, protected against downturns by their leases but saddled with low rents when the economy revives. Their robust rally of 2000 and 2001 began to die in the middle of 2002.
The odds are that a big portion of the total returns over the next few years are going to be primarily from income, says Sam Lieber, manager of Alpine U.S. Real Estate Equity Fund (EUEYX).
The typical American already has the majority of his or her net worth tied up in real estate, though it's in the form of the family home. In investment portfolios, by contrast, commercial real estate barely shows up. The total capitalization of public companies investing in property -- and the sector continues to be dominated by partnerships and other non-public ownership structures -- is only $156 billion, according to Standard & Poors, which amounts to just 0.42% of the S&P Super 1500 Index.
To a different drummer
Share prices of REITs move in syncopated rhythm, out of step with stocks and bonds. The prices of financial assets tend to be more forward-looking, whereas REIT prices, driven by their yields, look back at the trends influencing current payouts. Academic studies have shown REIT prices have a very low correlation with stocks and almost none with bonds.
Although a handful of property companies are conventional C corporations, more than nine in 10 are real estate investment trusts. REITs have the tax status that C corporations can only hope President Bush will win for them, exemption from tax on the income they pass on to investors.
To gain the exemption, REITs must pass at least 90% of their taxable income directly to shareholders who do pay taxes on it. And the resulting dividend payouts can be lush. Vanguard REIT Index Fund (VGSIX) yielded 6.59% in the 12 months ended Jan. 31, according to Morningstar.
REITs own hotels and hospitals and mortgages on commercial buildings, but the big three industries within the sector are owners of office buildings, apartment buildings and malls and shopping centers. Together they account for two out of three REITs.
Each of these industries moves in its own cycle. The Cohen & Steers fund, usually a leader in the group, fell to the bottom third of the pack last year because it was overweight office REITs, which were hurt by rising vacancies, and it was underweight retailing, which benefited from its defensive nature.
Office space
In our view, beyond any debate, the office sector is the cheapest on both valuation metrics of any sector in the real estate world, says Steers, referring to its discount to asset value and low multiple-to-growth ratios. Conversely, shopping centers have the largest premium to asset value in the entire REIT sector, so its our view that after several years of outperformance, shopping centers will underperform.
Barry Vinocur, editor-in-chief of Realty Stock Review newsletter, says the majority of REIT investors continue to favor retail companies, such as Simon Property Group (SPG, news, msgs). The Indianapolis, Ind.-based company is the nations No. 1 mall operator, with properties in 36 states. Possibly the best known is the Mall of America in Minnesota, the nations largest. Consumer spending has remained surprisingly strong in recent years, protecting malls from vacancies.
The segment doing worst among REITs is apartments. Demand has shrunk radically as what Vinocur calls renters by choice were lured into home ownership by low interest rates, while other renters lost their jobs and moved back home. But supply has continued to increase, because even single-digit returns from property look good compared with falling returns from bonds and negative returns from stocks.
Office buildings are kind of in the middle, Vinocur says. One school of thought, to which Steers subscribes, is that they're screaming bargains. But most REIT investors are still worried about a rising national vacancy rate. According to CB Richard Ellis, the national metro office vacancy rate was 13.5% in the fourth quarter of 2002, up from 11% in the first quarter of 2002.
So with two of its three principal legs weak, the property market peaked around April and has been in decline since. Despite their lofty yields, real estate funds are down an average of 2.3% this year, as of Feb. 19.
Stronger than you think
REITs are discounting either a double-dip recession or continued bad operating results in a lot of markets, says Richard Imperiale, manager of Forward Uniplan Real Estate Investment Fund (FFREX). He insists fundamentals are stronger than most people think, although he doesnt foresee gains in the coming year anything like the double-digit returns he racked up in 2000 and 2001.
Timing aside, real estate has proven itself effective at cutting portfolio risk. What's more, REITs can improve overall portfolio returns, claims Chicagos Ibbotson Associates.
Ibbotson specializes in analyzing market statistics, and last year it published research that examined investment returns since 1972. Although the modern REIT era was born in the early 1990s, the child of tax reform, REITs go back to the 1970s.
Ibbotson found that switching 20% of assets away from stocks, bonds and cash boosted a portfolios total return 0.4 percentage points annually.
| Improved returns, lower risk with REITs | | Allocation | Return | Risk | | 50% stock, 40% bonds, 10% cash | 11.3% | 10.9% | | 45% stock, 35% bonds, 10% cash, 10% REITs | 11.5 | 10.5 | | 40% stock, 30% bonds, 10% cash, 20% REITs | 11.7 | 10.2 |
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Note: Annualized returns, 1972-2001
Source: Ibbotson Associates
Real estate managed that feat by moderating the risk of the overall portfolio -- by making money when other asserts werent, such as in the high inflation of the 1970s and in the bear market that began in 2000.
We have added REIT funds in the last couple of years as a kind of inflation protection without the risk of high-growth funds, says Diahann Lassus, a principal of Lassus Wherley & Associates, a New Providence, N.J., investment advisory firm. Weve added them as a kind of risk balancer.
I used to think that the average investor has so much exposure to real estate, in the form of the family home, that owning a REIT fund was superfluous. I was wrong. Clearly, commercial real estate owned in the form of a REIT fund is an asset class unto itself that significantly increases a portfolios overall efficiency.
What they're buying now
A brand new start of it: At the Forward fund, manager Imperiale likes S.L. Green Realty (SLG, news, msgs), which he calls the quintessential New York play. The company focuses on non-trophy office buildings, which the industry calls Class B space. That doesnt mean dowdy. S.L. Green owns the MetLife (formerly the Pan Am) building above Grand Central Station on Park Avenue, as well as other fashionable addresses, albeit in dated, aging buildings.
Make it a double wide: A non-REIT in the portfolio of the Alpine fund is Clayton Homes (CMH, news, msgs), which makes manufactured housing. Many of its rivals fell victim to aggressive accounting and financing in the late 1990s, reducing competition and restoring pricing power to the survivors. Forty percent of retail outlets for mobile homes are gone, says Lieber. Claytons in a position to grow its business.
At the time of publication, Timothy Middleton did not own any of the securities mentioned in this article.
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