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Hot returns can lure you into the wrong REIT
Some funds specializing in real estate play conservatively, while others take the aggressive route. Here's how to dig before buying.
By Timothy Middleton
Funds that invest in real estate have been beating the market this year, as they did throughout the bear market of 2000-2002. With yields in the neighborhood of 6.5%, they look irresistible to many investors -- especially those on fixed incomes.
Real estate investment trusts have done well nine out of 10 years, says Marty Cohen, co-manager of Cohen & Steers Realty Shares (CSRSX). If Bill Gross and Warren Buffett are right, and the best you can expect in coming years is a 7% return, if you start with 6.5% on a REIT portfolio, you dont have to do much else to reach that level.
But real estate isnt a super-slide toward wealth. REIT funds dont benefit from President Bushs dividend tax cuts, and because so much of their total return comes from income, they dont get much of a break on lower capital-gains taxes, either.
Also, the nations commercial-property markets arent exactly rolling in clover. With unemployment rising, office buildings are hurting for tenants; hotels are vacant; apartments cant compete with low-rate mortgages.
Finally, picking the REIT fund thats right for you is anything but easy. The top performers arent necessarily the stable, steady hands conservative investors prefer. The thing the investor has to always keep in mind is not only the ride, but the speed of the ride, says Barry Vinocur, editor of Realty Stock Review, a newsletter that tracks property stocks.
Style purity and the lack thereof
The buccaneers in the property market do not confine themselves to property stocks. Home builders aren't REITs, but theyve been hot stocks lately. Funds that invest in them, such as CGM Realty (CGMRX) and Alpine U.S. Real Estate Equity (EUEYX), come out on top in any ranking that takes performance into account. They're both up about 40% this year.
So buy, but dig down into fund strategies before doing so.
Cohen, for example, wouldnt touch home builders with a 10-foot two-by-four.
Home builders are not real-estate companies, he says. Some mutual funds own shares of home builders, but I couldnt sell that to my clients. Strict property investors insist on style purity; home building belongs to the consumer-discretionary sector, according to Standard & Poors, while REITs are considered financial stocks.
Cohens fund, one of the oldest and best in the group, sticks to the marketplace defined by the National Association of Real Estate Investment Trusts, the trade group for property companies that distribute at least 90% of their earnings to shareholders. (They escape taxation, which is why they're exempted from the dividend tax cut.) The industries it represents are offices, apartments, shopping centers and malls, industrial, hotels and health-care facilities.
Funds of this type, which are the most numerous in the category, try to beat the Morgan Stanley REIT Index ($RMS.X) by rotating into strong groups, like retail currently, and away from downtrodden areas such as Sept. 11- and SARS-ravaged hotels.
Yes to office buildings, no to apartments
The Cohen & Steers fund, which is up about 17% this year, is heavily overweight office buildings, for contrarian reasons, and underweight apartments for more mainstream reasons.
Cohen says investors are so down on skyscrapers that office REITs are trading at substantial discounts to the value of their real estate. He believes job growth will come sooner than later, leading to rentals and rising REIT prices.
He dislikes apartments for the same reason everybody else does: With mortgage rates at historic lows, the best tenants are becoming homeowners. But low rates also encourage speculative development, so apartment buildings continue to be built even though existing ones are failing.
Enter home builders. The median home price nationwide has soared to more than $225,000 from less than $180,000, thanks to low rates that keep monthly mortgage payments about the same. Sam Lieber has more than 50% of the assets of Alpine U.S. Real Estate in companies such as home builder The Ryland Group (RYL, news, msgs).
Alpine manages another fund in a different fashion, and the pair illustrate the differing strategies property investors can follow. The other fund is Alpine Realty Income & Growth (AIGYX) and, as the name suggests, is focused on current income. That calls for a more conservative approach.
This is the closest thing Ive got to a widows-and-orphans fund, Lieber says. Typically, income amounts to roughly two-thirds of the total return that real estate has contributed over the past 25 years.
Common vs. preferred
So whereas U.S. Real Estate owns the common stock of Prime Group Realty Trust (PGE, news, msgs), a Chicago-centric office owner, Realty Income owns Primes preferred stock, which owes its shareholders a dividend of 9%.
The common, whose price collapsed when the dividend was cut, has new management and what Cohen thinks are good prospects. The price collapsed to $3 from $14 two years ago, and Cohens fund bought at an average price of $4. Prime now trades around $6 and we think its still got a few bucks to go, Cohen says.
But the common is too risky for income investors, he believes, so his income fund owns the preferred. Owners of preferred shares are first in line for dividends and, in the event of bankruptcy, have higher claims on assets than the common stock. Although Prime's preferred isnt paying a dividend currently, eventually it must.
The appreciation potential (of the preferred) is not great. Theoretically, its capped at a 60-odd-percent return, plus income, whereas we can double our money or more on the common, he says.
From energy to real estate
The most straightforward of the income funds is Stratton Monthly Dividend REIT (STMDX), which currently pays out 16 cents, or $1.92 a year, on shares with a net asset value of around $39.40, a 4.9% yield.
Until the early 1990s, the fund invested in electric utilities, switching to REITs when utilities began cutting their dividends. Drawn by yields of more than 9%, the fund has about an eighth of its assets in health-care REITs, a dowdy and depressed corner of the market because of unrelenting pressure on hospitals to cut costs.
Shrewd stock-picking has guided James Stratton to one of the highest Sharpe ratios in the sector -- a measure of return per unit of risk. The fund is ahead about 15% this year.
But the emphasis is on that monthly payout. Co-manager Jim Beers says many of his investors cash those checks, rather than reinvesting them, as is common with mutual funds.
Vinocur, whose newsletter tracks REIT mutual funds and who regards the Sharpe ratio as a prime analytical tool, says there are about 70 distinct funds, but he makes no attempt to rate them.
Its very difficult to homogenize them, he says. Lieber and CGMs flamboyant manager, Ken Heebner, will appeal to bold investors, and Stratton to conservative ones.
Youve got to look at the investment approach of the fund, and make sure its consistent with what youre trying to do.
A good place to start examining REIT funds is with our Deluxe Screener. Ive created a search that emphasizes strong managers, high Sharpe ratios and excellent long-term performance, which you can examine with this link.
What they're buying
Shop til you drop: Strattons Beers has made a major bet on New Plan Excel Realty Trust (NXL, news, msgs), a national shopping-center operator. Retail has performed quite well the last two years, he says, and New Plan has relatively new managers Beers believes have devised and are executing a stronger business plan than their predecessors.
Looking east and west: Even though Cohen doesnt like most apartment REITs, he makes exceptions for Essex Property Trust (ESS, news, msgs) and AvalonBay Communities (AVB, news, msgs), which operate on the high-cost coasts. There are barriers to entry there, and the cost of single-family homes is much higher than the national average, he says.
At the time of publication, Timothy Middleton didnt own any securities mentioned in this article. He is writing a book about Bill Gross, chief investment officer of Pimco Funds, to be published by John Wiley & Sons.
At the time of publication, Timothy Middleton didnt own any securities mentioned in this article.
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