REITS: AN EXCELLENT PORTFOLIO DIVERSIFIER, BUT SHOULD YOU INVEST IN THEM?

REITs, or Real Estate Investment Trusts, which are corporations or trusts that do not usually pay corporate income tax and are often tax-exempt for state income taxes as well, were created by law in 1960 as a rider to a Congressional bill. Structured much like an investment company or mutual fund, REITs own, develop, acquire and manage income-producing properties. This can include shopping centers, regional malls, hotels, apartments, mobile home parks, office buildings, industrial manufacturing, health care facilities and diversified REITs, which can include a number of different categories of properties as well as loans secured by these types of real estate. More extraneous types of REITs include golf courses, prisons and timberlands. They are also managed like a mutual fund. The management team selects a portfolio of investment properties – usually geographically diversified – on behalf of shareholders and manages the portfolio to enhance its value to shareholders. By law, to qualify as a REIT, they are required by their articles of incorporation to invest 75% of their assets in real estate and pay out 90% of all taxable income to shareholders.

There are three primary types of REITs:

• Equity REITs which own real estate and derive revenue principally from rent
• Mortgage REITs which loan money to real estate owners and generate revenue from interest earned on mortgage loans
• Hybrid REITs which combine strategies involving equity and mortgage real estate operations

While they have been in existence since 1960, it was not until October, 1993 that the modern era of REITs began. For the next few years afterward, numerous high quality/major player type real estate management companies became REITs and were traded on the major exchanges. Prior to that, REITs were mostly mom and pop type entities with very light trading on a daily basis. REITs, after late 1993, became a viable option for institutional as well as average investors because they were both large enough in terms of market capitalization and had significantly improved liquidity. Today, there are approximately 300 publicly-traded REITs, but realistically only 160 are institutionally investable. Total tradable capitalization today is approximately $250 billion.

The Case for REITs

Today’s REITs are not overly leveraged. Typically there is a little less than 50% leverage – better than most publicly traded corporations. Generally speaking, the first thing that comes to the astute investor’s mind when speaking of REITs is their high dividend yield. While still high, their spread over 10-year Treasuries (their historic yield benchmark) is narrowing. Yield is an especially attractive feature in non-taxable and retirement accounts. If this newsletter had dividend yield anywhere in the title, we could probably fold the case right here. However, we would much rather tout real estate’s ability to add meaningful diversification to an investor’s portfolio. We call it the diversification advantage of REITs. While it has risen a little in the last few years, the correlation of REITs’ returns with domestic equities (especially large caps) is still very low. See chart below.

Another advantage for REITs is that many have the majority of their debt in fixed rate form. Many investors who don’t truly understand REITs believe that when interest rates rise, REIT prices will fall. Actually, rising rates slow down new real estate construction, thereby making existing properties more valuable. Rising rates usually coincide with growth in the economy, which means more demand and hence increased rental rates. Ultimately, if interest rates rise high enough, it will mean lower returns for REITs due to vacancies caused by an economic slowdown. The REITs themselves will be less attractive due to there being less spread between their dividend yields and especially the 10-year Treasury yields. Small amounts of interest rate increases, especially as the economy is expanding, as it currently is, may actually enhance REIT returns. In fact, returns have come on very strong since the Federal Reserve Board started raising interest rates in May of 2004.

Furthermore, REITs have other advantages:

• A highly liquid form of owning professionally managed real estate;
• A strong track record of profitability through various market cycles;
• Ownership of property that has appreciation potential;
• REITs have low relative correlations (a similar pattern of performance) to broad market indices such as the S&P 500, Nasdaq Composite and the Russell 2000. Typically, REITs move similar to these asset classes approximately 35% of the time and often less and are therefore excellent diversification vehicles (see chart below). This chart is from the correlation matrix feature in Morningstar Principia Pro Plus. As a side note, we believe every advisor should be intimately familiar with the correlation matrix feature from Morningstar and should utilize it when designing new or analyzing existing portfolios to ensure adequate diversification.

• REITs have provided better returns since the beginning of 1990 through December 31, 2004 (11.84% as represented by The Wilshire REIT Index) than the S&P 500 (10.95%) with approximately 10% less risk. Since the beginning of 2000 through the end of 2004, REITs have increased 177.86% while the S&P 500 has provided a -10.82% total return.
• REITs have high dividends. Unfortunately, the dividends are fully taxable and not subject to the special 15% income tax rate, which was enacted in 2003. On the positive side, occasionally, additional cash distributions are made that are non-taxable. These distributions are called return of capital for income tax purposes, which actually reduce cost basis leading to a larger capital gain when sold.

REITs are subject to the usual risks such as recession, property damage and security threats, pricing problems, liability lawsuits, bad management, overbuilding, etc. However, there are other unique risks specific to REITs which include:

• In past years when discussions about changing the income taxation features of REITs have occurred (1998 for example), prices of these securities have sometimes dropped significantly.
• REITs, on average, are not as reliant on debt today as they were in the 1980s and most is of the fixed rate variety. However, some are heavily in debt. Also, where it exists, variable rate debt can cause significant financial problems as interest rates rise.
• Wall Street often causes significant problems by increasing the supply of REITs and selling additional amounts of equity through IPOs and secondary offerings. According to the Leuthold Group, REIT IPOs and secondary offerings for 2004 totaled $11.356 billion, the largest amount since 1997’s $16.299 billion. Coincidentally, in 1998, REITs suffered a steep decline in their prices and in 1999 they had a slightly negative return. Large amounts of capital being raised is one of the signs that the top is near.
• A great deal of hot money was invested into REITs in the second half of 2002. This is another sign that the market top is near.
• REITs are currently selling at a 13.2% premium above net asset value as compared to the stock market which is probably 40% overvalued based upon 10-year normalized P/E ratios. However, REIT prices are not as expensive as in 1997 and the premiums have recently decreased from higher levels reached earlier in 2004. Even REIT mutual fund managers are somewhat pessimistic. They expect REITs as a group to provide mid-single digit returns over the next several years, essentially what the dividends are, but they also expect to outperform the stock market. 

Overall, we believe REITs provide good diversification – better than most other asset classes. In our opinion, they should be part of almost everyone’s portfolio. Historically, since the early 1990s they have outperformed the S&P 500 with less risk and especially since the second quarter of 2000. However, one should not go overboard by placing too much of an allocation to REITs given that they are selling at a stiff premium, lots of cash flow is coming into REIT mutual funds, and the Wall Street offering machine is starting to work overtime.

For further information about evaluating the quality of a company’s earnings, call LOUIS P. STANASOLOVICH at (412) 635-9210.