TCS Daily


Putting on the REITs

By James K. Glassman - April 2, 2002 12:00 AM

Many investors have discovered real estate stocks over the past couple of years -- and for the obvious reason. They were going up while almost everything else was going down. During 2000 and 2001, the Vanguard REIT Index fund, which tracks the Morgan Stanley index of real estate investment trusts (REITs, pronounced "reetz"), returned a whopping 42 percent. Meanwhile, Vanguard 500 Index, which tracks the benchmark index of the broader stock market, fell 20 percent.

Of course, real estate stocks don't always go up. They plunged, for instance, in 1998 and fell slightly in 1999 -- years in which the rest of the market zoomed upward. But that's the whole point. At a time when the shares of many companies -- including those based outside the United States -- are moving in tandem with the U.S. market, REITs offer balance and stability for portfolios because they have what economists call "low correlation" with other stocks.

A study last year by Ibbotson Associates examined two portfolios over the period 1972 to 2000. The first was allocated this way: 50 percent stocks, 40 percent bonds and 10 percent short-term Treasury bills. The second: 40 percent stocks, 30 percent bonds, 20 percent REITs and 10 percent T-bills. Thanks to low correlation, the second portfolio was less risky than the first -- and it returned a little more. It's clear that every portfolio could use REITs; they make a good substitute for both stocks and bonds.

Long ago, REITs had a well-deserved reputation as volatile companies, deep in debt and run by risk-loving property jocks. No more. There are now 159 publicly traded REITs identified by their trade association (www.nareit.org), with a market capitalization (or value according to investors) of about $1 billion each. The best of them are good citizens, slowly and consistently raising their dividends. Despite the slowdown in the economy, their fundamentals have remained sound. And as interest rates on bonds have dwindled, REIT dividend yields have remained enticingly high. At the same time, investors have soured on a more traditional source of dividends -- utility stocks -- as the California meltdown and the Enron cataclysm put the industry in turmoil. So REIT stock prices have soared.

Consider Duke Realty Corp., one of the sturdiest of the REITs. Over the past five years, it has returned a total of 89 percent, including price increases and dividends. Duke, based in Indianapolis, owns nearly 1,000 separate properties -- mainly industrial and suburban office and retail space in the Midwest and Southeast -- worth about $5 billion. Duke currently pays an annual dividend of $1.80 a share. The stock hit a 52-week high on March 21 of $26.45, so its yield ($1.80 divided by $26.45) was 6.8 percent, which compares favorably with the 5.4 percent yield on 10-year Treasury bonds on that date.

Of course, one of the differences between Treasury interest payments and REIT dividends is that the latter aren't guaranteed by the U.S. government. REIT dividends can fluctuate, or disappear altogether. But they rarely disappear. Duke, for example, has raised its payout every year since it went public in 1993 with a dividend of just 84 cents. Equity Residential, one of three REITs that overcame a foolish prejudice at Standard & Poor's and were admitted to the S&P 500-stock index recently, has also boosted its dividend every year since inception. The string of consecutive increases at Federal Realty, based in Rockville, stretches back to 1991; at Kimco Realty, to 1992. United Dominion Realty, based in Richmond, has increased its dividends for 26 years in a row; Washington REIT, a D.C.-area firm that owns office buildings, apartments and shopping centers, for 31 years.

Another large REIT, New Plan Excel, increased its dividend every year from 1988 to 2000 -- from 70 cents to $1.65. But a slower economy hurt earnings last year, and management decided to hold the dividend steady. As a result, the stock price dropped, and investors who bought shares in late 2000 and early 2001 were treated to dividend yields in the double digits. The price has since recovered, but on March 21 New Plan was still yielding a hefty 8.1 percent.

New Plan is worth closer examination. It is stodgy enough to be included in the model portfolio of one of the investing world's most famous curmudgeons, Charles Allmon, editor of Growth Stock Outlook, a Chevy Chase newsletter. Allmon has been bearish for, oh, about a decade now, and he includes only six stocks in a portfolio that, overall, is 80 percent in cash. New Plan is Allmon's oldest holding, joining the list in 1994.

No wonder the cautious Allmon likes New Plan. With relatively low debt, it's the only one of the 23 REITs covered by the Value Line Investment Survey that wins a top ("1") rating for safety. Most REITs have a specialty, and New Plan concentrates on income-producing community shopping centers and malls, anchored by big supermarkets such as Publix and Albertson's and discount chains such as Wal-Mart and J.C. Penney. One of New Plan's major tenants, however, is Kmart, which filed for Chapter 11 bankruptcy protection this year.

At a hearing Jan. 22, Kmart filed a motion to reject 335 leases, but only two of them (with revenue of just $1 million) were held by New Plan. The REIT has 38 other Kmart leases in its portfolio, but few appear in serious jeopardy, and New Plan is well diversified, so no single company's bankruptcy can cut deeply into profit. Still, New Plan's adventures with Kmart illustrate the risks in REITs. Shares fell 5 percent on the Kmart news (a big drop for a REIT), but they have since risen sharply, hitting a 52-week high this month.

In examining REIT financials -- in Value Line's subscription research service (available at most libraries or online), or on Internet sites such as Yahoo Finance or MSN MoneyCentral, or at the companies' own Web sites -- what should you look for?

Hamid Moghadam, the chief executive of AMB Property Corp., a San Francisco-based REIT that specializes in warehouses near major airports, has been an outspoken advocate of earnings transparency. REITs are trusts that pass through their profits in the form of dividends to shareholders, who pay the taxes. The industry has long had a tradition of concentrating investors' attention on a profit figure called "FFO," or "funds from operations." This number has its nuances, but it essentially represents cash flow -- mainly, old-fashioned earnings with depreciation added back in and capital gains or losses from the sale of properties excluded. Moghadam, however, prefers standard earnings, reported using generally accepted accounting principles. It's good to look at both numbers to be sure they have been rising consistently.

Moghadam also tells investors to watch the ratio of a REIT's total dividend payments to its FFO. At some REITs, such as Equity Residential, Kimco and AMB itself, the ratio runs between 60 percent and 65 percent, so that, in tough times, those firms should have enough cash to keep dividends flowing. But at others, including Crescent Real Estate, the ratio has sometimes exceeded 80 percent.

What's remarkable about most REITs is that they have continued to increase their earnings, FFO and dividends despite the economic slowdown. "We're still growing earnings at 5 to 6 percent a year," Moghadam told me. "Business is not terrible." But on a scale of 1 to 10, he says that the period from 1998 to 2000 was an "11," but now it's more like "5" or "6." That should change, but often real estate lags the general economy in a recovery.

The safest way to buy REITs is through mutual funds, which typically package about two dozen of them in a single portfolio. The analysts at Morningstar pick two in particular: Security Capital U.S. Real Estate, which produced average annual returns of an attractive 10 percent for the five years that ended 2001, and Columbia Real Estate Equity, which had lower returns (8.3 percent) but also lower expenses and a lower risk rating. Another fund, Third Avenue Real Estate Value leans toward standard real estate "C" corporations rather than REITs. As a result, dividend yields are far lower, averaging just 1.2 percent, but price increases are higher. The fund is relatively new, but in the three years ended Dec. 31, it has returned an annual average of 18 percent, beating the S&P by 19 points.

The largest REIT fund, Cohen & Steers Realty Shares, has assets of more than $2 billion and average annual returns over the past 10 years of more than 12 percent. The fund's top five holdings are well diversified: Equity Office Properties, Vornado Realty, Starwood Hotels & Resorts, Avalon Bay Communities and Boston Properties. Cohen & Steers charges a reasonable expense ratio of about 1 percent, but the Vanguard index fund, which has done about as well and which owns more smaller REITs, charges only one-third of a percentage point. Cohen & Steers also offers a closed-end REIT fund, Cohen & Steers Advantage Income Realty Fund, that trades like an individual stock on the New York Stock Exchange under the symbol RLF.

Whichever you choose, get yourself some REITs. If you're a young investor who can take more risk, a small REIT holding makes sense, but investors closer to retirement can comfortably buy enough REITs to represent 10 percent of a portfolio.

A version of this article first appeared in the Washington Post.
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