TCS Daily


By James K. Glassman - May 7, 2004 12:00 AM

Rising interest rates have meant falling stock prices for real estate investment trusts, or REITs (pronounced "reetz"), which are companies that own portfolios of property or, in a few cases, mortgages.

In fact, REITs have gotten clobbered.

Between April 1 and April 27, the Bloomberg REIT Index dropped 12 percent, even after taking dividends into account. Simon Property Group (SPG), the largest shopping-center REIT, with properties that include the gigantic Mall of America in Minnesota and Forum Shops at Caesars Palace in Las Vegas, lost 18 percent of its value in three weeks. Equity Office Properties Trust (EOP), the biggest office REIT, dropped 12 percent in April, and Public Storage Inc. (PSA), which owns 1,400 storage facilities, fell 14 percent. Apartment REITs, such as Archstone-Smith (ASN) and AvalonBay Communities Inc. (AVB), have fared better, but they have still dropped nearly 10 percent.

The best way to understand this decline is that prices have fallen so that dividend yields can increase to become more competitive with bonds. For example, if a REIT is paying a dividend of $1 on a stock price of $20, then its yield is 5 percent (1/20=0.05). A 5 percent yield looks pretty good when interest rates on 10-year Treasury bonds are 3.8 percent, as they were a month ago.

But around that time, medium- and long-term interest rates started shooting up -- because of new data about a strengthening economy, new fears about higher inflation and new noises from the Federal Reserve about hiking short-term rates. With the 10-year T-bond at 4.4 percent (as it was in the middle of last week), a REIT yield of 5 percent doesn't look so attractive -- after all, real estate companies don't guarantee their dividends the way the federal government guarantees its interest payments.

So, REIT prices fell. At $17 a share instead of $20 a share, a REIT that pays a dividend of $1 has a yield of 5.9 percent (1/17=0.5882). That's more like it, investors believe.

In fact, the average yield for the 155 REITs that make up the Bloomberg index -- which includes every REIT with a market cap of at least $15 million -- was 5.95 percent on Tuesday. Simon was yielding 6.2 percent; Equity Office, 7.9 percent; Archstone-Smith, 6.3 percent; AvalonBay, 5.6 percent.

"A correction in REIT stocks is certainly justified," stated a report last week from Deutsche Bank. The question now is whether this is a good time for investors to add REITs to their portfolios.

Jonathan Clements, the personal finance columnist for the Wall Street Journal, thinks not. "This isn't the right time for REITs," he wrote April 21. "I would want to see a further 15 percent drop before I bought with any great enthusiasm."

Even if rates hadn't risen, according to the Deutsche Bank analysts, REITs were headed for a fall. They had gone too far too fast, went the reasoning. For example, the Vanguard REIT Index Fund (VGSIX) returned 36 percent last year after averaging gains of 15 percent annually from the start of 2000 to the end of 2002. The fund produced positive returns in each of those three years, while the benchmark Standard & Poor's 500-stock index was registering losses in each.

Maybe. But what goes up sharply doesn't always come down sharply. NAREIT, the REIT industry's association, looked at the six best-performing years for REITs prior to 2003. Each of those years (with average gains of 35 percent) was followed by another impressive year (with average gains of 19 percent). So far in 2004, REITs are down about 3 percent.

I frankly have no idea whether REIT stock prices will rise, but I have been a longtime fan of real estate stocks, and I still am. A year ago I wrote, "Are real estate stocks just too good to be true?" My answer was that, while REITs had enjoyed a terrific run, they were still wonderful investments -- in large measure because they had a "low correlation" with the rest of the market. In other words, when REITs are rising briskly, other stocks tend to be declining, or not rising as much -- and when REITs are declining, other stocks tend to be rising, or not declining as much.

Low correlation among assets is what you want in your portfolio for a smoother ride.

REITs also give investors exposure to a key segment of the U.S. economy. It's easier -- and safer -- to get that exposure through REITs, which are bunches of properties run by experienced managers, than by buying real estate yourself. Unless you are very rich, you won't get proper diversification, and, unless you have a lot of time on your hands, you won't be able to manage your properties with skill and efficiency.

Certainly, there's nothing wrong with owning a townhouse or a condo to get a consistent stream of income. But to own shopping centers, hospitals, hotels, office buildings, industrial parks and apartment complexes, you need REITs.

Yes, there are risks. When interest rates rise, bad things can happen to real estate.

First, REITs themselves borrow money to buy property, and the interest rates on some of that debt will increase, cutting into profits. Consider Rouse Co., the developer of Columbia, Md., and Summerlin, a community west of the Las Vegas strip. Rouse has $4.5 billion in debt and pays $223 million in interest on those loans. If the rate on Rouse's overall debt rises half a percentage point, that's $22 million in additional expenses, a big number for a company whose net profit in 2003 was $140 million.

The second problem with higher rates is that the companies and people who rent the properties that REITs own may become strapped for cash themselves as their borrowing costs rise. And the third problem is the one I cited at the start: When five-year Treasury notes shot up from 2.8 percent to 3.5 percent, Rouse's dividend yield, which in fact was 3.5 percent on April 1, lost some of its luster. So Rouse's stock fell, and its dividend yield is now 4.3 percent.

On the other hand, maybe the three negatives are outweighed by a single positive. As the Deutsche Bank analysts put it, "Rising interest rates imply a stronger economy which would benefit all property types." In other words, rates rise because business is booming, companies are earning higher profits and more people are employed at higher salaries. As a result, the properties that REITs own can boost their rents a lot more easily than in a sluggish economy when it's tough enough just to sign leases.

The Deutsche Bank analysis, which I find convincing, points out that, when interest rates start rising, the yield on 10-year Treasurys typically increases 2 to 3 percentage points over 12 to 18 months. So expect T-bond rates of 6 percent or so by the end of 2005. Currently, the REIT index is yielding about 6 percent, but, with REITs, unlike with bonds, investors have growth on their side. Deutsche Bank expects earnings and dividends to rise between 5 percent and 8 percent a year. Value Line projects 7.5 percent annual dividend growth for Rouse over the next six years.

(By the way, Rouse is not technically a REIT but a conventional corporation that owns and develops real estate. A REIT is a trust that must pass through 90 percent of its earnings to shareholders, who then pay the taxes. The 2003 tax cut reduced the rate on dividends for most companies to 15 percent, but for REIT dividends the rate remains the same as for all other ordinary income, including salary and bond-interest payments: a top rate of 35 percent.)

Growth is what makes a REIT different from a bond. Look at Washington REIT (WRE), which owns 66 properties -- office buildings, apartments, shopping centers and industrial distribution centers -- between Philadelphia and Richmond. In 1988, it paid a dividend of 63 cents a share; that payout has risen each year since, and it's expected to be $1.55 for 2004. The dividend yield for Washington REIT is 5.4 percent, but imagine if, over the next 16 years, the dividend increases by 11/2 times once more. Your original investment will be returning nearly 14 percent in the 16th year -- and rising.

For most investors, the best way to own REITs is through mutual funds because they offer diversification and good management at a relatively low cost.

The Vanguard fund, a proxy for the entire sector, has a rock-bottom expense ratio of just one-quarter of 1 percent. Cohen & Steers Realty Shares (CSRSX), launched in 1991 by two of the best managers in the business, Martin Cohen and Robert Steers, charges 1.1 percent in expenses and has produced almost the same returns as the Vanguard fund over the past five years -- an annual average of 12 percent. But Cohen and Steers did slightly better than Vanguard last year, and they've been around longer. Either makes sense.

Cohen and Steers also manage several closed-end funds, including C&S Quality Income Realty (RQI), which returned a spectacular 50 percent in 2003, its first full year. Also worth considering are Fidelity Real Estate Investment (FRESX) and Principal Investors Real Estate Securities (PREPX), a relative newcomer with a fine track record. Principal's top holding is General Growth Properties Inc. (GGP), which concentrates on shopping centers and got murdered in the recent downdraft, losing 24 percent in the first 25 days of April.

If you want to be selective, then consider a recommendation from Merrill Lynch to buy health care REITs that own nursing homes, acute-care facilities, rehabilitation hospitals and the like. Two examples are Health Care Property Investors Inc. (HCP), which yields 7 percent, and Healthcare Realty Trust Inc. (HR), yielding 6.9 percent.

But remember that many responsible analysts see REITs as too expensive, still. Value Line, for example, ranks REITs 98th -- last! -- among all the sectors its researchers cover.

My own view is that market timing is as senseless for REITs as for other investments. Don't guess about the direction of prices or interest rates. If you don't own REITs, get some -- maybe 5 to 10 percent of your stock holdings. They'll add ballast to your portfolio, and you'll reap nice dividends along the way.


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