0111 Whether or Not to Invest in REITs

Whether or Not
to Invest in REITs
(Real Estate Investment Trusts)

Anyone pondering the relative desirability of real estate investment trusts or REITs needs to examine: 1) overall financial markets, 2) personal financial objectives, and 3) specifics of the real estate industry. The following briefly examines each of these.

Financial Markets

The U. S. stock market has enjoyed an unprecedented rise through 1997. Some investors, however, are becoming more nervous about the prospects for a continuing rising market. The Value Line investment survey views a total market appreciation potential in the next three to five years of 35 percent, or about 7 to 11 percent per annum. This is far less than the 20 to 30 percent returns of the last few years. At the same time, interest rates seem relatively stable, especially near term. Hence, some advisors and analysts recommend that concerned investors look at an industry that is considered defensive and should hold up well in case of a market slide: real estate.

Financial Objectives

When people speak about real estate stocks, they usually are discussing real estate investment trusts, known as REITs. REITs have a unique corporate structure that requires approximately 95% of the company’s income be distributed to the stockholders. Consequently, REITs have one of the strongest dividends of any industry with an average return of about 6 percent. The dual benefit of such a stock, besides a good dividend, is that it is normally protected from a severe price decline. Should the stock price begin to go down, the yield becomes greater. If the dividend is reliable, it therefore becomes more attractive to yield conscious investors who will more eagerly support a stock the greater the yield becomes. Hence, this is a major reason REITs can be viewed as defensive. In light of the current overall market, certain investors may have a financial objective to increase their exposure to defensive stocks; purhcasing REITs either individually or through real estate mutual funds may satisfy this.

Second, the attractive yield of a stock is often a major incentive for many investors, especially those who need a fairly reliable source of income. This is particularly true for people near or in retirement. With a nation of aging baby boomers, the scarcity of investments with good yields can make REITs most appealing.

Third, as people accumulate more assets or become older, they are often more concerned with portfolio diversification and maintaining assets rather than growing them. Asset diversification among different types of stocks and other asset classes (such as bonds, a home, collectibles, a business, investment real estate, etc.), all help protect the financial security of an individual or a family. Some advisors recommend that at least 10 percent of the stock holdings be invested in REITs. This would be especially true if little or no other real estate is owned.

Fourth, appreciation potential is another desirable financial objective. It is often given up with higher yielding securities. Yet, REIT returns have exceeded those of most major indices for most of this decade and still provide attractive overall returns.

In summary, REITs can provide attractive income, low volatility, downside protection, appreciation potential and portfolio diversification. If these are important personal financial objectives for you, then you will want to look closely at investing in REITs individually or through real estate mutual funds.

The Real Estate and REIT Industry

It may seem as though REITs are too good to be true. They seem as though they would fit into any portfolio except those where income is not desired. However, some advisors are cautious because of developments in the REIT industry.

The REIT industry has grown at an astounding rate. From a capitalized value of some $10 billion at the beginning of the 1990s, REITs showed a capitalized value of nearly $140 billion at the beginning of 1998. one REIT alone surpasses $10 billion today and a few others are close. In order to maintain strong earnings and Funds From Operations (FFO) growth, REITs are acquiring or merging with other REITs, acquiring more properties and developing properties. Some analysts warn that REITs are paying too much for their acquisition of companies and for properties. However, of most concern is that the development will exceed at such a rate that it will create overbuilding. At worst, another real estate recession will occur; at best, a reduction in rental rate increases will reduce the growth of earnings, FFO and dividends. Also, the recent White House scrutiny of "paired shared" REITs dampened enthusiasm in general for most REITs in the beginning of 1998.

More optimistic analysts of REITs believe that the investment community is savvy of markets and trends and will curtail REIT capital and debt funding before markets become too overheated. Therefore, they consider a real estate recession to be highly unlikely. Throughout much of the country, vacancies are declining, pushing rental rates up, which helps increase the earnings of REITs. Further, the consolidation and larger size of major REITs provides efficiencies that decrease certain expenditures. Also, there are new opportunities for REITs in specialized property areas, such as prisons, entertainment, auto dealers and parking lots. Some REIT analysts also view the current yields of REITs to be attractive and the PE ratios to be more reasonable than the market as a whole. FFO and dividend growth rates are expected to slow in the next few years, but not appreciably. This may prohibit strong appreciation of REITs in the near term, but it does not preclude their modest appreciation to create total returns of 12 to 18 percent. Such returns (or more) could be achievable over the next few years, especially if interest rates continue to decline, as some economists expect. And some analysts view the present time, with concern about "paired share" REITs, to be a good time to purchase REITs in general.

Beyond REITs

Although the discussion of real estate stocks has been confined to REITs, it can be expanded to include developers, construction firms, home builders, building material firms, property services (brokers, managers, etc.) and others. However, the dynamics of these industries can be quite different than for REITs. Another important difference is that all non-REITs are in corporate entities that do not require such a heavy distribution of dividends, and therefore have much lower yields than REITs. Consequently, non-REIT real estate stocks are not considered as either defensive or income stocks and therefore may fail to meet as many financial objectives as REITs. They may, however, provide greater appreciation potential and should be considered if that objective outweighs other factors.