Real estate investment trusts, with their generous dividends, are supposed to offer protection against stock market declines. But REITs' high yields haven't been much comfort this year. Punished first by fears that a strong economy would spark a glut of new construction, real estate portfolios recovered a bit only to fall victim to global credit jitters this fall. The upshot: Even as the Standard & Poor's 500-stock index is up 16.5% this year, REITs are down 16%. Mutual funds that invest in REITs are even worse off--down an average of 17%.
But some real estate pros contend the worst may be over. With the Federal Reserve cutting interest rates, the economic picture has brightened--though not to the point of reigniting fears of overbuilding. Indeed, REITs are still expected to post profit gains of 11% this year, according to the forecasting firm First Call. Next year, analysts anticipate 7% to 10% growth--not bad in a climate of anemic blue-chip profits.
Like many other small-company stocks, REIT shares have fallen so far that they're now relatively inexpensive by historical standards. But "yield alone makes them attractive," says Gregory Whyte, managing director at Morgan Stanley Dean Witter. At a time when the dividend yield on the S&P 500 has dipped to a miserly 1.4%, REIT yields are still at 6.8%. Thirty-year Treasuries yield only 5.4% these days, and utility stocks, traditionally favored by income-oriented investors, pay 3.6%.
Still, even REITs' strongest boosters acknowledge that the industry's outlook is not as rosy as it was a few years ago. This year has been a bust for REITs, which were one of the decade's hottest success stories. REITs, which buy hotels, offices, apartment buildings, and other properties, had given small investors access to a market dominated by wealthy individuals. In fact, before this year's correction, they also gave shareholders average returns of 20% a year since 1991, according to data compiled by the National Association of Real Estate Investment Trusts (NAREIT).
Back then, REITs were benefiting from three factors--improving occupancy rates, rising rents, and acquisitions of inexpensive property built during a construction boom that fizzled in the early 1990s. Today, two of those growth engines are sputtering. Bargains have evaporated along with vacancies. And occupancy rates are unlikely to increase now that the economy is slowing, says Lawrence Raiman, a REIT analyst at Donaldson, Lufkin & Jenrette.
SPOILING THE PARTY. But unless the economy enters a deep slump, REITs should be able to count on rising rents to prop up earnings, he adds. That's because no one wants to finance the new construction that depresses rents by unleashing fresh supply onto the market. In the past, when rents soared, developers spoiled the party by going on a building spree. In fact, the construction boom of the late 1980s was so extreme that commercial property values have only recently recovered, says Janice Stanton, director of investment research at Cushman & Wakefield, a real estate firm in New York.
This time, however, the capital markets are holding overly ambitious developers in check. With their stocks in the dumps, REITs have been unable to issue the new shares they relied on to fund development. And because commercial mortgage-backed securities cannot compete with Treasuries as a safe haven, investors already nervous about real estate have abandoned that market, prompting banks to curtail mortgage lending for new construction. "None of the developers has access to money," says Mike Kirby, a principal at Green Street Financial, a research firm specializing in real estate securities. "It's a lot tougher than it was six months ago."
If a cooling economy continues to take the steam out of overheated property values, analysts say some of the strongest REITs may resume the bargain hunting that helped fuel average returns of 36% in 1996 and 18% in 1995 and 1997, respectively, according to NAREIT. Even if the economy falters, REIT stocks should offer protection. Because only 5% to 10% of a typical large office building's leases expire each year, most tenants are unable to renegotiate the rent when a downturn hits, says David Sherman, managing director and the head of REIT research at Salomon Smith Barney. This recession-proof quality has given REITs a reputation as a safe haven in turbulent times.
True, this year REITs fell woefully short of that mark. But that's because of a rare convergence of several events, including fears of a speculative real estate bubble, the bear market in small-cap stocks, the international liquidity crisis, and a sell-off by traders alarmed by the sector's slowing earnings. Analysts caution that the stocks may remain choppy for the rest of the year as investors unload them for losses to offset taxable gains. "But if you want to be early, buy selectively now," says DLJ's Raiman, who expects returns to range from 10% to 15% over the next year, provided the economic picture does not darken too much.
CASH CUSHION. How can you find a good REIT? Stay away from companies that concentrate on areas where construction is strong, such as suburban Dallas and Atlanta, Sherman advises. And think twice about companies that give all their cash to shareholders. Having a cash cushion allows a REIT to raise its dividend even if income slips, says Kevin McDevitt, an analyst at Morningstar, which tracks mutual-fund performance.
In sizing up debt levels, keep in mind that the industry's average ratio of debt to real estate assets is about 40%. Still, REITs with stable, long-term leases--such as those concentrating on apartments--can afford to go as high as 70%, Sherman says. At the opposite extreme, hotel REITs are riskier, he adds. (You can find additional information about REITs at www.nareit.com.)
REITs with strong balance sheets are also in the best position to take advantage of more reasonable property values, says Joseph Harvey, senior vice-president and director of research at Cohen & Steers, which operates three open-end mutual funds specializing in real estate: Cohen & Steers Equity Income, Realty Shares, and Special Equity. Harvey likes Vornado Realty Trust, which owns shopping centers and offices and--together with another REIT, Crescent Real Estate Equities--controls about 30% of the refrigerated warehouse market. Trading at about 10.2 times next year's expected funds from operations--a term roughly equivalent to cash flow--Vornado commands a slight premium to the market's average multiple of 9.3, Harvey says. At 5.2%, its yield is also a little on the low side for a REIT. But with projected earnings growth of 20% in 1999 and "over $1 billion in potential buying capacity," the stock is worth it, he adds.
PROFITABLE PURSUIT. G. Ken Heebner, managing general partner of the Capital Growth Management Limited Realty fund, expects Prime Group Realty Trust to report earnings gains of 15% in both 1999 and 2000. A Chicago-based office-and-industrial REIT, Prime Group Realty Trust has several strategies, one of which is to refurbish old buildings. In a market experiencing 13% rent hikes, this is a profitable pursuit. Selling at 7.5 times next year's projected funds from operations, Prime Group Realty can afford to borrow if it spots good opportunities, Heebner says. And at 8.5%, the stock has one of the highest yields around.
If you lack the time or cash to construct a diversified portfolio of REITs, check out the 50-odd mutual funds specializing in the sector. With REITs trading at 13% above their October low, shareholders have reason to be optimistic. The real test, however, will come if the stock market turns ugly again: Then REITs will show whether their high yields can provide that much-vaunted downside protection.