For the last decade, through two recessions, Michael Agran has dedicated 20 percent of his investment portfolio to real estate investment trusts.
The Los Angeles tax lawyer said he has no plans to diminish his stake in the real estate equities, figuring he can achieve a return of at least 7 percent, through common and preferred shares, even as the prospect of an economic slowdown looms.
“If there’s a recession, where am I going to put my money?” Agran said. “Am I going to put it in the bank and earn a quarter of a percent a year? Not going to do that. Am I going to put it in Treasuries?”
Mutual funds that invest in U.S. real estate investment trusts have attracted the most new money since 2006 as buyers seek yield. Investors have added $3.7 billion to REIT funds this year, according to a Sept. 8 report by Citigroup Global Markets, a unit of New York-based Citigroup Inc. Assets in the funds, including exchange-traded funds, are at a record $96 billion, surpassing the prior peak of $87 billion in February 2007, the analysis said.
“REITs are attracting attention because of their income, the dividend yield, and the fact that REITs do own hard assets, which offer inflation protection,” said Philip Martin, REIT strategist at Chicago-based research firm Morningstar Inc.
‘Starved For Income’
Most REITs are publicly traded companies that own and operate property including apartments, offices, retail, self-storage facilities and hotels. They must distribute at least 90 percent of their taxable income to shareholders annually in the form of dividends. Investors generally pay ordinary income tax on these distributions.
Investors are “so starved for income” that they’re lured by REIT yields, said Larry Glazer, a managing partner at Mayflower Advisors in Boston, which has almost $800 million in assets. The securities had an average dividend yield of 3.7 percent as of Sept. 12, according to the Bloomberg REIT Index of 129 publicly traded property owners. That compares with yields on 10-year Treasury notes of about 1.95 percent as of Sept. 12, and 0.02 percent for the seven-day compound yield of the average taxable money-market fund as of Sept. 6, according to research firm iMoneyNet.
“REITs could continue to attract modest amounts of capital given low interest rates,” Michael Bilerman, head of the real estate and lodging team at Citi Investment Research & Analysis and author of the firm’s Sept. 8 report, said in an e-mail.
Equity REITs give investors dividend yield and the potential for price appreciation, said Mark Biffert, senior REIT and commercial real estate analyst at Bloomberg Industries. The Bloomberg REIT index hit a 52-week high on July 22, before falling 23 percent by Aug. 8, Bloomberg data show.
Dividend growth and payouts from REITs are heavily dependent on the underlying portfolio’s ability to generate cash flow, primarily through rents and rental growth from tenants, said Martin of Morningstar.
Equity REITs have had an average annualized dividend growth rate of 5.75 percent the last two decades as of August, or more than double the average rate of inflation, according to Morningstar. Annual dividend growth is projected to be from 4 percent to 6 percent for the next several years, likely exceeding inflation, Martin said.
Those convinced that the U.S. is “at the beginning of a horrible recession” should be wary of investing in REITs because an economic decline would weaken demand for commercial space, increase vacancies and limit cash flow at income-producing properties, said Ralph Block, the Westlake Village, California-based author of the Essential REIT newsletter and the upcoming fourth edition of “Investing in REITs” guidebook.
“For anybody to make an investment it requires some kind of faith in the future,” Block said. “It requires faith that businesses are going to be profitable, they’re going to want to grow, they’re going to want to take more space. If you don’t think any of that’s going to happen, you shouldn’t be investing in REITs.”
Agran, the Los Angeles investor, said he’s relying on higher dividends from preferred shares to get him past any market downturn. He said he plans to rebalance his REIT allocation, so that 50 percent of his investments are in REIT preferred stock and 50 percent in common shares to put his portfolio in a “safer position.”
Bloomberg’s Biffert said he looks at rent growth and the ability to drive cash flow over the long term when evaluating REITs. “You’d want to increase your exposure to sectors where cash-flow growth is outpacing inflation,” he said. The average inflation rate through July was 2.9 percent, Bloomberg data show.
Apartment REITs are projecting net operating income growth from 4 percent to 6 percent this year, Biffert said. Retail shopping center rents are projected to grow from 1 percent to 2 percent in established markets, offices in core central business districts such as New York and San Francisco may rise as high as 2 percent, and suburban office rents may decline 2 percent to 3 percent. Industrial properties may be flat to down 1 percent, he said.
“The growth outlook for commercial real estate will be highly dependent on asset type, quality and market,” Biffert said.
REITs and Inflation
Since 1974, REITs generally have outperformed other assets, including gold, during periods of high inflation, data from the National Association of Real Estate Investment Trusts in Washington show. That’s because commercial REITs generally structure leases that let them adjust rents periodically to respond more quickly to inflation, said Michael Grupe, executive vice president of research and investor outreach at NAREIT.
REITs don’t protect a portfolio in all types of inflationary environments, said Robert Greer, product manager of Pacific Investment Management Co.’s “Real Return” business, a series of funds and strategies designed to protect against inflation. “REITs may not protect you from inflation caused by a rise in food and energy prices, especially if caused by a constraint in supply,” he said.
Another consideration is whether the flows into REITs have bid up prices ahead of the potential for appreciation, said Sam Katzman, chief investment officer at Constellation Wealth Advisors, a New York-based firm managing about $5 billion in assets.
While the industry is currently trading at a “slight discount” to fair value, according to Morningstar analysis, apartments are among the more “overvalued” types of REITs, said Martin. “We’d be very, very company, stock and geographic specific there.”
Demand for apartments has soared in the U.S. as home foreclosures forced people out of their residences and prospective buyers have found it harder to get mortgages. Equity Residential, the largest publicly traded apartment REIT in the U.S., has gained about 16 percent year-to-date as of Sept. 12. AvalonBay Communities Inc., the second-biggest multifamily housing owner, has gained about 19 percent this year.
“Property types including office, industrial, retail and lodging may experience more operating performance volatility if the economy stalls, which may negatively impact dividend growth, cash flow and share prices,” Morningstar’s Martin said. The research firm is focused on REITs that can weather a slower economic environment including those with lower debt levels and dividend payout ratios, and ones that invest in more need-driven properties such as health-care facilities and grocery-anchored shopping centers, he said.
Even in a slow-growth economy, commercial properties with longer leases will do well because they have a set amount of cash coming in and there isn’t a lot of competition since there’s little construction right now, said Jon Cheigh, senior vice president at Cohen & Steers, a New York-based firm with about $44.3 billion in assets, the majority of which is in real estate.
Agran, the Los Angeles investor, said he generally sees publicly traded real estate as a good investment no matter what the economy does or where inflation goes. In flush times, the firms can raise rents, while in recessionary periods, they have access to investor capital to buy properties that others are disposing of “at bargain-basement prices,” he said.
“With real estate it’s kind of like being in the business of making waxed fruit,” he said. “It’s there, it’s going to be there.”