When Is It Un Real Estate?

The case for REITs is strong, but they may be becoming too popular

There's an ancient joke about a visitor to New York City being talked into an unwise real estate investment--the Brooklyn Bridge. Well, real estate investment trusts are so hot this year, their stocks up a whopping 17%, that chary investors have a right to wonder: Is the REIT boom only just beginning, or are investors being sold a latter-day version of you-know-what?

In fact, the arguments for REITs are still compelling. REITs are akin to closed-end mutual funds except that they own portfolios of properties instead of stocks or bonds. So long as rates remain low and doldrums persist in commercial real estate, abetted by ongoing Resolution Trust Corp. auctions, REIT operators will keep on snapping up worthy properties at bargain-basement prices. With their costs remaining low and rents apparently firming, REIT operators are generating yields that often exceed 7%.

BEWARE OF DOGS. "Essentially, what's happened is that investors realize REITs are the only way to take advantage of the liquidity crunch in the real estate market. All the traditional sources of capital for the real estate industry have gone away," notes John Moran, who tracks REITs at Kidder, Peabody & Co. The result is a boom in initial public offerings by new REITs and secondary stock offerings by old ones.

The spate of recent REIT stock offerings have generated ample commissions for underwriters, of course. But investors haven't made out so badly either (chart). And some bulls argue that even an upturn in rates won't hurt REITs too badly, especially if the economy strengthens and commercial real estate prices firm. "It's clear we've passed the bottom in many geographic areas and property types. As the economy gets better, commercial rents will be rolling over at higher rates"--keeping yields healthy, says Barry Greenfield, a veteran fund manager who heads the Fidelity Real Estate Investment Portfolio, a REIT mutual fund.

But playing the REIT game at this stage can be hazardous. Skeptics warn that the REIT boom is likely to attract less desirable operators--such as spin-offs from financial institutions desiring to expunge crummy properties from their inventories. Investors can avoid such dogs by sticking to experienced REIT operators who have significant equity interests in their operations. Moran says another rule of thumb is to buy REITs with yields at least as high as 30-year Treasury bonds (now 6.9%), a capital structure of no more than 40% debt, and a preponderance of long-term debt. Some companies, he notes, load up their balance sheets with short-term debt to lower their financing costs and thus boost their yields artificially. Moran's favorites include the newly public Taubman Centers Inc., a shopping center developer, and Bradley Realty Trust, a veteran real estate organization that owns shopping centers in the Midwest.

WILD CARD. REITs look so good that a problem has cropped up: excessive popularity. Just the other day, for instance, retail behemoth Merrill Lynch & Co. recommended that investors over-weight their portfolios with REITs. "It's the end of the cycle when everybody starts talking about REITs. It's always been that way," cautions Arthur Bonnel, manager of the MIM Stock Appreciation Fund. He notes that a similar REIT boom, 20 years ago, ended in disaster for investors.

Bonnel points out that one potentially worrisome wild card in the REIT biz is the upcoming tax bill. But Moran feels the bill could help REIT investors by freezing the capital gains tax rate. REITs must pay out at least 95% of their profits to avoid taxation, and part of their payouts consist of capital gains. So a capital gains freeze could boost the relative attractiveness of REITs as income vehicles for high-bracket investors.

Buying REITs may still be anathema to investors with sour memories of the real estate bust of the late 1980s. With all the IPOs rushing to market, brokers will be pushing them hard. There may be a few suspension bridges in the bunch, but REITs are still worth a look.

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