Now, Dividend Huntersare Stalking Reits

Given the severe ups and downs of real estate investment trusts over the past two decades, it seems incongruous to mention them in the same breath as conservative utility stocks. But with higher interest rates, regulatory problems, and competition threatening the generous dividends of many utilities, investors are increasingly turning to high-yielding equity REITs.

REITs, which acquire and operate apartment buildings, office complexes, and other commercial real estate, are currently offering dividend yields of 6% to 9%. An overload of new issues has pushed prices down about 6% from last September's highs, presenting some attractive buying opportunities. And equity REITs have generally held up better than stocks: Total return this year was 5.18% through the end of April, compared with 2.42% for the Standard & Poor's 500-stock index.

RESURGENCE. REITs are tax-free corporations that pass on at least 95% of their income to shareholders. But they've had a checkered past: Speculative real estate loans caused them to blossom and then crash in the 1970s, while heavy leverage led them to climb and plunge again in the late 1980s. Yet these days, they are enjoying a resurgence because of the recovering real estate market, which has allowed trusts to pick up good properties on the cheap.

The darkest cloud on the horizon for REITs is rising interest rates, which increase capital costs for property owners and could slow growth prospects. So far, though, REITs have shaken off recent rounds of Federal Reserve rate hikes. "Interest rates would hurt only if they rose really high," to, say, around 9%, says Fred Carr, a principal at Boston-based Penobscot Group, an adviser to institutional investors. The good news, he says, is that if rates are rising because the economy is improving, some REITs in certain sectors and areas of the country, such as the Southwest, can raise rents. Of course, that wouldn't apply to commercial real estate projects that are locked into long-term leases or in segments still slowly recovering.

VESTED INTEREST. In choosing a REIT investment, the most critical concern is management. REIT operators should be experienced not only in buying and selling properties but in running them. Look for management with a substantial ownership stake--10% or more. "When someone's got their money in side-by-side with yours, that tends to minimize mistakes," says Dean Sotter, a principal with Chicago-based PRA Real Estate Securities Fund.

Sotter and other pros say investors should make sure there's enough cash generated by operations to cover dividend payouts. Because REITs pass the bulk of their earnings on to shareholders, operating cash flow--not earnings per share--is the most important measure of a REIT's health. Investors should also steer clear of highly leveraged REITs. Generally, debt should be no more than 40% of stockholders' equity. Perhaps more important is the kind of debt: Fixed-rate, amortizing, long-term debt is preferable to the shorter-term, floating-rate kind, which can boost cash flow and lift the dividend yield but leaves a REIT vulnerable to a rise in short-term interest rates.

Investors should also examine the prospectus and other government filings to check the quality of assets and look for consistency in the portfolio by geographic region or property type. Are the properties located in an area where population and jobs are increasing and rents can be raised? Do they have high occupancy rates? Are the leases long-term?

While many investors buy REIT stocks for their current dividend yields, they should also look for REITs with the potential to increase yields 5% to 10% annually. Those are often trusts that are adding new properties or improving existing ones, which should result in higher rents, and in turn, an increase in cash flow and dividends. The National Association of Real Estate Investment Trusts (202 785-8717) offers other general information in its free pamphlet Frequently Asked Questions about reits.

DRIVE FOR VALUE. One promising REIT sector is factory-outlet centers. Specializing in manufacturer-run stores offering name-brand merchandise at deep discounts, these centers are the fastest-growing segment of the retail industry. "Demand is being driven by consumers who are looking for value and are willing to drive 30 to 40 miles out of their way to get it," says Samuel Lieber, manager of Evergreen Global Real Estate Fund. Yielding 6% to 7%, factory-outlet REITs, such as Horizon Outlet Centers, based in Muskegon, Mich., should rack up 20%-to-25% dividend gains over the next two years, thanks to new developments, expansions, and lease renewals at higher average rental rates, Lieber says.

How well factory-outlet centers continue to fare hinges on whether they can stand up to competition from value-conscious traditional retailers. Potential overbuilding is another issue. New development is driving the growth in this sector, which currently includes about 300 centers. An additional 98 are expected to come on line by the end of the year, according to Value Retail News, which tracks this industry. "When the development opportunity goes away, investors will have to be ready to jump out," says Barry Vinocur, editor of the Realty Stock Review in Shrewsbury, N.J. The current thinking is that the sector has perhaps two to three years of heady growth left.

Another hot REIT area with strong prospects is trailer parks, which the industry prefers to call manufactured, or mobile, homes. While mobile homes don't offer the fat rents enjoyed by office buildings or apartment complexes, they have the advantage of low vacancy and turnover rates. An average manu-factured-home community loses 4% of its tenants a year, while an apartment complex may see as many as half of its residents move in a year.

That means a reliable cash flow for trailer-park REITs. Investment pros are particularly high on Chicago financier Samuel Zell's Manufactured Home Communities, which owns 50 high-quality, mostly retiree communities in 17 states. PRA's Sotter expects Manufactured to increase its dividend 8% to 10% annually as cash flow gets a boost from acquisitions and rent increases.

Perhaps the biggest beneficiary of rent increases in an improving economy will be apartment REITs, particularly in the Southwest and Southeast. Construction stopped earlier in these markets than elsewhere in the country after the oil bust hit in the mid-1980s.

Now, as occupancy rates edge above 95%--thanks, in part, to spectacular population and job growth--rents are rising 6% to 10% a year, says Penobscot's Carr. He recommends Camden Property Trust, which owns developments in the South. He thinks Camden can increase cash flow and dividends by at least 15% a year.

SHOP CAREFULLY. Not everyone is optimistic about apartment REITs. "They're trading at a big premium to their underlying asset value," says Jon Fosheim, a principal at Green Street Advisors, which counsels institutional investors. "We think there's evidence that growth is slowing." Fosheim's REIT pick? DeBartolo Realty at less than $15 a share. He figures DeBartolo, the Youngstown (Ohio) spin-off of Edward J. DeBartolo Corp., one of the nation's largest regional mall owners and operators--has an underlying asset value of $18 a share. Although the country is pretty much saturated with conventional malls, they should benefit from the revival of department stores such as J.C. Penney and Sears Roebuck, says Fosheim.

The riskiest REIT sector is office buildings. Although the market has bottomed out, office buildings will see a slow recovery because there was so much overbuilding during the 1980s' real estate boom. If history is any guide, proceed carefully in REITs, especially in a sector that has been driven by excessive optimism.

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