Have REITs Lost Their Footing?

With dividend yields now below those of T-Bills, it could be time for smart investors to beat a retreat

If you've profited from the seven-year run in REITs, now might be the time to pull back. The total return on shares of publicly traded real estate investment trusts has been some 300% since the end of 1999, and many now look overpriced. In fact, the rally has wiped out a big part of REITs' appeal: attractive dividend yields.

The average REIT now yields only 3.6%. That's less than half the 8% REITs paid in 2000 and 1.3 percentage points lower than the current yield on Treasury bills. The last time REIT payouts dropped below Treasuries, in 1998, REITs fell 17%. And those comparisons were against higher-yielding 10-year Treasury notes. REIT yields have never been this low relative to T-bills.

By law, REITs must pay out 90% of their taxable income in dividends, and historically those payouts have accounted for much of their total returns. With such low current yields, today's investors can only hope that REITs will increase their payouts or that their underlying property values will continue to rise. Yet REITs, with average cash-flow growth of about 5% or 6% a year, usually don't grow fast enough to offer large dividend increases. And property values, especially in the office and apartment REIT sectors, have become quite frothy.

REITs currently trade at a 7% premium to their underlying property values, or net asset values (NAVs), according to Green Street Advisors Inc., a REIT research firm. That's not exorbitant by historical standards: The premium was 33% in 1997, right before 1998's slide. But it's not cheap either as REITs traded at a 20% discount when the sector bottomed in late 1999.

That 7% premium may also be understated as a rash of buyouts last year helped push up NAVs. That's because unless the share price increases as much as the NAV, the premium falls. "Every time a REIT is taken out at a price significantly higher than its NAV estimates, analysts ratchet up their valuations," says Keven Lindemann, director of the real estate group at Charlottesville (Va.) researcher SNL Financial. He cites Blackstone Real Estate Partners' November buyout, at $48.50 a share, of Equity Office Properties Trust. The high NAV estimate on the Street at the time was $42 a share. "The only way the deal makes sense is if Blackstone thinks the real estate in a private sale would be worth $60 a share," he says.


To an optimist, such acquisitions are an indication REITs may still have running room. To a more bearish investor, it could mean NAVs are now inflated.

Lindemann argues that REITs' status as an asset class separate from bonds or stocks justifies their increase in valuation, because they've taken on an increasingly important role in portfolios. "They've matured as an asset class to the point where pension funds allocate a separate portion of their portfolios to them," he says. "So there's a lot of capital flowing into the market."

REITs that own shopping malls is one group that seems more reasonably priced than the others. "They are operating high-end malls where the consumer is still quite strong," says Mike Kirby, Green Street's director of research. He likes Simon Property Group (SPG ), General Growth Properties (GGP ), and Taubman Centers (TCO ). Green Street's estimated 2007 price-operating earnings ratio for mall REITs is 24, vs. an estimated 26 for all REITs and 15 for stocks in the Standard & Poor's 500-stock index. So they're cheaper than their peers but no screaming buy.

Some money managers have started to hit the exits. GMO, a Boston firm with $127 billion under management, sold much of its REIT position at the start of 2006 after being bullish for years. "This was the first time since 1998 that we started to dislike REITs more than we disliked the rest of the stock market," says Ben Inker, GMO's director of asset allocation. Inker expects REITs' annualized total return for the next seven years to be -0.2%, even with dividends. The stock market, he predicts, will deliver 0.8%.


Interestingly, as investors have piled in, REITs have begun to behave more like conventional stocks. Their plump yields, which served as a cushion during past downturns, are gone, and they've become more volatile and more correlated with stocks. "There are many days now where we see a 1% move in REITs," says Sam Lieber, who as CEO of Alpine Woods Capital Investors runs $2.2 billion in real estate mutual funds. "We didn't see that previously." Exacerbating the problem: In recent years, REITs have been incorporated into broad market indexes such as the S&P 500, and large index funds now buy and sell them with the rest of the market.

Regardless of whether one views REITs as a real estate or a dividend play, there are alternatives. Many non-REIT companies own real estate yet don't command such rich valuations. Lieber favors hotel stocks, such as Hilton Hotels (HLT ), Starwood Hotels & Resorts Worldwide (HOT ), and Orient-Express Hotels (OEH ), that don't have high yields but are considerably less expensive. On average, such stocks trade at 11 to 13 times Lieber's 2007 estimates for their cash flows, vs. the 17 to 24 times for the REITs he follows. He also thinks luxury hotel chains might become acquisition targets.

If your primary interest is yield, Lieber points to bank stocks such as US Bancorp (USB ) and Bank of America (BAC ), which have dividend yields of about 4%. They also have better prospects for earnings growth than REITs, since they can reinvest their profits.

Beyond stocks, GMO's Inker recommends Treasury Inflation-Protected Securities. Like real estate, TIPS' values rise with inflation. Currently, TIPS yield 2.3% plus the inflation rate. Inker expects a 4.8% annualized return for them through 2013.

Of course, no one suggests dumping REITs entirely. But until yields start to rise again, you may want to trim your REIT position and hold off on throwing any new money their way.

By Lewis Braham

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