Shareholders in real estate investment trusts, or REITs, have fully recovered from their spectacular tumble in 2008. This year, they are outperforming the stock market, with a total return of 14.9 percent, as measured by the FTSE NAREIT Index, against 9.5 percent for the SandP 500 stocks.
An average 3.5 percent dividend yield contributes to that performance, and therein lies much of the argument for real estate investment.
It goes like this: Americans frozen out of the home market are filling up apartments. Retailers are slowing filling vacant storefronts in shopping malls, and aging baby boomers should mean a growing market for health care REITs. The office market is still troubled, especially in the suburbs, but a few big cities are seeing revival.
Put all that together and it spells rising profits for landlords and rising payouts for REIT shareholders. Dividend yields today vary, mainly between 2 and 6 percent.
That’s the upside. On the downside, REITs in recent years have proved just about as risky as stocks. Since shareholders buy them for their dividend, they could be at risk if interest rates turn upward and income-loving investors switch back to bonds.
“As long as interest rates stay low, we’ll be bullish on REITs,” says John W. Guinee III, analyst at Stifel Nicolaus and Co. “If interest rates go up appreciably, you don’t want to be in REITs.”
REITs used to be a good way to diversify an investment portfolio. They moved a little when stocks moved a lot, giving investors a smoother ride over all.
That’s not true anymore. There’s now a fairly strong correlation between the stock market and REIT prices. Part of that is because big stock indexes began including REITs.
REITs matched the market during the great meltdown of 2008, falling 37 percent, dividends included. Then they bounced back, returning 28 percent in 2009, and again at 28 percent in 2010, and then 8 percent last year.
The 2008 crash had its roots in a real estate bubble. In normal market pullbacks, expect REITs to fall less than stocks, says Guinee. That 3.5 percent dividend yield gives them a cushion as money runs to safety. On the other hand, expect REITs to underperform a bit when stocks are on a roll.
REITs buy real estate, using borrowed money to do it. Some are generalists, while others concentrate in segments – office, industrial, retail, apartments, health care, self-storage, hotels, even timber.
By law, REITs must pay out at least 90 percent of their profits in dividends to shareholders, so rising profits tend to go directly to investors’ pockets rather than the corporate treasury or share buybacks.
But Uncle Sam wants his cut. REITs pay no federal income taxes, passing that burden on to investors. As a result, investors pay ordinary income tax rates on REIT profits distributed as dividends. They don’t get the lower rate afforded to stock dividends. However, a small portion of the REIT dividend may come in the form of capital gains and return of capital, which gets kinder tax treatment.
The average investor isn’t a real estate expert, notes analyst John Sheehan of Edward Jones in Des Peres. “The typical investor finds it hard to be a sector picker,” says Sheehan.
So, he recommends Realty Income (ticker symbol O, yield 4.3 percent), a retail property investor which has been branching out into other sectors. He calls it a good play on the real estate market. The company just raised its dividend, and is likely to do so again in August. “Four or five years ago, they were raising it every quarter,” says Sheehan.
Retail REITs took a beating in the Great Recession and the slow recovery. Not only were consumers stingy, but giant players such as Circuit City went broke, leaving big boxes abandoned across the country.
Now those boxes are slowly filling up again. Also, smaller retailers are starting to fill the empty storefronts in strip shopping centers.
“It’s starting to tighten up a little,” says Sheehan. “I think they’re finally starting to get some traction.”
Sheehan recommends Kimco Realty (KIM, 4.2 percent yield), as a play on the recovering retail space. It specializes in neighborhood shopping centers. Sheehan likes its big investments in other countries, such as Canada and Mexico, where the retail recovery has been stronger.
The crash in housing prices and soaring foreclosures has been a balm to the apartment market. Hard times turn homeowners into renters, and tighter lending standards keep would-be homeowners in their apartments.
At Stifel Nicolaus and Co., analyst Guinee likes Post Properties (ticker PPS, yield 2.1 percent), which concentrates on high-end apartments in the south, and United Dominion (UDR, yield 3.5 percent), an apartment owner in dense coastal areas.
Office REITs have produced wildly differing performance, depending on where they invest and how smartly. Lately, those with big investments in San Francisco and New York have been cashing in on hot real estate markets, says Guinee.
Kilroy Realty (KRC yield 3 percent) scored a 24 percent total return in the past 12 months. It invests in office and industrial properties, largely in California and Washington State. By contrast, Parkway Properties (PKY, yield 2.7 percent) lost 3 percent and invests mainly in offices in the Southeast.
Nationally, the office market has developed a dual personality: happy downtown and sad in the suburbs. Landlords in central business districts are doing okay, with vacancy at 14 percent and dropping, says Sheehan. But the suburban office market is still sick, with 18 percent vacancies and iffy prospects.
Besides high unemployment, which means less rental space, landlords have to contend with the digitizing work place. The amount of space needed per employee employee is shrinking. For instance, law firms need smaller libraries because law books are online.
That makes office REITs into comparative laggards, although they were still up 8 percent year to date through June 22. Guinee likes Douglas Emmett (DEI, yield 2.75), which owns offices in Los Angeles and Honolulu, along with New York landlord S.L Green (SLG, yield 1.32).
Graying baby boomers will be needing more assisted living. That’s why Sheehan likes Health Care REIT (HCN, yield 5.23), which is a demographic play on aging America. It owns medical properties, with an emphasis on senior living centers.
Investors who don’t feel comfortable picking individual REITs can use mutual funds. Vanguard REIT Index fund (VGSIX, yield 3.29) is a proxy for the entire industry, following the MSCI U.S. REIT index.
©2012 the St. Louis Post-Dispatch
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