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A REIT is a company that buys, develops, manages, and sells real estate. Some focus on particular property types like apartments, shopping malls, or office buildings, while others own diversified portfolios. In exchange for preferential tax treatment, REITs distribute at least 90% of their taxable income to shareholders. As a result, they tend to blur the line between stocks and bonds, combining high dividend yields with consistent capital appreciation.
Like the broader real estate market, REITs enjoyed phenomenal returns in 2004. (See "REIT Sector Performance," below.) For example, the Morgan Stanley REIT Index gained more than 31% last year, dwarfing the S&P 500 and even outpacing the Russell 2000's impressive 18% gain. In fact, REITs outperformed every major market sector last year, many by a wide margin.
Market-beating returns are nothing new to REIT investors. Since 2000, the National Association of Real Estate Investment Trusts (NAREIT) Composite Index has averaged gains of over 23% per year. Compare this to the S&P 500 and Nasdaq Composite indexes--both of which have averaged negative returns since 2000--and it's easy to see why REITs are becoming so popular.
"They have performed this well in part because they were so undervalued in 2000," says Alex Peters, CFA, who manages $2 billion in real estate investment products, including Franklin Real Estate Securities Fund. Peters, a vice president at Franklin Advisers in San Mateo, Calif., cites Indianapolis-based Simon Property Group (SPG) as one example. "In 2000, the company was an amazing bargain in the low 20s with a 9% yield. Part of what we've seen lately is just a return to more rational industry valuations." SPG now sells for about $60 per share with a yield near 4.6%.
The collapse of the technology bubble also helped propel REITs higher. "After the technology sector imploded, investors turned to more stable asset classes," Peters says. "The focus shifted to firms with real earnings and dividends. REITs were an obvious choice."
Falling interest rates were another REIT catalyst. "Declining interest rates helped REITs in two ways," notes Michael Bergmann, Ph.D., senior executive vice president and cofounder of Denver-based AMG Guaranty Trust, which manages more than $2.5 billion in assets. "Lower financing costs helped to boost REIT profits, and falling rates also made REIT dividend yields more attractive compared to bonds and other fixed-income securities."
But after five straight years of outperformance, REIT valuations are stretched thin. At the end of 2000, the average REIT traded for less than nine times funds from operations (FFO)--a commonly used measure of REIT operating cash flow. The typical REIT now trades at a price-to-FFO multiple of nearly 14.5.
Premiums to net asset value are also at extreme levels. Historically REITs have traded roughly 5% to 7% above their net asset value--a modest premium. But according to Bergmann, the typical REIT now sells for more than 10% above the value of its underlying real estate holdings.
In addition, real estate capitalization rates have fallen precipitously in the past three years to near-historic lows. Capitalization rates, called cap rates for short, are calculated by dividing a property's net operating income by its price. They provide a general gauge of how much the market is currently willing to pay for real estate income. Low cap rates signify that investors are bidding up real estate prices without a concurrent rise in overall net operating income or property market fundamentals.
Extended valuations aren't the only problem facing REITs. Speculation is also creeping into the REIT market. Last year, 29 new REITs went public, more than double the number of REIT public offerings during the prior five years combined. In addition, REITs raised almost $39 billion in new capital during 2004--the highest yearly total since 1997.
Inflows into real estate mutual funds have also reached stratospheric levels, topping $6.7 billion in 2004, including $1.3 billion in December. With inflows into closed-end REIT funds, total fund inflows were over $9 billion for the year.
"We're beginning to see a feeding frenzy among REIT investors," cautions Matthew Chope, a CFP and partner with Southfield, Mich.-based Center for Financial Planning. "Capital flows into real estate mutual funds are at historic highs, valuations are exorbitant, and new offerings are flooding into the marketplace. To me, this feels an awful lot like the technology bubble back in the late 1990s."
Another problem facing REITs is rising interest rates. Because REITs are capital-intensive businesses that often rely heavily on debt financing, higher interest rates mean higher capital costs and lower REIT profits.
But rising interest rates also mean more competition for investor funds. The average REIT now yields around 5%, only slightly higher than 10-year Treasuries. As rates rise, bond yields will eventually surpass REIT dividend yields, enticing many income-conscious investors to abandon REITs. Investors were treated to a brief preview of how violently REITs can react to the prospect of higher long-term interest rates in April 2004, when REIT prices dropped roughly 20% during a six-week period on fears that the Federal Reserve would begin aggressively raising rates.
"The Federal Reserve has hiked interest rates seven times since June of 2004," Chope warns. "At some point, these rate increases will start to negatively impact REITs. Realistically, we're in the eighth or ninth inning of the REIT boom, and I'd rather get out early than risk being too late," he explains.
But not everyone believes it's time to ditch REITs. "They still look fairly attractive on a relative basis," Peters notes. "Industry trends remain positive, and while rising rates may hurt the sector, they're a negative for most other asset classes, too. In fact, REITs might outperform stocks and bonds in a rising rate environment, since they will still provide solid yields and a hedge against rising inflation."
Instead, Peters suggests that advisers stick to a balanced asset allocation strategy, including perhaps 10% to 20% in REITs and other real estate. "Because REITs have a low correlation to most other asset classes, they're great for portfolio diversification. Over the long term, owning REITs still makes a lot of sense." Peters' view is backed by several recent studies, including a 2002 report released by Chicago-based Ibbotson Associates showing the inclusion of REITs in a portfolio can increase compound annual returns by up to 1.3 percentage points.
Rebounding industry fundamentals also bode well for REITs. A recent Prudential Real Estate Investors report predicts significant improvements in property markets during 2005, fueled by continued economic expansion, job growth, and declining vacancies. The report says that vacancy rates "have peaked and new supply, outside of the apartment and retail sectors, is at a cyclical low point and should remain fairly modest for the next few years."
Even experts who think REITs are overvalued acknowledge that improving industry fundamentals could help shield the sector from a major decline. "We're faced with a conundrum," Bergmann reports. "Although REITs are expensive and rising interest rates are a major concern, overall real estate fundamentals are improving. So the real question to ask is how much improving industry fundamentals will offset the headwinds created by rising rates and higher capital costs."
Some advisers aren't waiting for the answer. Chope has reduced his clients' REIT exposure significantly in favor of commodity mutual funds and other alternative investments. "For our clients, REITs are primarily a way to diversify portfolios and hedge against rising inflation. We can achieve both goals using commodities and other non-correlated assets, but with less valuation risk."
Other options for advisers are non-exchange-traded and private REITs, where the valuations are less extended. "The publicly traded REIT markets are very volatile, and valuations can quickly become stretched when investors flood into the market as they have recently," explains Troy Smith, a CFP with Navigon Financial Group in Raleigh, N.C. "In this environment, non-listed REITs look much more attractive."
Another option is remaining invested in REITs, but confining the exposure to specific sectors. For example, Smith believes apartment REITs should do well in the current environment. "Low mortgage rates have allowed more people to buy houses rather than rent. As interest rates rise, apartment REITs will benefit by increasing demand and pricing power, particularly in major metropolitan areas." And because most apartment leases are short-term agreements, this increased pricing power will quickly benefit apartment REITs' bottom lines.
Office REITs may also do well if employment growth remains robust. "Office REITs are suffering from huge vacancies. If the economy stays strong and businesses add personnel and office space, these REITs should experience solid FFO growth," Bergmann predicts. "But investors should be cautious and focus on regions with strong population growth, like the West Coast and Sun Belt states." Office REITs should also be helped by the fact that new office construction has declined significantly from 122 million square feet in 2001 to around 29 million square feet last year.
Finally, REITs that invest in shopping centers, malls, and other retail locations may still hold some promise. Retail REITs have outperformed most other REIT sectors recently, buoyed by strong retail sales and rising consumer confidence. In fact, retail REITs were up over 40% last year, eclipsing all other REIT sectors by at least seven percentage points.
"Retail REITs are perhaps the safest group right now," Bergmann explains. "As long as consumer spending remains strong, the sector should be fine. But because occupancy rates are already fairly high, there isn't nearly as much upside in this sector."
Since 2000, REITs have been market stars, but nothing lasts forever. The sector's negative showing during the first two months of this year may be proof of that (see "REIT Sector Performance," above). While opinions differ on whether REITs are headed lower or were simply due for a breather, a repeat performance of their spectacular gains in 2005 appears unlikely. Nevertheless, for investors willing to ride out a potential downturn, REITs will likely continue to be an important part of a diversified allocation strategy.
David A. Twibell, JD, is executive vice president of BankWest in Colorado Springs, Colo., where he directs the bank's portfolio management and wealth advisory practice. He can be reached at (719) 482-7015 or dtwibell@bankwest.net.
