Third time lucky?
Returns for equity real estate investment trusts, REITs, skyrocketed nearly 28 percent each of the last two years. The question for investors is: Can that possibly happen again?
With the economy finally starting to gain traction, it’s a valid question. A stronger economy is good for REITs, because it leads to better occupancy rates, more financially secure tenants, and higher property values.
But as the economy improves, interest rates also rise—as they have for the most part this year—and that increases the cost of borrowing for REITs as they buy properties.
So can investors expect another year of 28 percent returns? Probably not. But REITs have the potential to do fine, particularly if the economy continues to strengthen.
“In an environment with moderately positive fundamentals driven by a moderate economic recovery and relatively flat or gently rising interest rates, we expect a 15 percent up year; roughly equal to the S&P 500,” says John Guinee, managing director at Stifel Nicolaus.
Guinee, however, has some caveats. If the yield on the 10-year Treasury note falls below three percent, making it cheaper to borrow, returns could rise more than 20 percent, says Guinee.
Lower Treasury rates also make REITs more attractive to investors seeking income, since they pay an average dividend of 3.45 percent.
Then again, goes the argument, if the 10-year note rises above 4 percent, returns could become negative.
“The ‘yin-yang’ is property fundamentals versus interest rates,” Guinee says. “Is one strong enough to trump the other?”
Other analysts see the fundamentals of the real estate business strengthening to the point that they outweigh the effects of interest rates on REITs.
“Residential occupancy has started to stabilize, and rents are starting to increase across all sectors,” says Ken Weissenberg, leader of the Real Estate Services Group at EisnerAmper. “So, I think as interest rates rise, it’ll be more than offset by increases in operating profits.”
Sounding a Cautious Note
Still, other analysts are more cautious. “Most of the REITs we cover currently trade near or above our fair value estimates,” said Todd Lucacik, senior equity analyst in real estate at Morningstar.
“Consequently, while REIT operating metrics should generally improve somewhat in 2011, we don't expect the strong sector stock performance from 2010 to recur in 2011."
Paul Simon, CIO of Tactical Allocation Group, would like to buy REITs as an inflation hedge as the economy improves, but he's turned off by what he sees as their lofty levels.
“The problem is the valuations, in terms of how we value REITs, they are very expensive by just about every measure we look at,” Simon says.
Equity real estate investment trusts, a nearly $360 billion market, are required to own 75 percent of their assets in real estate, and to distribute at least 90 percent of their income to investors in the form of dividends.
One reason REITs have been so popular is they are among the few yield-producing securities available to investors these days.
Dividend yields for some REITs are substantial. CommonWealth REIT and Hospitality Properties Trust boasted a 7.8-percent dividend yield last year, Senior Housing Properties had a dividend yield of 6.7 percent, and National Retail Properties had a yield of 5.7 percent.
The average dividend yield of equity REITs in 2009 was 3.7, and in 2010 was 3.5 percent, according to the FTSE National Association of Real Estate Investment Trusts. That compares with an average dividend yield of 1.95 percent for the S&P 500 in 2009 and just under 2 percent in 2010.
So far this year, the dividend yield has slipped to 3.4 percent, compared with about a 1.78 dividend yield for the S&P 500.
Investors, however, should look beyond dividend rates when analyzing REITs, argues Craig Leupold president of Green Street Advisors, an investment research firm specializing in REITs. Instead, focus on the value of the underlying property value, says Leupold.
“Companies can either overpay or underpay their dividends relative to the cash flow being generated,” Leupold says. “You need to be careful not to look at them in isolation.”
At the moment, he doesn’t believe REITs are “dramatically overpriced,” but he doesn’t view them as a bargain, either.
Those 28 percent annual returns in equity REITs(as calculated by the National Association of Real Estate Investment Trusts) have taken a toll. Many REITs, as a result, are trading at a 7-to-10 percent premium to their net asset value, or the value of their properties, he says.
The value of high-quality, institutional commercial properties (not mom-and-pop or low-quality buildings) sank 40 percent, on average, from their peak level of mid-2007 to their bottoms two years later. Since then, property values have climbed back about 30 percent, Leupold says.
But Leupold doesn’t think prices will necessarily return to pre-crash levels, and realistically, will probably rise another 5 percent, less than the premium at which REITs are trading.
Investing in Mutual Funds
Despite the risks, it makes sense for investors to diversify their assets and have some investments in real estate.
Leupold recommends individual investors “dollar-cost average” into the sector over an extended period of time, and invest in mutual funds instead of individual REITs—which take time to research—or exchange-traded funds like SPDRS Dow Jones REIT or iShares FTSE NAREIT Residential Index Fund, which invest in a basket of publicly-traded REITs.
“In the REIT sectors, actively-managed funds have tended to outperform the indices over extended period of times,” Leupold says. “There are inefficiencies in the market that allow active managers to outperform.”
Last year, Forward Strategic Realty , JPMorgan US Real Estate , Morgan Stanley Real Estate and T. Rowe Price Real Estate were the best performing real estate funds, posting returns of 29 percent or more, according to Morningstar.com. These funds have minimum investment requirements ranging from $1,000 to $4,000, while ETFs don't require a minimum investment.
Investor interest in REITs, in fact, may be one of the fundamental factors in their favor this coming year. Flows into REIT mutual funds and exchange-traded-funds are on the rise, and that should continue to boost returns, Guinee of Stifel Nicolaus says.
The percentage of assets in Simon Property Group generated by ETFs, for instance, has steadily grown, and was just less than 20 percent of the portfolio by the third quarter last year, according to Stifel Nicolaus.
So, while yes, REITs may be trading at the high end of what analysts see as fair value, Guinee says: “Funds flows and good fundamentals outweigh possible full valuation.”