Thursday, March 03, 2005

REIT hot, right now — but for how long?

USA Today
Savvy home buyers know that there are certain things to avoid when you're buying a house. Cracks in the foundation, for example. Sawdust drifting from the rafters. A disembodied voice from the basement that says, "Get out!"

If you're investing in real estate investment trusts, or REITs, you may have similar forebodings. And that's a good thing. Unless you're a long-term investor out for dividend income, a REIT fund might be a poor place to be right now.

Real estate winners
Top-performing real estate funds the past five years:

Total return*
Fund, ticker
5 years
Alpine US Real Estate, EUEYX
CGM Realty Fund, CGMRX
Third Avenue Real Estate, TAREX
Kensington Strat. Realty A, KSRAX
AIM Real Estate A, IARAX
Average real estate fund
* — Dividends, gains reinvested through Feb. 28.Source: Lipper

REITs are companies that invest in real estate: apartments, shopping malls, office space and even storage units. A REIT distributes at least 90% of its income to shareholders in dividends, which is one reason REITs have been popular lately. The average REIT sports a 5.13% dividend yield, according to the National Association of Real Estate Investment Trusts, the industry trade organization. The Standard & Poor's 500-stock index, by comparison, yields 1.8%.

The past five years, REITs have bulldozed the S&P 500. REITs have gained an average 21.3% a year the past five years, while the S&P 500 has lost an average 1% a year. If REITs continue to gain at that pace, shareholders will be able to give their kids blocks of Manhattan to play with.

That's one problem with REITs: Nothing grows at a 21.3% annual pace forever, even in a red-hot market. To put that in some perspective, the last time the S&P 500 turned in a similar performance was the five years ended October 2000, a few months into the biggest bear market since the Great Depression.

No one is predicting a real estate depression. But some investors worry about REITs because of:

Prices. After such an impressive run-up, you'd suspect that REITs would be on the pricey side, relative to their earnings — and you'd be correct. Wallace Weitz, manager of Weitz Value fund and one of the nation's top bargain-hunters, says he no longer has REITs in his portfolio. They're too expensive, he says. "I've talked to three analysts who follow REITs closely," he says. "It's a bad thing when they have nothing to recommend."

Kenneth Heebner, manager of CGM Realty Trust, has also evicted REITs from his portfolio. Instead, the fund is mainly invested in hotel and homebuilding companies. "The move up in REITs has ignored a decline in operating results," Heebner says. "I'm concerned there could be a pullback."

Yields. REITs offer juicy dividend yields when compared with most other stocks. But five years ago, the average REIT yielded 8.48%, vs. 5.13% now. As the Federal Reserve raises rates — and it has done everything but put up billboards saying it will do so — REIT yields become less appealing.

Interest rates. REITs have fallen 5.3% this year, at least in part because of interest-rate jitters. Just as rising rates disqualify borrowers from the housing market, they would also disqualify some borrowers from loans on office buildings and strip malls. And borrowing costs would increase for those who could qualify for the financings, increasing their costs.

Several academic studies have shown that REITs are not terribly sensitive to rising interest rates. But on Wall Street, perception is reality: If investors think REITs will get hurt when rates rise, they will sell their REITs when rates rise. That's exactly what they did in April, when interest-rate jitters sent REIT shares tumbling 18%.

Samuel Lieber, manager of Alpine U.S. Real Estate, the top-performing real estate mutual fund, is a bit more upbeat — but not a lot. "I'm cautious but constructive," he says.

Institutional investors, tired of being burned by the S&P 500, began moving into real estate a few years ago, bidding up REIT prices, Lieber says. He thinks that institutional buying will continue for another 18 months to two years, which will keep REITs from tumbling.

Historically, dividends have accounted for two-thirds of the overall return from REITs, Lieber says. In recent years, however, price gains have powered the majority of a REIT's total return. Until the market digests all its price gains, Lieber says, dividends will probably account for most REIT gains — meaning single-digit returns for the next few years.

It's not all doom for REITs. Among the 10 largest, insiders are selling fewer of their own stocks than before, says David Coleman, editor of Vickers Weekly Insider Report. That's usually a bullish sign. Some real estate sectors, most notably lodging and hotels, have excellent prospects, Lieber says.

Who should invest in real estate funds now? If you're looking for an investment that doesn't move in lock step with the S&P 500, a real estate fund is a good diversifier. If you're looking for a fund with an above-average dividend yield, a real estate fund is a good way to go. Just don't expect to build a fortune on REITs. You could end up with a case of buyer's remorse.


At 11:39 PM, Anonymous Greg | said...

Great post! It is important, esp for first time real estate investors to carefully choose their very first deal and one of the safest way to do it is to turn to REIT companies. I can't think of a better time to invest than now esp that the market is currently low esp for Single Family homes. On top of that, the society is now slowly evolving into a renters society.


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