Are real estate stocks just too good to be true?
It certainly seems that way. Take Vanguard REIT Index (VGSIX), a mutual fund that’s a good proxy for the entire sector. So far this year, it’s up 10.6 percent. For the past three years, it has returned a total of 44 percent, compared with a loss of 32 percent for the benchmark Standard & Poor’s 500-stock index. And those gains were achieved with shockingly low risk. The real estate stocks in the portfolio were more than 80 percent less volatile than the market as a whole.
The Vanguard fund was launched only in 1996, so for more history check out Cohen & Steers Realty Shares (CSRSX), another broadly diversified fund. Over the past 10 years, it has returned an annual average of 9.7 percent — a tiny bit ahead of the S&P but, again, at risk levels that are between one-third and four-fifths lower than the market, depending on which gauge you use.
Risk counts. Most investors can’t bear returns that bounce wildly up and down from year to year. Volatility provokes mistakes — such as selling at the bottom. A smooth ride is what we crave, especially if it’s a lucrative journey.
How smooth is real estate? Very. Between 1992 and 2002, the Cohen & Steers fund declined in only one calendar year. In the others, its returns ranged from a low of 3 percent (1999 and last year) to a high of 38 percent (1996).
In fact, real estate stocks — especially real estate investment trusts, or REITs, which have special tax treatment — behave so differently from the rest of the market, they’re almost a separate asset class rather than just a different industry.
This divergence — in financial jargon, “low correlation” — is something else we crave. If your portfolio includes assets with low correlations, it means that when some investments are declining, others are declining less, or even rising. The result is a kind of blissful financial harmony. You don’t have fantastic years, but you don’t have wretched years either.
A recent study by Sanford C. Bernstein & Co., the research and money-management firm, found that between 1991 and 2002 REITs had a correlation of just 0.3 with the S&P 500. In other words, only 30 percent of the movement of REITs can be explained by the movement of the market as a whole. By contrast, a portfolio of international stocks over the same period had a correlation of 0.66. So American REITs diversify American stock holdings better than foreign shares do.
Bonds have an even lower correlation to the S&P: just 0.11 over the past decade. But history shows that long-term U.S. Treasury bonds provide returns that are only half those of stocks. REITs, at least in their more recent, well-managed, lower-risk incarnation, return about the same as conventional stocks.
To illustrate how REITs have smoothed the ride, I assumed that over the past five years an investor held a portfolio composed this way: 75 percent Vanguard Index 500 fund (VFINX), which mimics the S&P 500, and 25 percent Vanguard REIT Index fund. (Note: Do not try this at home; 25 percent is too big a proportion of REITs for most investors, but it illustrates my point vividly.) In 1998, the S&P fund returned a hefty 29 percent while the REIT fund lost 16 percent, so the portfolio overall gained 18 percent. Here are the year-by-year results, comparing the mixed portfolio to the all-S&P portfolio:
The average annual returns are almost the same, but look at the difference in volatility! In three of the five years, the all-S&P portfolio rose or fell by more than 20 percent. The mixed fund never hit such extremes in any year.
Investors shunned REITs during the tech boom of the 1990s. I remember giving a speech in 1999 to a group of REIT executives who were particularly grouchy because the performance of their firms was going unappreciated and their stocks were falling.
Overall that year, the NAREIT index, maintained by the National Association of Real Estate Investment Trusts (which, by the way, maintains a website with excellent information for investors) fell 14.1 percent in price — a decline that was only partly offset by dividends that averaged 7.6 percent. But 1999 was a fine year for REIT profits, as was 2000. Typical was Mack-Cali Realty (CLI), a large REIT based in New Jersey that specializes in office rentals. The company increased its “funds from operations” (FFO) that year by 10 percent and raised its dividend from $2.10 to $2.26 per share, yet the stock lost one-sixth of its value.
FFO, by the way, is generally viewed as the most significant profit indicator for a REIT. It represents cash flow — roughly, old-fashioned earnings with depreciation added back in and capital gains or losses from the sale of properties excluded. Some analysts prefer to concentrate their attention on earnings, others on dividends.
But back to the unhappy REIT execs: My advice to them was to cheer up. Investors were transfixed by tech, but they would turn their attention back to REITs soon enough. And they did, since consistently rising profits are hard to ignore. Mack-Cali has boosted its dividend every year since it went public in 1994, and today, when 10-year AA-rated corporate bonds are yielding 4 percent and the average stock in the Dow Jones industrial average is yielding 2.3 percent, Mack-Cali is yielding a gorgeous 7.5 percent.
And it’s not alone. Kimco Realty Corp. (KIM), one of the largest REITs, specializing in community shopping centers with classy tenants, is currently yielding 5.8 percent; Kimco has increased its FFO and dividend every year since its initial public offering in 1992. Another solid REIT, Duke Realty (DRE), has a dividend yield of 6.5 percent; Equity Residential (EQR), a giant REIT that owns 223,591 rental units, yields 6.3 percent; and a more speculative REIT, Hospitality Properties Trust (HPT), which owns 251 hotels in 37 states, yields 9.8 percent.
There are 171 publicly traded REITs, with an average market capitalization of $1 billion each, and, as you can see, they come in many flavors. What they have in common is that each owns a group of properties that generates income from rentals, or from capital gains when the properties are sold. (There’s one exception: mortgage REITs, which deal in debt on property rather than property itself.) Among the riskier plays these days are REITs such as Health Care Property Investors (HCP) and Healthcare Realty Trust (HR), which own buildings used by hospitals, clinics, and small medical practices. For both REITs, HealthSouth Corp., now under investigation for alleged accounting fraud, is a big tenant. Each REIT yields more than 8 percent.
REITs pay large dividends because of their special tax status. REITs are required to pass at least nine-tenths of their taxable income on to shareholders each year, and those dividends then become deductible to the REIT as an expense, thus virtually eliminating corporate income taxes. That sounds like a nice deal all around, but there’s a drawback: If a company doesn’t retain its profits, then how does it get the capital to grow?
To buy new properties, REITs often have to borrow or issue new shares. The lack of internally generated profits can certainly frustrate REIT executives with a yen for expansion, but maybe that’s not so bad. Recent academic research has found that conventional businesses that distribute a high proportion of their profits to shareholders tend to be better run and produce higher returns than businesses that retain the bulk of their earnings.
Perhaps operating without tons of cash is good discipline. If a REIT needs money for expansion, it has to do a good job convincing investors that the money will be put to productive use.
Whatever the explanation, it’s hard to argue with the results. Consider United Dominion Realty Trust (UDR), an apartment REIT that has increased its dividend for 27 years in a row. Washington REIT (WRE) — a wonderful company that owns a mix of office buildings, apartment complexes, small shopping centers, and industrial distribution centers in the area between Philadelphia and Richmond — has raised its dividend for 32 straight years. If you had bought 1,000 shares of Washington REIT in 1987, your dividends that year would have totaled $580; this year, they will total $1,450. Rising payouts show why REITs are better than bonds.
But while a few REITs have impressive long-term records, the real question is how well the asset class will weather a severe downturn in real estate values, whenever it happens. The recession of 2001 and the struggling recovery since then have not hurt most real estate investments — because interest rates have fallen, reducing the cost of REIT debt, and because consumers have kept shopping, a boon to retail REITs (those invested primarily in shopping centers and strips), which represent about one-fourth of the industry’s market cap.
The 1991 recession was harsher, but many REITs did not come into existence until afterward. Profits took a nose dive, from $1.87 to just 97 cents a share between 1990 and 1991 for BRE Realty (BRE), formerly BankAmerica Realty, and the REIT recovered slowly from the setback — though it did not cut its dividend. Pennsylvania REIT (PEI), which owns apartments and shopping centers, suffered a much smaller decline in profits — and also maintained its dividend.
Some analysts believe that low interest rates and a lack of opportunities elsewhere have puffed up a substantial real estate bubble, in the residential sector especially. When it pops, they say, REITs will hit the skids.
Certainly, REIT prices can go down as well as up, and a few companies have already been hurt by the economy, including AvalonBay Communities (AVB), which owns more than 20 residential properties in the Washington area and dozens elsewhere in the country. Share prices fell by more than one-fourth between April 2002 and March 2003, but in recent weeks they have surged. Another REIT with a cautionary tale is Crescent Real Estate (CEI), whose price has fallen 40 percent in the past five years. Today, it’s yielding an enticing 9.9 percent. But don’t forget that, unlike the interest on a bond, the dividend for a REIT, or any other stock, is not guaranteed. Crescent chopped its distribution from $2.20 in 2000 to just $1.50 last year.
Another possible problem for REITs is President Bush’s tax plan. The original proposal called for ending the double taxation of dividends. REITs are currently taxed only once, so they were not covered in the plan. If the plan passes intact, it would decrease the advantage REITs have over other stocks — though probably not by much. And, at this point, no one knows what the final tax law will be.
The best way to own REITs is through mutual funds. I have already cited two of the best: Cohen & Steers Realty, which carries an expense ratio of 1.1 percent, and Vanguard REIT Index, whose expenses last year were just 0.3 percent. Their past returns and risk profiles are similar, but the C&S fund requires a $10,000 initial investment; for Vanguard, the minimum is $3,000.
No-Load Fund-X, a newsletter with an excellent track record, gives its highest ratings to C&S and to Fidelity Real Estate Investment (FRESX). A smaller fund with a fine record is Security Capital U.S. Real Estate (SUSIX).
Since the REIT universe is relatively small, the portfolios of the larger funds look alike. For example, three of the top five holdings of Cohen & Steers are among the top five holdings of Vanguard: Equity Office Properties (EOP), Simon Property Group (SPG), and ProLogis (PLD).
A more unusual real estate fund, Third Avenue Real Estate Value (TAREX) has a preference for real estate operating companies, which adopt standard tax treatment and don’t have to distribute any of their profits to shareholders. As a result, the fund’s dividend yield is negligible. Manager Michael Winter runs a small, highly concentrated portfolio — just 33 stocks, with the top five accounting for more than 40 percent of total assets. With companies that few of the other funds own — such as Forest City Enterprises (FCE) and LNR Realty — Third Avenue has produced average annual returns of 14 percent since it was started in late 1998, nearly twice the average for the sector. Morningstar gives the fund a top (five-star) rating, but its expense ratio is relatively high at 1.5 percent.
All diversified investment portfolios need real estate stocks — to dampen overall volatility and provide good, consistent returns. How big should your REIT holding be? In most cases, between 5 percent and 10 percent of total financial assets is about right. Certainly, there are no guarantees REITs will continue to offer high gains at low risk, but, considering their history of the past decade — in good markets and bad — I find it very hard to ignore real estate.
— James K. Glassman is a fellow at the American Enterprise Institute and host of TechCentralStation.com. This column originally appeared in the Washington Post.