Stick with REITS that have all their assets in office buildings and industrial and retail space. By James K. Glassman, Contributing Columnist September 30, 2007 My list of the past century's half-dozen greatest financial inventions for small investors reads like this: the stock mutual fund, the money-market fund, the 401(k) plan, Treasury Inflation-Protected Securities (or TIPS, which are Treasury bonds indexed to inflation), the exchange-traded fund and the real estate investment trust. Do real estate investment trusts really belong on such an honor roll of grand achievements? Yes, indeed. REITs allow even the smallest investors to own diversified portfolios of hundreds of properties, spread across the country or the world. Before REITs, the alternative for small investors was expensive, fee-laden limited partnerships in one or more properties that seemed to benefit the broker and general partner first and the investor last. The downturn. For REITs, however, these are unhappy times. An index of 117 REITs compiled by the industry's trade association lost 13% of its value in the first seven months of this year, falling almost 8% in July alone. Part of the problem is the severe slowdown in the residential market. But there's a broader difficulty as well. The tax laws treat REITs differently than regular corporations. A REIT passes nearly all its profits straight through to its shareholders in the form of dividends, which means the shareholders pay the income taxes, not the REIT. The only problem with this system is that for a REIT to grow, it needs to purchase new properties, and because it sends its profits to the shareholders, the REIT doesn't have internally generated cash it can use to grow. So it has to issue new stock or borrow. This past summer, troubles in the market for mortgage debt to subprime, or relatively risky, borrowers spread to other parts of the credit universe, and REITs, too, found themselves facing higher rates, or even a credit crunch. REITs come in many flavors. Most specialize in a sector -- for example, apartment buildings, medical facilities, shopping centers or hotels. About two dozen REITs concentrate on commercial office buildings. Although commercial developers are having a harder time borrowing money to build, their plight is far less dire than that of residential developers. Advertisement A recent report by money-management and research firm Sanford C. Bernstein points out that over the past few years, commercial real estate has especially benefited from financing innovations, including both the rise of REITs and the public trading of debt using commercial mortgage-backed securities. In addition, private-equity firms, which get their money mainly from big pension funds and wealthy investors, have jumped into commercial property in a big way. These changes have led to lower-cost financing for developers, which, in turn, has "been a major driver of the recent boom and has supported much richer valuations." Between 2002 and 2006, the annualized return for commercial real estate was 18%, compared with 10% for hedge funds and slightly more than 6% for Standard & Poor's 500-stock index. The question of whether commercial real estate will keep climbing at such a spectacular rate seems to have been resolved in the negative this summer. A better question is whether it will settle back to its historical rates of return, which are nice enough. Between 1987 and 2006, the asset class returned 9.4% annually, of which 3.5% was capital appreciation and 5.9% was income from dividends. That return is two percentage points lower than the S&P's over the same period, but commercial real estate had about half the volatility. Bernstein calls commercial property a "happy medium." I agree. It's a good split between appreciation and income, return and risk. Advertisement Lagging yields. But is it the place to put some of your money right now? If commercial real estate has benefited from financial engineering, then the gains of 2002Ð06 -- and perhaps even of 1987Ð2006 -- could be one-time events. The value of income-producing property depends on rents, and here the story is not encouraging. A remarkable chart in the Bernstein report shows that in 12 of 13 top metro markets, rents over the past 20 years have increased at a rate slower than inflation. In one market -- Houston -- rents increased at the same pace. And this trend has occurred during a great period for the economy. In 2006, the yield on commercial real estate -- that is, the income that the average property throws off -- declined to just 7%, the lowest point in at least the past 40 years and 2.6 percentage points below the average yield (also called the capitalization rate) since 1965. Investment ideas. So why has commercial real estate been such a good investment over the same period? Two reasons. First, prices. As more investor cash has flowed into the sector from around the world, property prices have risen, providing the chance for some sizable capital gains. Second, leverage. With borrowing costs so low, developers could put up a tiny amount of their own funds, go deep into debt and still make a fine profit from rental income. But the fun may be over. Higher interest rates raise costs for both developers and their customers. What should investors do? Advertisement This is no time to dabble in the residential market. But for the long term, commercial REITs make a reasonable addition to a portfolio. For now, stick with REITs that have all their assets in office buildings and industrial and retail space. Prices appear sensible right now, although they could certainly go lower. Unfortunately, some of the largest commercial REITs have recently been taken off the public market. Equity Office was bought by Blackstone, the private-equity firm (which itself went public later), and Crescent Real Estate agreed to be acquired by Morgan Stanley. Among the large commercial REITs that remain are Vornado (symbol VNO), which concentrates on properties in New York City and the Washington, D.C., area; Duke Realty (DRE), which focuses on the Midwest and Southeast; Liberty Property (LRY), which has a heavy industrial component; and Realty Income (O). Vornado shares rose from less than $40 in August 2002 to a peak of nearly $136 in February of this year. On August 6, the stock closed at $107. Others have suffered even more severe declines during the six months following the February highs. Duke and Liberty were off by more than one-third. Liberty's sharp fall brought its dividend yield up to an enticing 7%; Vornado currently yields 3.2%. But remember that unlike dividends from conventional corporations, which have a federal tax rate that's currently capped at 15%, most REIT payouts are taxed at the full, ordinary-income rate, up to 35%. And there's no guarantee that dividends won't fall in the future. Over the past decade, however, Vornado has boosted its dividend every year, from $1.36 a share in 1997 to $3.60 today. Advertisement Vornado carries typical leverage for a REIT. Its total debt of $12 billion is about two times its shareholder equity. Realty Income, by contrast, has no mortgage debt on any of its properties and less than $1 billion in debt overall. The REIT specializes in long-term "net" leases, which pass along costs such as insurance to high-quality tenants. The result is a stock with an attractive yield (6.4%) and relative stability. In early August, it was down only 16% from its February high. An excellent way to play commercial real estate is through a company such as Jones Lang LaSalle (JLL), which provides management services for building owners rather than putting capital at risk as a developer. Business is booming, and so is the stock, which has risen from about $13 in early 2003 to $110 in August. The stock is down about 15% from its high, and the drop could present a buying opportunity. The stock's PEG ratio -- that is, its price-earnings ratio divided by the projected annual growth rate -- is just 0.84. Anything less than 1.0 is considered a bargain. Bars and stripes. One commercial real estate stock I haven't mentioned is Corrections Corporation of America (CXW), which owns and manages jails and prisons under contracts with federal, state and local governments. Revenues jumped from $310 million in 2000 to a projected $1.5 billion this year. Yes, the company is highly leveraged, but its price has held up exceptionally well in the summer carnage. And why not? Alas, it's part of a growth industry. James K. Glassman is a senior fellow at the American Enterprise Institute and editor in chief of its magazine, The American.