Utilities Trump REITs

Income Investing

Utilities Trump REITs

Real estate investment trusts may be in bubble territory and utilities are in the bargain basement.

Real estate investment trusts and utilities are close cousins. Both routinely outyield CDs and Treasury bonds and are capable of generating steady dividend growth. And both showed their ability to wrestle the bear by coming through the awful aughts in reasonably good shape. Over the past ten years through May 7, the average property-owning REIT returned 11.5% annualized, while Standard & Poor's Utilities index gained 7% a year. Over the same period, the S&P 500-stock index, which tracks shares of large U.S. companies, was essentially flat.

The data suggest that investors should buy a bunch of REITs or utilities, or both, and happily hold them forever. Under normal circumstances, I wouldn't disagree. But these aren't normal times. Since early 2009, REITs have gone crazy, more than doubling in price. Meanwhile, utility stocks have returned just 15% -- decent for a conservative sector, but one of the worst records for any group during the bull market. REIT shares have made huge strides even though rents and property values for offices, industrial spaces, shopping centers and other types of real estate continued to sink. Yet utility stocks have trudged along even as earnings have improved markedly, thanks to the economic recovery.

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Diverging opinions. Given all this, it's natural to ask whether REITs are in bubble territory and utilities are in the bargain basement. Some investment advisers clearly think that's the case. Scott Schluederberg, of Hardesty Capital Management, in Baltimore, sees value in lagging utility stocks -- such as Duke Energy (symbol DUK), which at an early-May price of $17 yielded 5.8% -- but won't touch REITs. "If I were looking at the two areas, I would much prefer utilities," says Maury Fertig, who specializes in high-yielding investments at Relative Value Partners, in Northbrook, Ill. Fertig says that REIT shares are unattractive now because most are trading at high premiums to the value of their underlying property holdings.

Donald Wood, chief executive officer of Federal Realty Investment Trust (FRT), says investors are "making no distinction between good real estate and not-so-good real estate." The trusts are issuing boatloads of new stock and are on pace this year to issue record amounts of bonds. But, says Wood, REITs that are raising fresh money will struggle to find property cheap enough to justify all that financing.


Federal Realty, which owns shopping centers and mixed-use properties in the Northeast, the Mid Atlantic states and California, is among the most successful REITs. Over the past ten years, the stock has delivered an annualized return of 16%. But as the stock soared from $39 in March 2009 to a price of $74 in early May, its yield fell to 3.6%. I don't think you should own any REIT, even a proven winner, that yields less than 5%. If you're a recent investor in Federal Realty and you're sitting on a big gain, wait until you've reached the one-year holding period to qualify for favorable capital-gains treatment, then sell and take your profit. If you're a longtime investor, it's okay to maintain your position, but don't buy more.

What about utilities? The bullish case rests on more than just depressed share prices. Power companies sell more electricity when industry hums, more people have jobs, and families can afford to run the A/C at lower temperatures. Plus, it's tough to get permission to build or expand a power plant, and that limits competition. Whether a company uses coal, gas or nuclear to produce power, its generating capacity becomes continually more valuable.

Long-term returns from Southern Company (SO, $34) and Exelon (EXC, $42) equal or surpass those of most REITs, but their prices are less volatile. And their current yields -- Southern's is 5.3% and Exelon's is 5.1% -- are reasonable. So buy utility stocks, turn on the lights, and share in the prosperity you're helping to create.