It's time to think outside the big box when it comes to real estate investment trusts. The NAREIT composite index of U.S. property-owning REITs rose strongly in the first five months of 2008, but it began to sink in early June and is now flat year-to-date through June 24. The group yields 5% on average, suggesting that REIT share prices are down about 5% so far this year.
Considering the rotten stock market, the struggling economy and the lousy real estate market, the '08 performance of REITs isn't terrible. But the swoon that started in June could continue for a while. With the economy almost certainly in recession, real estate operators face the prospect of rising unemployment, which typically leads to lower demand for office and retail space.
At the same time, rising inflation will likely lead to higher interest rates, which means higher borrowing costs for REITs. In sum, the longer it takes for the economic malaise to dissipate, the worse the outlook for the shares of many big-name REITs -- the sort that are down 10% or more over the past month.
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Another problem is that some of the largest REITs are members of Standard & Poor's 500-stock index. So when the market plunges, the selloff typically ensnares bellwether REITs such as Boston Properties (symbol BXP) and Simon Property Group (SPG), whether justifiable or not.
For instance, when the S&P 500 lost 1.8% on June 20, Boston Properties, which owns such landmarks as the Prudential Center, in Boston, and Citigroup Center, in New York City, fell 3.2%. Simon, the nation's leading operator of upscale malls, lost 2.8%. Simon and Boston Properties have impeccable pedigrees, but neither strikes me as a timely idea for new investment money.
Given the turmoil in the markets and the obstacles the industry is facing, you might be tempted to abandon real estate entirely until both consumer spending and the banking industry recover. But to exclude commercial real estate from a long-term investment strategy is not wise. REITs in particular provide diversification, tax advantages and, often, high dividend yields.
But what kind of REITs should you buy now? There are at least ten REIT sub-sectors, and those subgroups do not perform in sync or track the overall REIT indexes. Many of the best-performing REITs today focus on obscure niches. Their market values are small, and their yields are high.
This complicates things if you invest in realty exclusively through a mutual fund or an exchange-traded fund because they invest almost exclusively in blue chips such as Simon, Boston Properties and ProLogis (PLD). For example, more than one-third of the assets of iShares Cohen & Steers Realty Majors (ICF), the largest real estate ETF, is in just five REITs. The fund lost nearly 2% year-to-date through June 24 and 8% over the past month.
Vanguard REIT ETF (VNQ) invests in the same gorillas, but it's a little less top-heavy and charges lower expenses than the Cohen & Steers fund. It, too, has lost nearly 2% so far in 2008 and 8% over the past month (adjust wording depending on performance of two ETFs). The Vanguard fund is an acceptable choice for a long-term real estate portfolio. Beware, though, that the fund's 12-month distribution yield is a skimpy 3.8%.
For a better shot at beating the REIT averages in the second half of 2008 and into 2009, you should turn to some lesser-known real estate names. Below are five REITs that sport above-average dividend yields and represent different sectors of commercial real estate:
Entertainment Properties (EPR) owns multiplex cinemas, which are cheaper for families to drive to than beach resorts and theme parks. Its portfolio includes some oddities, such as a few charter schools (someone has to own those buildings and rent them out) and vineyards. But 98% of EPR's debt is at low fixed rates, and the REIT has an excellent record of dividend growth. The company boosted its dividend 10.5% earlier this year. At the stock's June 24 close of $53, Entertainment Properties yields 6.4%.
If you're all about income, no need to look much beyond First Industrial (FR). At $30, this REIT yields a stunning 9.6%. The yield tends to be high because investors and analysts are skeptical of the company's business model, which involves developing warehouses and light industrial space. Recession fears have pushed the yield up even further. But First Industrial benefits from strong exports, and high occupancy levels paired with high rents support its dividend. The company carries a lot of debt but nearly all of it at low fixed rates. The juicy dividend is the draw while you wait for fresh economic growth to boost the share price.
Realty Income Corp. (O) is a "triple-net" real estate owner, which means its tenants-mostly famous national retailers at free-standing locations-pay not only rent but also property taxes, insurance and maintenance. This leaves the REIT more cash flow for dividends, which Realty Income pays monthly and has raised 49 times since 1994. Realty Income's 2,375 properties are unexciting-single-tenant buildings occupied by drugstores, auto-parts shops, convenience stores and the like-but they are 98% occupied under long-term leases with built-in rent increases. At $23, Realty Income yields 7.0%.
I've saved health care REITs for last because it's not a case of one REIT, but any of about a dozen. REITs that own medical buildings, hospital property, nursing homes and assisted-living facilities have performed well during the economic slowdown, throwing off good dividends and delivering some capital growth as a bonus. If an ETF that held just health-care REITs existed, I'd strongly endorse it. There isn't one, so you get to pick and choose by property type and location. Health Care REIT (HCN) and HCP (HCP), formerly Health Care Property Investors, are diversified and well respected. HCN, which closed at $45, yields 6%. HCP, at $32, yields 5.6%. Even if you have no particular interest in real estate, you can justify holding one or both in just about any kind of portfolio.
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