Get Ready for a REIT Rebound

When I look for stocks to buy, I try to avoid industries that everyone else loves. Rather, I like to look at the sectors that have lagged the most. Here’s an example: At the end of September, the average large-company stock fund had returned 20% for the year. Of the 14 mutual fund sectors Morningstar surveyed, all but one had shown a positive return. The exception was precious metals funds, down a whopping 41%. But because I have a lifetime aversion to owning anything connected to gold, I looked at the next-worst performer; it was up a measly 2%, 18 percentage points behind the average large-company fund.

That sector was real estate. Most real estate stocks these days come packaged as real estate investment trusts, or REITs. A REIT is a company that owns a portfolio of properties that generate income from rentals plus capital gains when they are sold. A REIT must pass on at least 90% of its profits to investors in the form of dividends. A total of 171 property-owning REITs trade on the New York Stock Exchange, with a total market value (shares times price) of $657 billion. Most REITs specialize in a particular kind of property. Office buildings, apartments, hotels, shopping centers, industrial buildings, medical facilities and self-storage units are the major categories. (Other REITs invest in mortgages, but my focus is on property-owning REITs.)

A big appeal of REITs these days is their dividend yields — on average, 3.7% at a time when a ten-year Treasury note yields 2.6%. (For a look at other types of high-yielding stocks, see 5 Stocks Yielding 5% or More.) Of course, because REITs depend on their own earnings to fund payouts to investors, those dividends aren’t guaranteed. In 2009, for instance, one of the largest REITs, Vornado Realty Trust (symbol VNO, price $85, yield 3.5%), which owns offices and retail space, cut its annual dividend rate from $3.52 per share to $1.52. Since then, the payout rate has inched up to $2.92. Vornado’s stock, which I like, peaked at $137 in February 2007 and plunged to $27 by March 2009, before recovering to its current price. (All prices, yields and returns are as of October 4.)

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Housing’s Impact

It’s no secret why Vornado’s price fell. Real estate values soared in the early and mid 2000s, then collapsed starting in 2007, triggering a sharp recession. The S&P Case-Shiller index of home prices rose moderately from 70 in 1988 to 100 in 1999, then rocketed to nearly 200 in 2007 before dropping to about 125. The values of homes and other kinds of real estate aren’t always linked, but the collapse of residential prices affected commercial-property values, too. For instance, shares of the average REIT that owns retail space fell 45% in 2008, compared with a 37% plunge for Standard & Poor’s 500-stock index.

Residential housing prices have been climbing back over the past two years. They are up 12.4% in the past year alone, and other real estate sectors are up, too. The CoStar General Commercial index, for instance, shows that prices of office buildings sold in the past year have risen by 12%.

Investors have anticipated the rebound. Shares of Equity Residential (EQR, $53, 3.0%), a giant apartment-building REIT, rose 58.1% in 2010 and 12.8% in 2011. But as investors looked forward, their enthusiasm waned. Equity Residential rose a mere 2.5% in 2012 and has fallen 5% so far in 2013, trailing the S&P by a mile. Vacancy rates for apartments nationwide are now a low 4.3%, and average rents have been rising steadily. But it’s the future that counts, and real estate experts worry that the market is softening.

Why? Three reasons. First and foremost is the economy, which is still running a low-grade fever. It just can’t seem to regain robust health, and spending and household formations are suffering. Second, low interest rates in recent years and the lack of new construction have inspired developers to build more. In the apartment sector, for example, a lot of units will be coming online in 2014 and 2015 (though still at only about half the rate of 2000–07). If the economy comes back, things will be fine; there will be plenty of renters to occupy those units. Otherwise, it may be hard to raise rents and fill properties. Third, although interest rates are still low (inspiring developers to build now), they are rising, discouraging consumers.

So where do we go from here? I am optimistic enough to be willing to buy, though I’d feel more comfortable if REITs fell another 10% or 20%. Here is the case: Demand is building up in the economy, and when it is released, it will explode — maybe even as much as it did right after World War II. Young Americans want to move away from their parents, businesses want to expand, and retailers want to open new shops. But the economy has them scared. If the U.S. continues to grow at just 2% a year, then interest rates won’t rise much, and REIT yields in the 3% to 4% range will continue to look attractive compared with other income alternatives. If the economy comes roaring back, REITs will be huge beneficiaries.

What to Buy

Vanguard REIT Index (VGSIX), a mutual fund that tracks the MSCI REIT index, is a solid choice. It charges just 0.24% per year and has returned 9.2% annualized over the past ten years with a portfolio that includes the works: apartment, office, retail and specialty REITs. Its biggest holding is the largest REIT, Simon Property Group (SPG, $149, 3.1%), which owns about 325 shopping malls. For an actively managed fund, the best is Cohen & Steers Realty (CSRSX), run by a firm that specializes in real estate stocks. Its annual expense ratio is higher, at 0.98%, but its record over the past ten years is a bit better: an annualized return of 10.2%. Simon Property is also this fund’s top holding, but the rest of the portfolio looks very different from the index. One drawback is a $10,000 minimum investment.

As for individual REITs, look for those with yields that are above the industry average. Washington REIT (WRE, $25, 4.7%) is a well-run company with a mix of office buildings, shopping centers and apartments in the Washington, D.C., area. (I recommended the stock in a February article on ways to get annual income of 4% or more.) Glimcher Realty Trust (GRT, $10, 4.1%) owns regional malls, such as Colonial Park in Harrisburg, Pa., and Healthcare Trust of America (HTA, $11, 5.4%) owns medical office buildings.

Over the past ten years, the REIT subsector with the best record is self-storage, with annualized returns of 18.4%. Rather than buying a bigger house, some people rent a storage unit for their stuff. I am a big fan of Public Storage (PSA, $163, 3.1%), the largest REIT in the category, with a market value of $28 billion. Public Storage shares got clobbered in 2007, but they have risen in each of the past six years, including 2008 (a rare stock that climbed during that calamitous year) and so far in 2013.

Uh-oh. Should a contrarian be wary of a stock Mister Market likes so much? Well, yes, but I am willing to make a few exceptions for great companies.

James K. Glassman is a visiting fellow at the American Enterprise Institute and author, most recently, of Safety Net: The Strategy for De-Risking Your Investments in a Time of Turbulence.