Randy Schmidt, an Investment Centers of America advisor who works at the ChoiceOne Bank in Kent City, Mich., got burned in the dotcom bust 10 years ago, so when real estate went wild in 2007, he steered clear of the sector and avoided the damage when property stocks and real estate investment trusts (REITs) crashed. Many REITs eliminated their dividend payouts altogether.
Yet this year, Schmidt has become a big fan of the sector—at least selectively. "We've got about 25% of our clients in REITs," he says. "Once I explain that we're not investing in more speculative, volatile REITs, but ones that have a good prospect for steady income of say 5% to 7% and growth in line with inflation, I get very little push-back." Schmidt prefers hospital and office building REITs with high occupancy rates.
Given stagnant unemployment, declining housing prices, high vacancies in office buildings and idle strip malls, it might seem odd to talk about investing in real estate. But particularly commercial retail REITs and multifamily rental property REITs have been having quite a run. Some top-performing vehicles are up over 100% and 200% for the year, while the overall index has risen 26% by early November. REIT mutual funds "have had a good run in '09 and they're up over 20% this year," says Morningstar analyst Andy Gogerty. "A lot of the run may have passed you by, so you can't look at investing now as a timing move, but if you're looking to add real estate as an allocation, I'd say 5% to 10% or even 15% could make sense."
There's another more compelling reason to hold REITs: the payout. REITs are legally required to pass on 90% of their income from rents and mortgages to investors. This gives clients an alternative source of income to bonds in a low-interest-rate environment. Until the financial crash, REIT payouts were 8% and above, but more recently, some REITs lowered or even temporarily eliminated their dividend payments. Now they're making payments again, which currently average about 3.8%—although some pay up to 6% to 9%.
Even better, while REITs offer income like bonds, they do so without the same interest-rate risk. "When interest rates go up, bond yields rise, but the price of the bond falls," says George Hunt, senior equity research analyst for bonds and REITs at Wells Fargo. "That's not automatically true with REITs." Since the payout on the REIT is a pass-through of the rents and/or mortgage interest being collected on the underlying properties in the REIT, it isn't necessarily affected by changing interest rates.
Moreover, REITs offer the appreciation potential of stocks without being correlated with the equity market. As the market improves, REITs should gain value. "If you're willing to hold on to them, you can get capital appreciation and a good reliable income stream too," says Schmidt. Adds Hunt, "A REIT's price is linked more to the stock market through the underlying value of the particular properties in the REIT, giving not just potential for income, but appreciation."
Normally REITs are also a good way to diversify a portfolio, because historically they don't correlate well with either stocks or bonds and that's a main reason why ChoiceOne's Schmidt likes them for clients.
Some REITs may hold as few as 20 properties. Investors can get greater diversification with REIT mutual funds or ETFs. Hunt suggests that for those with investable assets of less than $100,000, investing in REITs via a fund or ETFs "makes more sense."
Morningstar's Gogerty offers three fund recommendations. First is T. Rowe Price Real Estate Fund (TRREX), which doesn't buy properties outright, but invests in publicly traded shares of large-cap REITs. With a 13-year track record, TRREX was up 26.4% year to date through Nov. 1, and 46.39% over the past 12 months. His second pick is the JP Morgan U.S. Real Estate Fund (SUSIX), a "more conventional fund" that holds shares in 20 to 25 publicly traded REITS and was up 21.02% year to date as of Nov. 1, and 45.93% over a year ago. Gogerty's third pick is First American Real Estate Fund (FREAX), which tends to "trade around positions more opportunistically," but which "consistently outperforms its peers." The fund is up 27.74% YTD, and 46.06% over the past year.
Industrial REITs in particular have a gloomy outlook. With the economy still in the doldrums, and unemployment high, it probably won't revive soon. Ditto for building property REITs (though Schmidt notes that there are exceptions to be found).
However, commercial retail REITs and multifamily property REITs are doing great. "Even though you've got big job losses continuing in 30 of the top 40 regions of the country, we're seeing new rentals going off the charts," says Bill Acheson, an analyst with The Benchmark Co. in New York.Driving this growth is an unprecedented decline in the national home ownership rate, down 0.7% this year over last. "People are just not willing to commit to home purchases and some people are leaving homes and becoming renters," he says. That's keeping rental rates strong and even leading to modest rent increases, at least in line with inflation. "This all works to the advantage of multifamily rental REITs," Acheson says.
Commercial retail REITs are thriving because with the country in a "new era of thrift," REITs that consist of mall properties anchored by big box stores or factory outlets are doing well. Meanwhile top-end malls that feature high-end department stores are in good shape "because the well-off haven't really stopped spending," Acheson says. "These REITs are not cheap right now, but if the economy keeps improving and we start to see job growth, then, looking back, they will be seen that way."
Steven Marks, analyst, managing director and head of the U.S. REITs group at Fitch Ratings, agrees that after a bruising few years, things may be looking up. Fitch just upgraded its outlook on the sector from negative to stable in June. Dividend payouts are rising again, though he doesn't expect them to reach pre-crisis levels soon, and multifamily residential and commercial retail REITs should benefit from prices and rents in those property categories starting to recover in 2011. "There's been a modest amount of deleveraging in the industry, and a dramatic improvement in liquidity and access to capital," he says. "The poor employment picture is the major problem, causing ongoing headwinds for REITs of all types."
Ritson Ferguson, chief investment strategist at ING Clarion Real Estate Securities says you should look at global REITs, REIT mutual funds and ETFs. "We expect weighted global earnings growth of 6% to 7% going forward," he says. With global dividends averaging over 4%, people can hope for 10% to 12% returns that would be "solid and safe."