These days, Anthony Soslow often finds himself facing a problem most reps haven't faced since clients were clamoring for hot IPOs back in the heady years of the last millennium. When Soslow, president of Global Capital Management, a financial advisory and money management firm in Conshohocken, Pa., tries to help balance a client's asset allocation by recommending a 10 percent to 15 percent allocation for real estate investment trusts, usually through REIT mutual funds, “many people want to own more,” he says. “They've seen what's happened to the Nasdaq, and they've seen how the value of their home has increased in the last couple years, and they want to load up on real estate.”

Soslow preaches caution. He knows how well REITs have performed — and for him and other advisors, that's just the problem. He worries that now might be the worst time to be loading up on real estate. He often finds himself talking down his clients' expectations of the REIT market, although it lately has been one of the most stable asset classes available. “They're great investments — but aren't they getting too expensive?” he asks.

The Standard & Poor's 500 index fell by 45.2 percent between January 2000 and the close of the market on Oct. 11, 2002. Conversely, the Nareit Composite REIT index (composed of REIT issues tracked by the National Association of Real Estate Investment Trusts) climbed 42.8 percent. For those prescient enough to have bought REITs two years ago, the diversification has proven a nice cushion against the market's grinding plunge.

But what of Soslow's concern that it may be too late to get in on the real estate rise? Are we in the midst of a REIT bubble that, much like the dot-com bubble before it, is bound to pop?

Undeniably, REITs are more expensive than they were in early 2000. This sector, however, is no hot air balloon. For the most part, REIT fundamentals remain sound, and REITs are still priced more cheaply than their historic average. If you're new to REIT investing, you may have missed the wild party of the past two and a half years. Nevertheless, the argument for owning REITs remains strong. “The returns of the last few years have been impressive,” says AIM Real Estate fund (IARAX) manager Joe Rodriguez, “but this is no bubble. The higher prices are all backed by solid fundamentals.”

REITs took off in 2000 in part because valuations were so depressed. At the time, the average REIT was selling at a discount of 18 percent to its Net Asset Value (NAV). That means that if the REIT were to sell all its properties and pay off all its debt, the cash it would hold would still be 18 percent more than its stock market capitalization. Some savvy investors who weren't blinded by the crescendo of the tech-stock bull market noticed these ridiculously cheap valuations and started bidding up the prices. By the end of the year, the Nareit index had climbed a whopping 25.9 percent.

In 2001, as the S&P 500 fell 13.1 percent, the downturn was in evidence almost everywhere: The dot-coms imploded; the Nasdaq was a scene of carnage; the Dow Jones Industrial Average, long a rock of stability when the general markets became frothy, ended in negative territory. Even utility stocks, supposedly the most conservative equity investment one can make, were down a stunning 28.7 percent. But what about those REITs?

Late Cycle Bloomers

REITs in 2001 shined, with the Nareit index up 15.5 percent by the end of the year. And it made perfect sense. REITs, like all real estate investments, are late cycle bloomers. When an economy starts its downturn at the end of a cycle, REITs typically begin to outperform most other sectors. That's because income is based on their long-term leases and the impact of a slowing economy tends to lag by two to three years. Back in 1998, as the markets were booming and companies were expanding at a feverish pace, new real estate leases were being signed at a dizzying rate. The income produced by those leases still flowed in 2001, during a time when little else seemed to be making money.

Winning REIT Funds Ranked by Three-Year Returns
Y-T-D 1 Yr. 3 Yrs. 5 Yrs.
Kensington Strategic Realty A 1.11 7.12 26.34 NA
Alpine Realty Income & Growth Y 13.41 20.13 19.62 NA
Phoenix-Duff&Phelps Real Estate Sec A 9.9 12.35 17.23 5.31
Third Avenue Real Estate Value 1.14 6.82 16.49 NA
SSgA Tuckerman Active REIT 5.88 9.32 16.47 NA
Undiscovered Managers REIT Inst. 4.94 9.62 15.61 NA
Alpine U.S. Real Estate Equity Y 2.77 25.72 15.51 0.79
Spirit of America Investment A 7.74 12.77 15.44 NA
Delaware Pooled Real Estate Inv. Tr II 4.71 9.72 15.19 NA
Cohen & Steers Equity Income A 5.49 10.44 15.1 6.93
Fidelity Real Estate Inv. 4.04 7.62 15.07 3.8
Stratton Monthly Dividend REIT 6.67 14.25 14.87 5.92
First American Real Estate Secs Y 5.85 10.4 14.85 4.66
T. Rowe Price Real Estate 3.98 8.03 14.61 NA
DFA Real Estate Securities 3.66 8.22 14.59 4.81
AIM Real Estate C 7.21 10.5 14.36 2.1
Fidelity Real Estate High-Income 13.44 15.07 14.36 10.33
Gabelli Westwood Realty AAA 3.39 7.51 14.35 5.51
Delaware REIT A 3.91 8.82 14.33 5.4
M.S.D.&T. Diversified Real Estate 3.72 7.95 14.27 5.4
Principal Real Estate A 6.86 10.47 14.19 NA
American Century Real Estate Inv. 5.31 9.78 13.99 3.45
Forward Uniplan Real Estate Inv. 3.65 8.26 13.97 NA
Cohen & Steers Special Equity 6.06 9.83 13.95 0.27
Excelsior Real Estate 2.95 7.67 13.75 4.23
Source: Morningstar

REITs have again outperformed the broader market. The Nareit index is down just 1.8 percent through Oct. 11 — a respectable performance when compared to a painful loss of 29.9 percent in the S&P 500 during the same period.

Does all this outperformance mean that REITs are poised for a downturn? Though they might be close to fair valuation, REITs are by no means expensive, says Rodriguez of AIM. “They're not extraordinarily cheap like they were in January of 2000, but by no means are they overvalued.”

Valuing REITs

The most common method of valuing REITs is via the P/FFO ratio, or stock price divided by funds from operations. FFO is a common method of measuring earnings for a real estate company by which one takes its past four quarters of net income, adds or subtracts any gains or losses from the sale of assets and then subtracts the depreciation of its remaining assets. Like the P/E ratio commonly used to value traditional stocks, the P/FFO ratio provides a sense of how expensive a REIT stock is compared to its ability to make money. According to First Call/Thomson Financial, the average P/FFO of the overall REIT industry for the last 10 years is 9.5. Currently, the average is 9.2. By comparison, at the outset of the last bull market in December 1993, REITs traded at an average P/FFO of 11.2.

Another way to measure the relative value of REITs is to look at the P/NAV ratio. This valuation tool divides the market capitalization of the stock by the overall value of its real estate holdings minus its debt. In other words, this ratio sheds light on exactly how much cash a company would have in relation to its market value if it were to immediately sell all of its assets and pay off all its debt. On the basis of P/NAV, REITs look even cheaper. Historically, REITs have traded at an average P/NAV premium of 4 percent. In other words, the price of the stock is worth 4 percent more than the value of the firm's assets minus its debt. Today, REITs are trading at an average P/NAV discount of 5 percent, according to Rodriguez. “The ‘REITs are cheap’ thesis is less compelling than it was a year or two ago, but it still holds water,” says Mike Kirby, head of research for Green Street Advisors, a REIT-only research firm.

Investing in REITs is not just about capital gains. By law, REITs must pay out 90 percent of their earnings to shareholders to receive special tax treatment. Therefore, yield is another factor in valuing REITs. Currently, REITs pay about 6.9 percent in dividends, on average. And in terms of total return, REITs over time stack up nicely: Over the 10 years ended in 2000, the S&P 500 averaged an annualized total return of 11.4 percent and the Salomon Brothers Broad Investment Grade bond index 7.4 percent while the Nareit index returned 12.7 percent.

Past returns, of course, don't justify future investment decisions. In the final analysis, the best reason to own REITs is the diversification of portfolios. REITs are a proven hedge because they have low correlation to the broader equity markets. Compare the Nareit index to the S&P 500 over the last 10 years and you'll find a correlation of only 0.27. Its correlation to the Nasdaq is even less: 0.09.

According to a recent study by Ibbotson Associates, a Chicago-based research firm, the correlation between equity and REIT performance has declined dramatically over the last three decades: during the 1970s, the Nareit index's correlation was 0.64. Thus, any correlation has declined over the last three decades. “The goal of diversification is to lower the risk of a portfolio for a given level of return,” said Michael Henkel, president of Ibbotson Associates. “Because of their declining correlations with other types of investments, REITs offer a significant source of portfolio diversification.”

Caveat investor: Not all REITs are created equal. It's important to understand in which part of the commercial real estate industry a given REIT is invested. Fundamentals, for example, differ between office and apartment REITs. And retail REITs don't respond to changes in the economy in the same way as funds that hold industrial properties.

The office market, for instance, has been hard hit by corporate downsizings. Some markets, such as in northern California, have 40 percent vacancy rates. Even those that are doing well, like New York, have a relatively high vacancy rate of 12 percent. Meantime, a glut of sublease space is driving down asking rents. Those forces are starting to have an impact on the cash flow of office REITs. Analyst Steve Sakwa of Merrill Lynch estimates that the average FFO growth of office REITS (which usually average around 5 percent) will grow only 4.3 percent in 2003. The cause for the slowdown, according to Sakwa, is that the supply/demand conditions appear even more challenging than previously anticipated. In other words, vacancies are rising.

Could Be Worse

Still, the picture is not as bad as the recession of the early 1990s, says Delaware REIT fund co-manager Tom Trotman. “This time, it's sloppy and weak demand that's the villain, not an oversupply of office space,” he says.

Ken Statz, the co-manager of the Security Capital U.S. Real Estate Shares fund, is avoiding the office market because he doesn't expect the situation to get better in the next couple of years. “Occupancy rates are down in some markets to as low as 85 percent, which is about as low as it has gotten in the last two decades,” he says.

A brighter spot is the industrial REIT market, which mostly own warehouses. Unlike office buildings, which take long to develop and lag the economy, industrial structures can be built quickly and be shut down even faster. Industrial REITS, therefore, tend to mirror current economic conditions. “They are a great way to invest in the concept that we're entering a long, slow recovery from recession,” says Steve Buller, manager of the Fidelity Advisor Real Estate fund, which launched in September. “This group's fundamentals are sound, and their valuations haven't gotten too pricey.”

The retail sector — shopping centers, strip malls, etc. — is more of a mixed bag. Retail real estate stocks have been the best performers of the last two years, thanks to the valiant U.S. consumer, who has single-handedly kept the economy afloat. “Retail REITs kept their spaces filled and even raised rents, which is something special during a recession,” says Statz.

But the success of retail REITs has overheated the sector. Three consecutive years of double-digit returns, each time far outdistancing the performance of the broader market, have puffed up the valuations of retail REITs so high that some value investors now are steering clear of them. “Their fundamentals are solid, but they're just not as cheap as they used to be,” says Fidelity's Buller.

If it's low prices you crave, explore the apartment REIT sector. As interest rates plummeted, renters fled their apartments for cheap mortgages and vacancy rates rose. Consequently, investors fled this arena, gutting its stock prices in the process. Yet, several money managers see opportunity amid the mayhem. “When rates start to rise, the exodus to homes will end and the apartment business will be healthy again very quickly,” says Trotman.

Statz isn't waiting for a change in interest rates. In expensive housing markets like New York, Southern California and Washington he says, “it doesn't matter how low rates go when it costs a half a million dollars for a starter home.” His fund selectively buys apartment REITs in those markets while avoiding cheaper housing markets like Chicago and Atlanta.

Hotel REITs have also been pummeled. Business and leisure travel have been hurt by the economy and the aftermath of September 11, the results of which were felt most immediately by hotels. Starwood Hotels, which owns numerous hotels in the New York area, dropped 39 percent immediately after September 11. It recovered most of its losses a year later, but then dropped another 40 percent in September and October of 2002 because of investor doubts about a real recovery in business travel. Because of the recent dropoff, hotel REITs trade at low multiples.

The last major subsector is healthcare REITs. These companies own hospitals, nursing homes or doctors' offices. Again, there is debate about future growth prospects in the sector. On the one hand, a growing list of hospitals and nursing homes are going bankrupt. “I like the acquisition opportunities in health care,” says AIM's Rodriguez. “If the REIT has a good management team, it can buy bankrupt properties cheaply and turn them into a good income-producing business.”

On the other hand, as in all things related to health care, changes in government regulation must be factored in, according to Fidelity's Buller. “A slight change in how much Medicare pays for nursing home care could have a catastrophic effect on nursing home REITs,” he says. Buller focuses his health care REIT investing on the hospital REITs, and even those aren't cheap.

All these sectors have one thing in common: They will be deeply affected by the rate of economic recovery. If, for example, you expect a long, slow recovery, industrial REITs are your best bet. If you foresee a sudden jump in the economy and, conversely, in interest rates, apartment REITs will likely hit the jackpot. And if you expect the recession to come back and haunt the market with a double dip, office REITs with their long-term leases might be one of the last safe harbors.

All of these considerations, of course, assume that you're interested in timing the market. If you're more interested in settling into REITs for the long-term, now is just as good a time as any. “They might not be as table-pounding cheap as they were three years ago,” says Delaware's Trotman. “But it's still a great time to buy REITs.”

REIT Terms

Like all investment vehicles, REITs have their own language. Here are some of the most common terms and abbreviations.

REIT — Real Estate Investment Trust. A REIT is a company that owns and operates real estate and has chosen to pay out at least 90 percent of its funds from operations to shareholders as dividends. REITs are the most conservative type of real estate investment for the individual investor and are also the most common. REITs account for 85 percent of all publicly held real estate companies.

REOC — Real Estate Operating Company. A REOC is like a REIT in that it is a company that owns and operates commercial real estate, but unlike a REIT in that it has the freedom to reinvest all its funds from operations back into the company. REOCs tend to be more aggressive investments and have higher growth prospects than REITs, but they don't produce as much income.

FFO — Funds From Operations. This is a method of calculating earnings that is tailor-made for the real estate industry. The formula is relatively simple: Take the net income a company produces, add or subtract any gains or losses from the sale of properties and subtract the depreciation of its assets. Unlike the earnings figures used by most corporations, FFO is much more difficult to manipulate by financial wizardry and thus is a much more stable and believable sign of how well a company is performing.

P/FFO — Price to FFO Ratio. The most commonly used valuation tool for determining how cheap or expensive a REIT is. Like the P/E ratio (price-to-earnings ratio), it is a simple act of division: Divide the price of the REIT's stock by the sum of its trailing four quarters' funds from operations.

NAV — Net Asset Value. The value of all of a REIT's properties minus its debt; in other words, the equity a REIT owns in its properties. Like the equity that a homeowner accrues in a mortgage, the NAV tells how liquid and financially healthy a REIT is.

Yield — Dividend Yield. This is the same ratio used for any dividend-producing stock: the income paid out in dividends divided by the stock's price. Remember that it's not the same thing as an interest rate. A dividend can remain the same, but the yield can go up or down depending on the movement of the price of the stock. Also, remember that REITs only pay dividends when they're making money. Thus it's possible (unlike with a bond) for a REIT to not have a yield.

CMO — Collateralized Mortgage Obligation. This is a derivative product that masses together mortgages and goes up and down in unison with them. Therefore, it can be very exposed to interest-rate risk. Some REITs, called Mortgage REITs, invest their entire portfolio in CMOs. Other REIT mutual funds will buy some CMOs to supercharge their portfolio. But remember that there's a lot of risk involved with them, especially when interest rates have nowhere to go but up.
SJ

The Many Flavors of REITs

Every REIT involves commercial real estate, but similarities end there.

  • Health Care REITs. Usually, these REITs invest in either hospitals or nursing homes, although some hybrids invest in all types of medical facilities. They are heavily influenced by government regulations on how Medicare pays medical bills. (They account for 5 percent of the Nareit Composite REIT index.)

  • Hotel REITs. These firms own hotels or resort properties. Occupancy rates are the most crucial statistic in keeping track of these companies. Rates are now at historic lows, hurt by cutbacks in corporate travel. Everyone is expecting a recovery in these stocks, but no one knows when (5 percent of Nareit Composite.)

  • Industrial REITs. The name is slightly misleading, as most of these companies own warehouse space, not factories. Because warehouses are so easily built and shuttered, this subsector responds quickly to changes in economic conditions (6 percent of Nareit Composite.)

  • Multi-Family Housing REITs. Otherwise known as apartment REITs, these firms tend to move in the opposite direction of housing prices. As interest rates fall, more apartment dwellers leave to buy their own homes. They also are heavily effected by employment trends: the higher the unemployment rate, the more twenty-somethings move back in with their parents. Right now, this is the cheapest subsector in the REIT universe (18 percent of Nareit Composite.)

  • Office REITs. These companies own office properties, from downtown office buildings to suburban office parks. They tend to be shielded from sudden shifts in the economy by their long-term leases (23 percent of Nareit Composite.)

  • Retail REITs. They own shopping malls and strip malls, and often move in unison with retail stocks. As long as they can keep their storefronts filled and rents steady or rising, they'll do well. These REITs have performed especially well in the last two years (23 percent of Nareit Composite.)

  • Specialty REITs. They invest in prisons, land tracts, storage lots, casinos and even mortgage-based derivatives. “Unless you have some special personal experience in that particular business, it's best to avoid these stocks,” says Security Capital Real Estate Shares fund manager Ken Statz. “Luckily, I have no intimate knowledge of the prison REIT world” (20 percent of Nareit Composite.)
    — SJ

Is Your REIT Fund Really a REIT Fund?

The easiest way to own REITs is buying a REIT fund, but they're not all alike.

On the face of it, the Davis Real Estate fund (RPFRX) looked like a pretty good mutual fund in which to invest at the beginning of 2001. It had come off an excellent year of performance, shooting up 25.7 percent, and in the previous three years it had handily beaten its bogey, the Wilshire Real Estate Index. It stuck to high-quality companies with good balance sheets. Yet, if you owned the fund during the turbulent year of 2001, you would have been sorely disappointed. It squeaked out only 0.64 percent total return, while the index managed 10.5 percent.

You might have gotten a better sense of the impending doom if you had looked at the fund's top holdings and found Six Flags (PKS) isted. An amusement park company in a real estate fund?

That just goes to show that a surface skimming of past performance isn't enough to pick any fund, least of all a REIT fund. Because the primary goal of these funds is to own real estate, they often stretch the definition of the term to its limits. Sometimes that can lead to breathtaking results. At other times, it can leave a fund submerged while its index sails quickly away.

The latter is what happened to the Davis fund in 2001. Andrew Davis, the manager of the fund, admits freely that his deviation from traditional REITs is the main reason for his fund's 2001 underperformance. He lays the blame especially on Six Flags and American Tower (AMT), which leases cellular antennas to phone companies. He bought the companies because of their large land holdings, but ignored the fact that the primary business of both firms has nothing to do with real estate. “Simply put, these two investments were mistakes,” says Davis.

He and his fund company have since gone to great lengths to correct the mistakes. At the end of July, the fund altered its prospectus, telling investors that only 20 percent of the fund's assets can be held in non-real estate companies (previously the limit had been 35 percent). The changes appear to have worked. In the first seven months of 2002 the fund had a total return of 7 percent, exactly even with the Wilshire Real Estate index and more than 27 percentage points higher than the return of the S&P 500 during the same time period.

Other funds have done consistently well while owning some nontraditional real estate companies. Take the Delaware REIT fund (DPREX), whose managers Tom Trotman and Damon Andres are willing to take a flier on a stock whose business is only tangential to real estate. Trotman has owned land companies and even “dabbled” in casinos. “But the difference between us and some of our peers is that you'll find stocks like that at the bottom of our portfolio holdings, not at the top,” says Trotman.

So what's the best way to pick a REIT fund? Read its disclosure documents carefully. Make sure that its main holdings are indeed REITs, or at least REOCs. Read the management's discussion of previous results and look for clues about how the fund is managed. And of course look at the fund's performance record, but make sure that you compare it to its peers or a good real estate stock index like the Wilshire or the Standard & Poor's Specialty Real Estate Index, as opposed to the larger market.

Another factor to consider is the size of the fund. Remember that the REIT industry is tiny compared to the overall market. Add up the market capitalizations of every REIT and you end up with about $150 billion. The stock market itself has a capitalization well into the trillions. Even if a REIT is so big that it looks like a monster compared with its peers, it's still a small cap stock. And with small size comes a small float and liquidity problems.

Which is not to say that a huge fund should be discounted just because of its size. Some of the REITs with the longest histories have the most experienced managers and are examples of well-run companies. Among the most notable is Cohen & Steers Equity Income (CSEIX), managed by a boutique firm that engages only in real estate investing.

Martin Cohen and Robert Steers introduced the first real estate mutual fund in the United States in 1985, and it's lauded throughout the industry as the most experienced and adept real estate vehicle. Their fund has grown to $1.2 billion in assets and for the last few years has done little more than track the index. That in itself is not necessarily a black mark. However, if you're looking for a higher-octane fund for an aggressive investor, a smaller fund might have more leeway to jump in and out of the smaller REITs, which have a higher potential for return.

The most important thing to remember about picking REIT funds is to know what you're buying. Do your homework so that you understand the fund and how it works. That way you'll have fewer surprises when the quarterly performance reports start coming back.
SJ