Real Estate Investment Trusts Still Attractive

BERLIN – When home prices were soaring, real estate investment trusts (REITs) prospered along with them. Now that the housing market has cooled, it’s natural to assume that REITs are no longer as attractive an investment. But in this case, things aren’t quite so simple. REITs invest in a range of largely nonresidential properties as well as mortgages. And even during these days of housing-bubble woes, many REITs continue to show strength, albeit more selectively than before.

“Four years ago, you could have thrown darts at a list of REITs and done very well,” says Steve Sakwa, Senior REIT Analyst with Merrill Lynch’s Global Securities Research and Economics Group. “There are still attractive opportunities, but valuations have risen and it has become a stock picker’s market.”

For three of the four years since those dart-throwing days, the All REIT Index of the FTSE Group and the National Association of Real Estate Investment Trusts has racked up 30-percent-plus total annual returns. Now some mortgage REITs, which invest in loans either directly or through mortgage-backed securities, are feeling the effects of the subprime mortgage meltdown. However, equity REITs — which own and operate pools of commercial property, such as office buildings, shopping centers, apartment buildings and warehouses — tend to be insulated from the concerns of the housing market.

Sakwa currently rates only about one-third of the 60 or so REITs covered by Merrill Lynch analysts as “buys,” compared with almost 50% of that group that received a similar rating a few years earlier. Many REITs may find it difficult to improve on their already lofty valuations, says Sakwa, who notes that price-to-earnings ratios, useful for gauging most stocks’ value, tend to be less helpful when evaluating equity REITs. He prefers such measures as price-to-private-market value and price-to-cash-flow ratio. Price-to-private-market value considers what a company would be worth if it were broken into individual operations. Price-to-cash-flow, calculated by dividing the share price by cash flow per share, measures a company’s financial health by removing depreciation and other non-cash items from earnings. (That makes sense in the case of REITs because property rarely depreciates.)

REIT dividends also have to be viewed differently than most stocks’ payouts, according to Sakwa. Even though the average REIT pays an above-average dividend (with a yield of about 3.5 percent, compared to 1.8 percent for large-capitalization U.S. stocks), the cash that REITs provide is typically taxed as income, at personal marginal rates as high as 35 percent. Most stock dividends, on the other hand, qualify for a 15 percent tax rate.

Yet while tax considerations and valuations both need to be taken into account when evaluating REITs, there’s another factor to weigh: Because fluctuations in real estate prices tend not to track the ups and downs of stock and bond markets, REITs can bring useful diversification to a portfolio, Sakwa says. Overall, during the past quarter-century, the correlation of REIT returns with the returns of Standard & Poor’s 500® Index stock was 0.4. And the category’s numerous subsectors —from offices, apartments and regional and community malls to industrial complexes, self-storage facilities and manufactured housing — also tend to move independently of one another.

Of course, the diversification value of REITs doesn’t guarantee that their prices will rise, and today’s high valuations could heighten the risk of short-term declines, says Sakwa. Another increase in interest rates, for example, could push down the value of many REITs, at least temporarily.

What’s more, there are a variety of REIT strategies, including certain international REITs, that may match your specific long-term goals and risk tolerance. It’s why it’s important that you work with your Financial Advisor to determine the appropriate strategy for you.

(The writer is a Merrill Lynch Senior Financial Advisor. She can be reached at 410-213-9084.)