It's a Wrong Time For REITs

By ANDREW BARY From Barron's

--August 16, 2005

Until a recent setback, real-estate investment trusts, or REITs, had been one of the hottest sectors in the stock market.

Even with the pullback of 7%, the stocks appear to be no bargain because dividend yields are at record lows and valuations are high based on various measures of REIT earnings. "REITs are being priced for perfection," says Peter Siris, who heads Guerrilla Capital, a New York investment firm. "REITs have benefited because the economy has stayed strong while rates haven't gone up. But I don't think you can have a decent consumer economy and lower rates forever." Morgan Stanley's REIT index is still up about 6% this year, after gaining more than 30% a year in 2003 and 2004. It had been more than 10% higher until a three-day sell-off that started Aug. 4.

Five years ago, REITs had juicy dividend yields close to 9%. Now, dividends average just 4.5% and some leading REITs, including Vornado Realty Trust (VNO), Boston Properties (BXP), Simon Property Group (SPG) and Public Storage (PSA), yield less than 4%.

REITs don't buy single-family homes, but they do own nearly all types of income-producing properties, including office buildings, shopping malls, apartment complexes and storage facilities. There are about 200 public REITs with a combined market value of $300 billion. The run-up in REITs has mirrored the surge in home prices across the country. Oddly enough, the rising commercial-property market hasn't reflected great improvements in operating profits. Rather, institutional investors have been hungry for commercial real estate and have bid up prices.

REITs generally are valued based on certain measures of cash flow, rather than reported earnings, because investors deem the depreciation charged against reported profits to be a phantom expense. Most properties aren't losing value, they argue. REITs trade on average for about 20 times a widely used cash-flow measure called adjusted funds from operations (AFFO). That's very rich by historical standards.

REITs are vulnerable if interest rates continue to rise. As income-oriented investments, REITs are hurt if yields rise on alternatives, such as bonds. Investors also need to recognize that REITs didn't benefit from the reduction two years ago in the federal tax rate on dividends. The result is that the after-tax yield on a REIT yielding 4.5% is about 3.2% for someone in a high tax bracket. A similar 4.5% dividend on a common stock would result in an after-tax yield of 3.8%.

Income-oriented investors might do better owning high-yielding stocks such as the Baby Bells, Altria (MO; formerly Philip Morris,) Citigroup (C) and Bank of America (BAC), all of which have dividends of 4% or more.