Investing in REITs

Bloomberg Press

Contents

INTROUCTION..................................................................................................................................1PART I Meet the REIT........................................................................................................................6CHAPTER 1 REITs: What They Are and How They Work An essential framework for investors......................................................81CHAPTER 2 REITs vs. Competitive Investments How they stack up against common stock, bonds, and utilities...................................26CHAPTER 3 Today's REITs A revolution in real estate investing..............................................................................48CHAPTER 4 Property Sectors and Their Cycles From apartments to malls, office buildings to prisons..........................................64PART II History and Mythology................................................................................................................102CHAPTER 5 REITs: Mysteries and Myths Setting the record straight...........................................................................104CHAPTER 6 A History of REITs and REIT Performance From the trials of the 1960s to the comeback of the 1990s and beyond.....................124PART III Choosing REITs and Watching Them Grow..............................................................................................156CHAPTER 7 REITs: How They Grow A look at net value-from net income to FFOs.................................................................158CHAPTER 8 Spotting the Blue Chips Types of REITs and investment styles.....................................................................192CHAPTER 9 The Quest for Investment Value Defining a strategy that suits your needs.........................................................238CHAPTER 10 Building a REIT Portfolio Choosing the right mix of investments.................................................................268PART IV Risks and Future Prospects..........................................................................................................292CHAPTER 11 What Can Go Wrong It pays to know the pitfalls..................................................................................294CHAPTER 12 Tea Leaves: Where Will REITs Go from Here? New opportunities for today's investors..............................................324RESOURCES....................................................................................................................................363INDEX........................................................................................................................................390

Chapter One

What's your idea of the perfect investment? How about one that promises not to double overnight or make you an instant millionaire, but instead will pay you a consistent 6 or 7 percent in quarterly dividends and can rise another 6 or 7 percent annually as surely and steadily as if they were, say, rent? How about real estate?

Sure, you say, but only if there were a way to buy and own real estate in a hassle-free way, as if an experienced professional dealt with the business of owning and managing it and just gave you the profits. And only if you could sell your real estate-if you wanted to-easily, as easily as you can sell a common stock. Well, read on. This is all possible with real estate investment trusts, or REITs, as they are commonly called.

REITs have provided individual investors all over the country with a way to buy skyscrapers and shopping malls and hotels and apartment buildings-in fact, just about any kind of real property you can think of. REITs give you the perk of the cash flow that real estate leases provide, but with the benefit of a common stock's liquidity. Equally important, REITs often have access to capital and can therefore acquire and build additional properties as part of their ongoing real estate business.

Besides that, REITs can add stability to your investment portfolio, because real estate as an asset class has long been perceived as an inflation hedge and has enjoyed low correlation with other asset classes.

REITs have been around for forty years, but it's only been in the past ten years that most people have really started buying into these high-yield investments. From the end of 1992 to the middle of 2001, the size of the REIT industry has increased almost tenfold. But, according to many experts, the REIT industry, having so far captured only about 10 percent of the $3.5 trillion commercial real estate market, still has plenty of room left for growth.

Stan Ross, managing partner of E&Y/Kenneth Levanthal Real Estate Group, defines REITs by saying, "They are real operating companies that lease, renovate, manage, tear down, rebuild, and develop from scratch." That helps define a REIT, but you need to know not only what a REIT is, but also what it can be to you and what you can expect from it in terms of investment behavior.

REITs provide substantial dividend yields, which generally range between 4 and 10 percent, making them an ideal investment for an IRA or other tax-deferred portfolio. But unlike most high-yielding investments, REIT shares have a strong likelihood of increasing in value as the REIT's properties generate higher cash flows and additional properties are added to the portfolio.

REITs own real estate, but, when you buy a REIT, you're not just buying real estate, you're also buying a business.

When you buy stock in Gillette, for example, you're buying more than razor blades. REITs are corporate real estate entities overseen by financially sophisticated, skilled management teams who have the ability to grow the REITs' cash flows by 4-8 percent annually-and sometimes much more. Adding a 6 percent dividend yield to capital appreciation of 4-8 percent, resulting from 4-8 percent annual increases in operating cash flow, provides for total return prospects of 10-14 percent.

A successful REIT's management will accept risk only where the odds of success are very strong. This is because, generally, they are investing their money right alongside yours and don't want to risk loss of capital any more than you do. REITs run the properties in such a way that they throw off steady income; but they also have an eye to the future and are interested in growth of the property portfolio and in taking advantage of new opportunities.

TYPES OF REITS

THERE ARE TWO basic categories of REITs: equity REITs and mortgage REITs.

An equity REIT is a publicly traded company that, as its principal business, buys, manages, renovates, maintains, and occasionally sells real properties. It also acquires properties and frequently develops new properties when the economics are favorable. It is tax advantaged in that it is not taxed on the corporate level, and, by law, must pay out at least 90 percent of its net income as dividends to its investors.

A mortgage REIT is a REIT that makes and holds loans and other obligations that are secured by real estate collateral.

The focus of this book is equity REITs rather than mortgage or hybrid REITs (REITs that own both properties and mortgages). Although mortgage REITs can, at times, deliver spectacular investment returns, equity REITs are less vulnerable to changes in interest rates and have historically provided better long-term total returns, more stable market-price performance, lower risk, and greater liquidity. In addition to that, equity REITs allow the investor to determine not only the type of property he or she invests in, but also the geographic location of the properties.

GENERAL INVESTMENT CHARACTERISTICS

PERFORMANCE AND RETURNS

DURING THE TWENTY-YEAR PERIOD ending October 31, 2001, equity REITs have delivered an average annual total return to their investors of 12.6 percent. Compared to the performance of the stock market during that period, those returns aren't bad, are they? Look at the chart shown below. According to the REIT trade association, The National Association of Real Estate Investment Trusts, or NAREIT, equity REITs have, over long time periods, provided their investors with compounded annual total returns close to that of the S&P 500.

However, if REITs' performance was merely comparable to the S&P Index, you wouldn't be reading a book about them. The performance of lots of high-risk stocks have substantially exceeded the returns provided by the broad market. Here's the difference: REITs have nearly matched the S&P's total return in spite of having benefits not usually enjoyed by stocks that keep pace with the market, namely low correlation with other asset classes, low market-price volatility, limited investment risk, and high current returns.

LOW CORRELATIONS

CORRELATIONS MEASURE how much predictive power the price behavior of one asset class has on another to which it's compared. In other words, if we want to predict what effect a 1 percent rise (or fall) in the S&P 500 Index will have upon REIT stocks, small caps, or bonds for any particular time period, we look at their relative correlations. For example, if the correlation of an S&P 500 Index fund with the S&P 500 Index is complete, i.e., 1.0, then a 2 percent move in the S&P 500 Index would predict that the move in the index fund for the same period would also be 2 percent. Correlations range from a perfect +1.0, in which case the movements of two investments will be perfectly matched, to a (1.0), in which case their movements will be completely opposite. Correlations in the investment world are important, as they allow financial planners, investment advisers, and individual investors to structure broadly diversified investment portfolios with the objective of having the ups and downs of each asset class cancel each other out. This, ideally, results in a smooth increase in asset values over time, with much less volatility from year to year or even quarter to quarter.

According to NAREIT, REIT stocks' correlation with the S&P 500 during the period from January 1993 through October 2001 was just 0.24. Thus price movements in REIT stocks have had only a 24 percent correlation with the broad market, as measured by the S&P 500 Index, during that period. Theoretically, in a hot market, when the S&P 500 Index is rising sharply, REITs' relatively low correlation will act as a drag on their performance relative to the broad stock market indices. This happened in 1995, when REIT stocks lagged behind the popular indices but still provided investors with total returns of 15.3 percent, and in 1998 and 1999, when REITs' returns were actually negative despite strength in the S&P 500. Conversely, in a bear market, such as in 2000 and most of 2001, low correlating stocks such as REITs should provide stability to cushion the drop in the value of a fully diversified portfolio.

REITs offer diversification to your portfolio because they don't correlate well with the rest of the market.

A study of correlations completed by Ibbotson Associates in 2001 concluded that the correlation of REITs' stock returns with those of other equity investments has declined significantly when measured over various time periods since 1972, when NAREIT first began to compile REIT industry performance data. For example, REITs' correlation with large-cap stocks, as measured by the S&P 500 Index, was 0.55 during the entire period 1972-2000, but was just 0.25 for the seven years from 1993 to 2000. A similar reduction in correlations occurred with small-cap stocks; the average over the entire period was 0.63, but was only 0.26 since 1993. Based upon this and other historical data used by Ibbotson in its study, a $10,000 investment in 1972 in a portfolio consisting of 50 percent S&P 500 stocks, 40 percent bonds, and 10 percent T-bills would be worth $219,049 at the end of 2000. However, adding REITs to this portfolio at the beginning in 1972, with a composition of 40 percent S&P 500 stocks, 30 percent bonds, 10 percent T-bills, and 20 percent REIT stocks, would have generated asset values, at the end of 2000, of $238,349. The difference in return amounted to approximately one-half a percentage point annually, and reduced portfolio risk by a like amount.

Why have REIT stocks performed so well relative to their investment peers despite, as we'll see below, their lower volatility and risk? One possibility is that, because of the myths and misperceptions concerning REITs that we'll explore later, REIT stocks have not been efficiently priced and were, in fact, priced below what one would expect in a perfectly efficient market. In other words, in addition to all their other advantages, REITs may be considered value investments.

LOW VOLATILITY

a stock's "volatility" refers to the extent to which its price tends to bounce around from day to day, or even hour to hour. My observations of the REIT market over the past twenty-seven years have led me to the conclusion that REIT stocks are simply less volatile, on a daily basis, than other equities.

REITs' high current yields often act as a shock absorber against daily market fluctuations.

Equally important, there is a predictability and steadiness to most REITs' operating and financial performance from quarter to quarter and from year to year, and there is simply less concern about major negative surprises.

Why is this important? Our biggest investment mistakes are emotional ones. When our stocks are going up, we tend to throw caution to the winds in our pursuit of ever greater profits. Likewise, when our stocks are dropping, we tend to panic and dump otherwise sound investments, because we're afraid of ever greater losses. When is the "right" time to sell or buy? Prudent investors have learned through experience to temper their emotional reactions, but low volatility in a stock can make patient and disciplined investors of us all.

Sometimes our financial decisions are not based on prudent market strategy but on what's going on in our personal life. Let's say the market is having a bad week. You know this is not the time to sell, but your daughter's tuition is due. Not to worry. If your shares are in a REIT instead of a tech stock, chances are you can sell them at very close to the price at which they were trading last month or even last year-and they've been paying all those fat dividends in the meantime.

LOW RISK

THERE'S JUST NO WAY to avoid risk completely. Simple preservation of capital carries its own risk-inflation. Since inflation came along, there's no such thing as "no risk." Real estate ownership and management, like any other business or commercial endeavor, is subject to all sorts of risks. Mall REITs are subject to the changing tastes and lifestyles of consumers; apartment REITs are subject to overbuilding and declining job growth in their properties' geographical areas; and health care REITs are subject to the politics of government cuts in health care reimbursement, to cite just a few examples.

Yet, despite this, those who own commercial real estate can limit risk, including the risk of tenant bankruptcies-if they are diversified in sector, geographic location, and tenant roster. For example, if one tenant is doing badly, there are usually other tenants who are doing fine. This kind of thing happened repeatedly during the past twelve years in the retail industry, and the retail REITs have continued to do well; they continually find new tenants to replace the losers. Beware, however, of real property designed for a single use, in which case the departure of the one and only tenant could present a real problem for the property owner.

Holders of most common stocks must contend with yet another type of risk, related not to the fundamentals of a company's business but to the fickleness of the financial markets. Let's say you own shares in a company whose business is doing well. The earnings report comes out and the news is that earnings are up 15 percent over last year. But because analysts expected a 20 percent increase, the price of the stock drops precipitously. This has been a common phenomenon in the stock market in recent years, but REIT investors have rarely suffered from this syndrome.

Analysts who follow REITs are normally able to accurately forecast quarterly results, within one or two cents, quarter after quarter.

This is because of the stability and predictability of REITs' rental revenues, occupancy rates, and real estate operating costs. True, compared to tech stocks, REITs are not very exciting, but think of what you'll save on aspirin and Maalox.

When you look at the riskiness of equity REITs, you see that very few have gotten into serious financial trouble over the years. Those that have had difficulties have done so through excessive debt leverage, poor allocation of capital resources, or questionable transactions with directors or major shareholders. Such shenanigans can occur in any company. Remember, there is no such thing as no risk. If you're investing primarily in the higher-quality REITs (and we'll tell you how to be the judge of that), the long-term risk of REIT investments is far lower than that of most other common stocks.

Continues...

Excerpted from Investing in REITsby Ralph L. Block Copyright © 2002 by Ralph L. Block . Excerpted by permission.
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