REITs .. Don't Fail Me Now ..
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Mortgage rates are at historic lows, and housing prices have taken a beating. But for investors eyeing real-estate income, the best deals can be found in shares of professionally managed property portfolios.
Real-estate investment trusts, or REITs, mostly buy property such as apartment buildings and office parks. They avoid paying taxes on their income so long as they pay the bulk of it out to shareholders as dividends. Investors buy REITs as they would regular stocks, with particular attention to the dividend yield, or the percentage of the share price paid out as dividends.
REITs have been hit hard recently: As of Friday, the MSCI U.S. REIT Index had dropped 19% since July 22, versus 16% for the Standard & Poor's 500-stock index.
That is an opportunity, says Kevin Bedell, manager of the JP Morgan U.S. Real Estate Fund. "It's a Goldilocks situation, with low interest rates but also strong demand and tight supply," he says. "And we've had a nice correction, so now prices are attractive, too."
REIT investing can be tricky, however, because the portfolios can specialize in everything from hotels to data centers.
One way for investors to compare different portfolios is to compare the lease periods for the buildings they hold. When leases are short, cash flow changes more quickly in response to economic conditions, for better or worse. When leases are long, the investments usually are steadier.
That puts hotel REITs at one extreme of the universe, because their "leases," or room bookings, often cover only a night or two, and health-care facilities near the other end, because their leases often last 10 or 15 years, according to Mr. Bedell. In between are multifamily housing (typical lease: one year), industrial warehouses (three to five years) and shopping malls (seven to 10 years or longer.)
The most popular parts of the market usually aren't where the best deals are found. Office space in the central business districts of New York, San Francisco and Washington is in strong demand, for example, but because of high costs in those markets, many REITs focused on such properties have dividend yields of only 2% to 3%.
Mr. Bedell prefers high-quality suburban office property, which offers more income for the price, he says. Among his favorite REITs is Mack-Cali Realty, based in Edison, N.J., which has diversified property on the eastern seaboard and offers a dividend yield of 6.4%. It is a stable portfolio and the company is able to borrow at attractive rates, he says.
Another is Corporate Office Properties Trust, based in Columbia, Md. Shares have fallen 29% since the end of June in part because of the portfolio's focus on government tenants, especially in the defense sector. But while investors fear defense spending cuts, the REIT is focused on information-technology tenants that are better protected from cuts, according to Mr. Bedell. The dividend yield is 7%.
REITs focused on multifamily housing also are well positioned, says Haendel St. Juste, an analyst with Keefe, Bruyette & Woods. With the single-family market still in the tank, there is "huge negative sentiment" toward buying a home, he says. Each 1% drop in the homeownership rate brings more than a million new renters, he estimates, and supply hasn't kept pace. What's more, the population of 20- to 34-year-olds, a key renting demographic, is swelling, he says.
Mr. St. Juste recommends shares of AvalonBay Communities and Equity Residential, which focus on pricey locales like New York, D.C. and Seattle, rather than "Sun Belt markets, where the jobs don't offer a lot of pricing power for landlords."
Health-care REITs could offer opportunities as well. Worries about Medicare cuts hurting tenants have turned investors off, but there are two reasons shares might perform better than expected, Mr. St. Juste says. First, REIT managers usually require that tenants earn much more than they need to cover their rent, so lower profits wouldn't necessarily change the cash flow on the real estate. Second, property owners can help health-care operators cut costs—for example, by combining more operations into a given space.
Mr. Bedell points to HCP and Ventas as good buys. Both have diverse portfolios that include labs, office space, assisted-living facilities and more. HCP has the higher yield, at more than 5%.
One last point: REIT buyers should pay attention to leverage. Most real-estate investors use debt to increase returns, and for now, at least, interest rates are favorable. But just as conservative banks prefer to lend no more than 80% of the purchase price of a house, conservative REIT buyers should be wary when debt levels exceed 65% of assets, analysts say. (Cash flow and other factors play a role, of course.) The REITs cited above have debt of 40% to 60% of their assets and generate ample cash.
—Jack Hough is a columnist at SmartMoney.com. Email: jack.hough@dowjones.com
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