Real estate investment trusts are on a roll. Property-owning REITs in the FTSE Nareit US Real Estate index returned an eye-popping 15.3% in the fourth quarter of 2011, beating Standard & Poor's 500-stock index by 3.5 percentage points. For the year, property REITs gained 8.3%, clocking the S&P by 6.2 points.
One terrific quarter isn't necessarily a harbinger of additional gains. But things are looking good for REITs. Commercial real estate fundamentals are favorable, led by signs of a moderate but sustainable economic upturn. Apartment REITs remain attractive because young people with good-paying jobs don't want to tie themselves to one city. So they'll pay higher rents rather than buy a house, low mortgage rates or not. Retail property values are seeing a bump from the upturn in consumer spending. Most retail REITs will barely feel the wave of store chain closings. For example, Kimco Realty (symbol KIM) says spaces vacated by Borders bookstores and Super Fresh supermarkets took its overall occupancy rate from 93.5% all the way down to 93%.
Professionals analyze REITs several ways. One is to compare stock prices to the value of the assets a REIT owns. By that measure, REITs don't look particularly attractive. Share prices of dozens of prominent REITs exceed the value of the underlying assets by 10% and up. The most extreme case is Public Storage (PSA), which at a price of $136. PSA sells for a 35% premium to its assets. More than 90% of the storage king's structures are leased, and there's wicked competition in this, er, space, so you’re probably better off looking at its smaller and less-pricey rivals.
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The other primary way to evaluate a REIT is to look at it as an operating company rather than a collection of malls or apartments or rental lockers. One of the biggest positives for REITs is low interest rates, which lets them roll over maturing debt into new loans with lower costs or take out cash to reinvest in additional properties. Because credit has been cheap and widely available for most of the past decade (the period encompassing the financial crisis being a notable exception), REITs have been able to grow even while keeping their debt as a percentage of total capital roughly flat. REITs cannot sit on piles of cash for long anyway because they are required to distribute 90% of their net income as dividends.
Super-low interest rates also enhance the appeal of REITs. Property-owning REITs now yield 3.8%, on average. That's lower than the historical average but up from 3.4% a year ago. The yield is up mainly because REITs have steadily boosted their payouts, not because of lower share prices. The six largest REITs by total stock market value raised dividends by an average of 9.7% over the past year. And some REITs that almost went bust during the credit crisis and cut or suspended dividends, such as Host Hotels & Resorts (HST) and mall operator General Growth Properties (GGP), are now rebuilding their dividends.
In sum, the economic backdrop looks favorable for all manner of property REITs for the year ahead. If all you want is broad exposure to the category, put 5% to 10% of your stock portfolio in a real estate mutual fund or exchange-traded fund. Among mutual funds, reliable choices include T. Rowe Price Real Estate (TRREX) and Fidelity Real Estate Investment (FRESX), as well as Vanguard REIT Index (VGSIX) and its exchange-traded clone, Vanguard REIT ETF (VNQ). All these funds share many of the same stocks and are top-heavy in the largest REITs, such as Simon Property Group (SPG) in malls; Boston Properties (BXP) in trophy office buildings, and Avalon Bay Communities (AVB) in luxury rental housing. If I had to choose one, I'd opt for Fidelity Real Estate because its longtime manager, Steve Buller, holds more shares than the others in turnaround hopefuls, such as Prologis (PLD), a global industrial and warehouse owner, and Host Hotels. So I believe this fund has more upside potential than the others.
There's nothing wrong with owning shares of Simon or Public Storage or Avalon Bay. They're not steals, but they offer moderate yields and should throw off a growing stream of dividends. But if you seek more opportunity, check out the REITs below. Some of them have been disappointments, to say the least. But all are making financial progress, and all trade at a discount or a tiny premium to analysts' estimates of the net value of their properties (prices and other data are as of January 18).
Apartment Investment and Management (AIV, $23.52, 2%% yield) has lagged other apartment REIT stocks because it's lost money over the past few years. The REIT has been issuing new shares to fund its dividends. That's not a good way to run a REIT or anything else. But despite my distaste for this kind of maneuver, I believe Aimco, as the company is called, still offers promise. It has little debt and favorable credit lines, if needed, and its losses are narrowing. More to the point, it has reached 95% occupancy in its national collection of mid-priced apartments (average rent: $1,075) and is able to raise rents for new occupants by an average of 6% and 5% for holdover tenants 4. Aimco should benefit more from an improving economy and lower unemployment than REITs that focus on pricier rentals, whose residents have more money and better job security.
Duke Realty (DRE, $13.04, 5.2% yield) appeals if you're willing to wait for its huge mixed-use commercial and industrial projects to take root on its enormous holdings of vacant land. Duke's struggles with suburban office parks (a millstone for a lot of REITs) have held back the company and the stock. But Duke is now facing reality and dumping these dogs as quickly as it can. There is a plan here, so think of this as a long-term land investment that's worth a shot despite all of the frustrations. The dividend yield is high, but cash flow covers it comfortably.
Kimco (KIM, $17.46, 4.4% yield) owns hundreds of the kind of shopping centers that feature a supermarket, a chain drugstore, and a row of pizza joints, Chinese carry-outs, pet shops and hairdressers. It's been a poor long-term performer compared with spiffier rivals, such as Federal Realty (FRT). But there’s no obvious reason why Kimco can't improve, especially now that it's just refinanced some of its debt on better terms. The occupancy and rent trends are OK, and the shares are cheap when measured against the net value of Kimco’s properties.
Prologis (PLD, $30.79,3.6 % yield) has lost 70% over the past five years, which took some doing for a REIT. Prologis owns 3,500 properties all over the world, with 60% in the U.S., Canada and Mexico and about one-third in Europe. Its specialties are distribution hubs near ports and airports, and warehouses that are leased for relatively short periods. It would be easy to say the stock's been a failure because of the company's exposure to Europe, but it fell apart before the first whiff of euro-panic. What Prologis needs to regain its lost value is a sustained upturn in world trade -- and there are signs this is happening. Consider Prologis a worthwhile speculation.
Sovran Self Storage (SSS, $44.47, 4.0% yield) is the cheapest self-storage REIT on the basis of price relative to net asset value. Storage is a sweet business, so Sovran, whose brand is Uncle Bob's, is a good alternative to Public Storage simply based on value. Sovran is financially sound, and its rents are rising about 5% a year. The company reduced its dividend in 2009, but it has restored most of the cut. Besides, if you like simple businesses, you won't find one simpler than storage.
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