Why REIT Investors
Must Be Selective
NEW YORK -- Investors, jumpy about the volatile stock market and a barrage of corporate earnings misses, continue to see real-estate investment trusts as a refuge, thanks to their stable and attractive dividend yields.
However, some market experts caution that investors should carefully cherry-pick such investments in light of the prolonged economic downturn and not blindly base their choices solely on who offers the biggest yields.
REITs have posted total returns of 6.6% on average in 2002, with the dividend yield -- which currently averages 7% -- accounting for most of the gains, according to the National Association of Real Estate Investment Trusts. By contrast, the S&P 500 and Russell 2000 are down 18%, and the Nasdaq is off 29%.
"(REIT) yields are as -- if not more -- compelling than they were at the beginning of the year," said Morgan Stanley analyst Matt Ostrower. "It would be naive to assume dividend yields are not important in this low interest-rate environment."
Dividend yields are even enticing bond investors.
Banc of America Securities analyst Lee Schalop noted that the spread between REITs' stock and bond yields have contracted considerably. Normally, real-estate bond yields are 78 basis points higher than dividend yields. Yet, today, that spread has narrowed and, in some cases, reversed so that dividend yields outpace bond yields, Mr. Schalop said in a recent note.
"The question is whether the stocks are undervalued or the bonds are overvalued," said Mr. Schalop. The reverse spread could indicate that the market sees added risk in equity securities or that the stock is just cheap. He opts for the latter.
In general, REITs offering the biggest dividend yields have outperformed their peers and the broader market in 2002. Mortgage REITs lead the pack with dividend yields of 13% and total returns of 26% on average so far this year, according to NAREIT.
Some mortgage names boast even loftier yields -- such as Impac Mortgage Holdings Inc., with a 15.5% yield; and FBR Asset Investment Corp., with a 14.9% yield, according to SNL Securities, a financial-information research firm.
But the frothy days for mortgage REITs could be numbered as their performance is tied directly to interest rates. If the Federal Reserve Board starts raising rates, which it will no doubt do as the economy recovers, funding costs for mortgage REITs will increase and spreads will contract. This will be mean slower earnings growth.
"It's an interest rate play," said Mr. Ostrower.
Retail REITs came in next with dividend yields of 6.5% and returns of 17%. This was followed by health-care REITs, which boasted dividend yields of 8% and total returns of 15%.
Smaller-Cap Strength
Most of the best-performing REITs in 2002 have been smaller-cap names (having total market caps under $900 million) with high dividend yields, said Mr. Ostrower.
However, many of the conventional property sectors, such as office and residential, are being squeezed by the economy. As corporations pull in the reins on spending, cut staff and reduce real-estate needs, demand for office and residential space has dried up. This has caused rents and occupancies to fall, leading to lower cash flows and funds from operations growth.
A double-dip recession could pose an even greater risk -- possibly threatening the safety of the dividend. For that reason, Mr. Ostrower is suggesting investors choose REIT names that have safer cash flows and slightly less striking dividend yields.
In this segment, he names a mix of smaller-cap retail, office, net lease, industrial and health-care REITs that offer attractive, but not the highest, dividend yields. This list includes Mack-Cali Realty Corp., Entertainment Properties Trust, Equity One Inc., First Industrial Realty Trust, Glenborough Realty Trust Inc., Tanger Factory Outlet Centers Inc., Mission West Properties, New Plan Excel Realty Trust Inc., Health Care REIT, Commercial Net Lease Realty Inc., Keystone Property Trust Corp. and Kilroy Realty Corp. This group, which ranked second among five groups of REITs that were divided according to dividend yield size, boasts an 8.3% yield and total returns of 11.9% on average in 2002, he said.
In general, these stocks offer a dividend yield that's about 100 basis points lower than the loftiest yielding REITs, but the "tradeoff is a safer dividend," said Mr. Ostrower.
Lehman Brothers analyst David Shulman said it's risky in this environment to select REITs solely on their dividend yield. Some companies are suffering from deteriorating cash flows and may soon be forced to cut their dividend, he said.
Post Properties Inc., for example, offers an 11% dividend yield, but the company is selling assets in order to generate enough cash flow to pay the dividend, said Mr. Shulman. "It remains to be seen how long" the company can continue to sustain its dividend, he said.
For that reason, he said, it's critical that investors review the underlying fundamentals and earnings power of a company in addition to the dividend yield when selecting REIT stocks.
"Dividend yields are not as safe as they were two years ago," Mr. Shulman said. In general, he said mall, shopping-center and net-ease companies have held up better than other property types, such as office and residential.
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