Tuesday, September 13, 2011

Be Careful in Investing in REITs Today

I probably was spoiled when I was aggressively buying real estate investment trusts (REITs) a decade ago. They offered dividend yields on average of 7% and sold at sharp discounts from their estimated underlying real estate value.  So it's hard for me to be enthusiastic about REITs today with average dividend yields of 3.7%.  I realize that with interest rates at historic lows, there is less competition for yield--except from blue-chip equities.

Many investors disagree with me, as REIT mutual funds and exchange-traded funds (ETFs) have recently had the most inflows from since 2006.  Assets are at record levels.  The long-term conceptual case for REITs is compelling, as I also favor investing in tangible assets.  I think, however, that appeal is already well reflected in REIT share prices.  Apartment REITs have benefited from problems in the home ownership market.  The stocks of the largest apartment REITs (Avalon Bay and Equity Residential) have risen 19% and 16% this year, and their dividend yields are now only 2.7% and 2.3%.

The modest cash generation of most REITs is such that firms issue large amounts of new stock each year to raise money, and a portion of REIT distributions is often considered for tax purposes a return of capital, so the stated dividend yields can be misleading.  Instead, I favor blue-chip stocks such as G.E., Merck, and Vodafone, which have impressive cash generation from business operations and dividend yields of 4-6%.

The conceptual appeal of REITs as tangible assets that provide inflation protection is understandable, especially with interest rates so low.  But with economic growth likely to be sluggish, that will not be a good fundamental environment for office, shopping center, or industrial real estate.  Health care REITs will likely be a better sector.  But I'd suggest going outside the U.S. in considering Asian property companies, given the likely superior long-term growth in that part of the world.  Or if one prefers to stay in the U.S., in addition to health care facility REITs, I'd consider REIT preferred shares.  The preferred nature of the shares offers greater safety if the economy turns sharply lower, but in exchange for higher initial dividend yields, there will be no dividend growth by preferred shares.

A modest portion of one's portfolio could be allocated to these types of REITs, but in general I think it is NOT the time to add U.S. REITs to one's portfolio.

Steve Lehman

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