Why real estate funds stand on solid ground

REITs shine amid double-digit declines

Mutual-fund investors who purchased shares of Real Estate Investment Trusts (REITs) last year may swell their chests and regard themselves as Warren Buffet proteges.

How come?

Well, in December 1999, the famed billionaire investor auctioned off his 20-year-old wallet for $210,000 as part of an effort to raise funds for Girls Inc., an Omaha, Neb., charity.

In the wallet was a stock tip.

The tip was not for some then-hot high-tech firm. It was for First Industrial Realty Trust - a REIT. The Chicago firm owns warehouses and manufacturing and distribution facilities around the nation. Many would regard that as a fairly conservative, even dull, investment.

But "Mr. Buffet did make an excellent recommendation," says Michael Brennan, president of First Industrial. Indeed, Buffet, who still owns 5 percent of First Industrial's shares, and those who took his tip have racked up a 50 percent return on their investment between December 1999 and December 2000.

Most REIT investors didn't do quite that well last year. Still, those who put their money directly into the nation's 195 stock-exchange-listed REITs, or into the 50-plus mutual funds that invest in REITs, had an average return of about 26.8 percent in 2000.

Not bad, considering what happened to most other stock-market investments last year, especially those in Internet or other high-tech firms.

"REITs were the place to be in 2000," maintains Michael Grupe, research director at the National Association of Real Estate Investment Trusts (NAREIT) in Washington.

This year, the average REIT mutual fund has a slightly negative return - down 1.4 percent in the first quarter, according to Lipper Inc. "The year's not over," says Jeffrey Caira, portfolio manager of Pioneer Real Estate Shares. "I'm very optimistic about REITs."

Mr. Caira has some 17 years of experience in the real estate investment business. But he took over management of the Pioneer REIT fund only last July.

A REIT is a company that must generate nearly all of its income from investments in real estate. Most REITs derive most of their income from direct ownership and operation of property and the collection of rent. The real estate could be hotels, apartments, industrial properties, office buildings, shopping malls, and so on. Other REITs invest in mortgages backed by real estate. Some are "hybrids," investing both in property and mortgages.

By law, REITs don't pay corporate income tax on their basic operations. To qualify for this tax exemption, REITs must distribute 90 percent of their taxable income to shareholders in the form of dividends. It is the shareholders that pay the tax, either right away or on a deferred basis if the shares are in a 40l(k) or some other tax-advantaged plan.

Over the last decade, REITs have posted an average annual return that includes dividends and capital gains on their shares of about 11.5 percent. That's better than bonds, but less than the fancy return of high-tech stocks - before they began their tumble last year.

And REIT share prices can fall. They did in 1998 and 1999.

Kunal Kapoor, a senior analyst at Morningstar, a Chicago firm that offers mutual fund research, sees value in REITs as a form of "diversification over the long run" for an investor's portfolio. For most people, 5 percent of their total investments would be about right, Mr. Kapoor suggests.

Those in the REIT industry remain enthusiastic, despite the economic slowdown.

Here's why:

* REITs are "ideal" income investments, says Caira.

They currently offer an average dividend yield of 7.4 percent on the price of shares. That compares with 5 percent for super-safe 10-year Treasury bonds. Corporate stocks typically yield 1 or 2 percent in dividends.

That yield spread between REITs and bonds of 2.4 percent is triple the average spread of the past 10 years, notes Caira. Those investors seeking a higher return than popular Treasuries could switch to REITs. And since all REITs have a total stock-market value (capitalization) of about $136 billion, about one-third that of General Electric, it wouldn't take much of a switch to swell the price of REIT shares.

Further, says Caira, dividends are "well covered" by "funds from operations" (the REIT equivalent of profits) after property depreciation is taken into account.

* REITs have a stable asset base - property that doesn't go away in a slump. Their shares are less volatile than, say, the shares of many smaller companies.

Since the end of 1996, price volatility of the Standard & Poor's 500 Index has increased 56 percent, and of the technology-laden NASDAQ Composite by more than 100 percent. Price volatility of an index of equity REITs maintained by NAREIT was up 11 percent, half that of the NASDAQ.

REIT shares, however, are more volatile than bond values.

* Experts do not see overbuilding today of commercial properties, as occurred in the late 1980s. So the economic downturn should have less impact on property prices.

"Supply and demand are generally in check across the country," says Caira.

As rents go up over time, the value of REIT properties should increase somewhere in the 7 to 8 percent range a year, figures Caira. Thus REITs offer some protection against inflation.

Caira, like many other REIT mutual-fund portfolio managers, talks with managers of REITs and goes to see their properties. This research, he argues, makes it advantageous for individuals to invest in a REIT mutual fund, despite management fees, rather than directly in REIT shares themselves. His fund last year beat the REIT mutual-fund industry average by 2.5 percentage points for a total return of 29.3 percent. But if somebody slips you another Buffet tip for a REIT ... well, think about it.

(c) Copyright 2001. The Christian Science Monitor

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