A REIT recipe for dividends and more

By Lynn Novelli

The REIT investment proposition has gained awareness and acceptance in recent years, partly due to U.S. REITs’ seven consecutive years of outperforming the broader market benchmarks. Historically, REITs have been best known for their reputation as a strong and reliable source of income from their dividend yield. In fact, REITs are sometimes thought of as a compromise between stocks and bonds because they have been more income-oriented and less volatile than most stocks, but provided reliable capital appreciation not generally available through bonds.

With an average 14.48 percent total annual return of equity REITs (dividend plus share price appreciation), REITs have outperformed all major stock indexes over the past decade. This includes the S&P 500 Index (8.42 percent), the Russell 2000 Index (9.44 percent), the NASDAQ Composite (6.46 percent) and the Dow Jones Industrials (6.81 percent), according to Dividend Capital Investments.

Dividends have been an integral part of this strong performance. Since 1987, REITs have averaged 5.6 percent annual dividend growth, according to NAREIT data. Just a few years ago, dividends accounted for the majority of REITs’ total returns, but the balance has shifted as REIT share prices have increased over time.

		Forecast for Remainder of 2007 Royal Shepard, a REIT analyst with Standard & Poor’s, is cautious in his outlook for apartment REITs for the second half of 2007.

Yet, there’s a flip-side to this strong performance: with strong price appreciation, REIT dividend yields are now lower, averaging approximately 3.77 percent, less than half of where they were in 2002.

However, the key to REIT investing comprises far more than comparing dividend yields. One needs to look into the long-term story of income-based returns and price appreciation to see the whole picture.

Improved Fundamentals

At the heart of REITs’ steady dividend growth and high total returns has been the steady upward climb in commercial real estate valuations over the past seven years.

“All real estate has benefited from the up-tick in the economy as the industry pulled out of the trough from the early 1990s,” according to Edward Cronin, Chairman of Washington Real Estate Investment Trust (NYSE: WRE).

Simultaneous with the upward trend in property values, real estate fundamentals of occupancy and rental rates also steadily improved over this period for most property types. “Since REIT shares generally trade on the basis of the underlying property values in their portfolios, growing demand for office space and retail space, warehousing and multifamily residential units have reset property values and boosted share prices,” Cronin says.

For REITs, improving fundamentals translate to higher earnings and growth in funds from operations (FFO). Between 1994 and the first quarter of 2007, REITs experienced a 6.9 percent average growth in FFO per share. Since REITs are mandated by law to pay at least 90 percent of their taxable income in dividends, REIT dividends tend to grow along with FFO. The net result has been increases in REIT share prices, dividends and total returns. Attracted by dividend yields in the 7 percent to 8 percent range while the S&P 500 was paying out 2 percent or less, income investors were flocking to REITs. They also were attracted to the inflation-hedging properties of real estate.

A Place in the Portfolio

According to Brad Case, NAREIT’s vice president, research & industry information, current yields are low because current share prices are based on investors’ expectation regarding future dividends. High share prices indicate that investors believe dividends are going to increase, raising the yield.

What’s more, “increased revenues from REITs can support higher dividends and justify the higher share prices,” says Ralph Block, editor of the online publication The Essential REIT. “Meanwhile, the drive towards portfolio diversification among investors, coupled with greater availability of information on REITs, has led to a higher investor comfort level with and a greater demand for REITs.”

These factors lead to the expectation that total returns will continue to be strong. For example, UBS Securities projected last November that the total return in the fiscal year of November 2006 through November 2007 for U.S. REITs would be approximately 11 percent. Even though UBS believed share prices were overvalued at that time by approximately 4 percentage points, UBS expected net asset value (NAV) growth of 11 percent plus a dividend yield of 4 percent would more than compensate for a small share price decline into the near term.

“It’s important to realize that the reason for lower dividend yields is not because dividends are low, but that share prices are high. REITs are still strong,” Block says.

Additionally, Case says that REITs are still among the best investments in terms of inflation hedges. “Their role as a diversifier is very important,” he says. “There is no other sector of the stock market that offers the same combination of strong risk-adjusted performance and low correlation with other stocks—especially with the large-cap stocks that form the backbone of most equity portfolios.”

“REITs are still the best investment for dividend investors, offering respectable dividends and share price appreciation.” —Harry Domash, Winning Investing

Who’s the Competition

John Lutzius, CEO of Green Street Advisors, stresses that investors must look beyond dividend yields to truly understand REITs. “Looking at dividend yields alone is a poor way to evaluate REITs because they are driven by the law that requires them to pay at least 90 percent of their taxable income in dividends,” he says.
From Green Street’s perspective, share price is more meaningful in evaluating REITs when it is in the context of earnings yield. Based on this equation, REITs in the Green Street Index have a current earnings yield of less than 4 percent, compared with the S&P’s earnings yield of 6.8 percent. “This means that, per dollar of share price, the S&P produces more earnings,” Lutzius says.

Harry Domash, publisher of the Winning Investing newsletter, agrees with Green Street’s approach but tends to be more bullish on REITs. “The biggest mistake investors make is chasing high dividend yields without understanding the company,” he says. “REITs are still the best investment for dividend investors, offering respectable dividends and share price appreciation,” he says. “With the large demand for commercial real estate across all sectors, I cannot see that changing.”

“Compared with other income-related investments such as Treasury securities, investment grade corporate bonds and utilities, REITs offer more reliable, consistent dividends and a conservative risk profile that have great appeal to investors,” Block says.

“Real estate is a fundamental asset class that investors should include in their allocations. Its high yield, low correlation with other asset classes and diversification make it desirable for permanent allocation.” —John Lutzius, Green Street Advisors

Comparing utility stocks and banks, both with current dividend yields of around 4 percent, Domash noted that these assets lack the strong share price appreciation and risk-adjusted performance that REITs enjoy and have weaker total returns, as well as higher volatility and, at least for banking, higher correlation with stocks. “Long-term bonds, hovering around a 4.75 percent yield, may look good in terms of income,” he says. “However, they carry a significant risk that can’t compete with real estate’s stability.”

In this respect, Domash says that master limited partnerships (MLPs) may be REITs’ closest competition for income investors. Structured similarly to REITs in that they are exempt from corporate income tax if they pay out a certain percentage of income to stock holders, many MLPs operate in the natural resources industry. “MLP dividends probably are higher than REITs’ right now,” he says. “However, different tax laws apply to MLP dividends, which can make them less attractive to investors seeking income.” Additionally, MLPs do not have the transparency and liquidity that REITs possess, facts that make them problematic additions to any portfolio.

Continuing to Reign

REITs continue to be an excellent vehicle for adding real estate to an investment portfolio, despite some of the present uncertainties, Lutzius says. “Real estate is a fundamental asset class that investors should include in their allocations,” he says. “Its high yield, low correlation with other asset classes and diversification make it desirable for permanent allocation.”

With REITs publishing more corporate information, receiving more coverage in the business press and taking their place among 401(k) plan options, “REITs have definitely been discovered,” Blsock says. “Investors like them for their tangible assets, positive cash flow and low volatility. Add it all together and REITs are still a great investment.”