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REITs --- a Tool for RE-balancing
By Stephen J. Butler |
 Archives |
As Carolina Panthers coach George Siefert says about his slumping team, "I'm not happy with the situation, but I haven't slit my wrists yet." While speaking of his team's reversal of fortune, he could also be expressing the concern that many retirees have today when they peer into the abyss at their plummeting CD rates. The dramatic reduction in interest rates designed to jump-start the economy has raised havoc with the earnings on Certificates of Deposit (CDs)--the investments that traditionally provide income and security for retirement. A maturing CD that was paying almost 7% will be replaced by a 2.7% offering. Who can handle that drop in income?
The answer may lie in REIT stocks. REITs are companies that invest in a form of real estate ownership called a Real Estate Investment Trust. REITs were signed into law by Eisenhower in 1960 and have exhibited their share of controversial behavior over the years. Today, however, they reign as one of the few bright lights of the investment world over the past eighteen months, and they deserve a fresh look for those seeking more income.
REITs, by law, have to pay out 90% of the money they earn. Earnings, for this calculation, amount to rental income minus all the costs of operating the building including interest owed on mortgages. What is left is paid out in dividends to the owners, and this pay-out has typically ranged from 6 to 10% per year. A second source of earnings can be in the form of a "return of capital" which results when a REIT
sells a building for more than the building originally cost. While the term implies that investors are given their money back, it is really just additional profit that is treated differently than the stream of rental profits.
There are many different types of REITs. Some specialize in shopping centers while others focus on office buildings or apartment units. There are REITs that specialize in malls and others that specialize in
grocery-oriented properties--the latter being more stable in an economic downturn. There are even REITs that only own golf course properties. In short, there's a REIT for just about every type of real estate.
For the average investor considering REITs, it is important to spread money over different types to achieve some diversification. It is not so much the business acumen of company management as it is the sector of real estate that captures the company's focus.
In the past two years, average REIT investors have had share-price gains of about 24% after having losses totaling 34% in '98 and '99. Throughout this four-year period, regardless of changes in share prices, the average REIT investor would have enjoyed annual dividend payments amounting to about 8% per year. There are REITs that have operated for 20 years paying out 10% per year.
Now, with REIT share prices at a high point, does this investment make sense as a way to generate higher income over CD rates? It depends. The current dividend rate is around 7% for most, but for someone concerned about a drop in share prices in the short term, this would not be a sound move. For the longer-term investor, however, REITs can make good sense as a way to increase income. A fluctuating share price value is the price we pay for higher income.
With the economy in a recession, anyone contemplating real estate should be concerned about rental rates and occupancy rates holding up. However, the plummeting cost of debt helps to offset any softening of revenue to the REITs. Also, the product of the 1980s building boom (which doubled the entire amount of commercial space built in the US since 1776) has long since been absorbed. Supply and demand is more equally balanced today.
It is conceivable that a REIT could lose both capital value and see its dividend reduced, but the industry as a whole has earned a steady rate of 12.6% per year for twenty years. That represents the total annual return, which includes dividends plus capital gains. If we think about it, the annual dividend or profit from rentals has probably been about 7-8% and the balance of 4-5% has been just about the rate of inflation. Similar performance going forward is probably reasonable to expect if we are looking at a ten-year or longer time frame. A REIT investment today offers one of the highest rates of return when compared to traditional fixed income investments, but we are also buying in at a relatively high share price. We're picking our poisons, so to speak, but if we take our medicine religiously for at least ten years, we will probably be rewarded beyond what CD's would have provided.
Viewing the larger picture of our retirement portfolios, it is always important to try to maintain a mix of different investment types. Value stocks, growth stocks, and REITs all exhibit different performance characteristics during different periods of the economic cycle. While I started years ago with 20% of my portfolio in REITs, I bought more to rebalance after '98 and '99 when they were losers. Preparing for this year's re-balancing, I noticed now that almost half of my money was in these funds. Why? Because the S&P index has lost 30% over the past two years and my growth stocks have lost even more. My REITS are up 30% in the same period. It's time to sell off a portion of these winners to get them back to 20% of my portfolio. At the same time, I'll need to hold my nose and shift some more money into my growth and technology stocks. It's hard to sell winners and buy losers, but I know I need to do this. It will only hurt for a minute.
Ground zero for REIT information is the magazine "REIT Street" published in Walnut Creek, California. You can receive a copy of the magazine by calling 925-933-4040. There is also a good book by Ralph Block, "Investing in REITs."
As always, education is the backbone of a successful investment strategy.
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or profitability of any particular security, portfolio of securities,
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as a solicitation of an offer to buy and past performance is no
guarantee of future results. The opinions expressed above are
not necessarily those of BUYandHOLD, its officers, directors or
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