REITs May Have Fallen,
But They Still Have Miles
To Go Before They're Cheap
April 21, 2004; Page D1

This isn't the right time for REITs.

Whenever I see a market sector take a big hit, my immediate instinct is to reach for my checkbook. But I don't think this is the moment to load up on real-estate investment trusts.

To be sure, REITs have taken a drubbing, falling 15% since April 1, including a 3.6% plunge yesterday. But they are still far from cheap. I would want to see a further 15% drop before I bought with any great enthusiasm.

Trading Down: Property-owning "equity" REITs, which make their money by buying and then renting out shopping malls, apartments, office buildings and other real estate, have been possibly the current decade's hottest investment.

After dreadful returns during 1998 and 1999, these REITs went on a tear, posting healthy gains through the brutal bear market and continuing to sparkle during 2003's stock-market rally. Indeed, while the Standard & Poor's 500-stock index lost a cumulative 20% over the past four calendar years, equity REITs soared 105%, including dividends.

As REIT share prices skyrocketed, dividend yields shrank, falling from more than 9% in late 1999 to less than 5% earlier this month. Yields had never before been that low, according to Washington's National Association of Real Estate Investment Trusts.

Thanks to the selloff, yields are back closer to 6%. That may seem tempting compared with the S&P 500's 1.6% yield. But if you buy REITs today, you could be sorely disappointed.

The fact is, despite the dazzling results of the past four years, these things aren't growth stocks. They don't reinvest heaps of profits in an effort to clock handsome growth and thereby drive their share prices higher.

Instead, REITs pay out pretty much all of their earnings as dividends. There's a good reason for that policy. REITs aren't taxed on the earnings they distribute. But to qualify for this tax break, REITs must pay out at least 90% of their taxable income each year.

The bottom line: If you buy a collection of REITs yielding 6%, your long-run annual total return will probably be only a few percentage points higher than that yield -- and it could be somewhat lower if share prices continue to tumble.

That's a real risk. The recent REIT meltdown has been blamed largely on rising interest rates. But the decline could really pick up steam if commercial-property prices slump.

Chris Mayer, director of Columbia University's Milstein Center for Real Estate, says that when REITs trade above the value of the real estate they own, that often foreshadows both a fall in REIT share prices and a rise in property prices. Conversely, when REITs trade at a discount to their real-estate values, it indicates that REIT prices are likely to rise and property prices could fall.

Before the selloff, REITs were trading 22% above estimated property values, according to Green Street Advisors in Newport Beach, Calif. That premium has now all but evaporated. That may indicate investors have changed their minds about commercial real estate and are now expecting property prices to fall. "If you own commercial real estate, the decline in REITs could be a troubling sign," Prof. Mayer argues.

But would a fall in property prices hurt REIT investors? It could be that REIT share prices have already discounted that possibility -- or it could be that investors are in for a nasty surprise.

Tracking Dividends: Given all the uncertainty, what should you do? I would start by setting a target for what percentage of your portfolio you want in REITs.

Nelson Lam, an investment adviser in Lake Oswego, Ore., suggests earmarking 5% or 10% of your stock portfolio for the sector. But rather than focusing just on REITs, he advises combining a stake in a pure REIT fund, such as Vanguard REIT Index Fund, with a fund like Third Avenue Real Estate Value Fund, which owns both REITs and other real-estate companies.

One warning: Because REITs get the special corporate-tax break mentioned above, the dividends they pass through to shareholders usually aren't eligible for the low dividend-tax rate introduced last year. As a result, to avoid hefty tax bills, hold your REITs in a retirement account.

"Real estate should be an important and permanent asset class in any portfolio," Mr. Lam says. "But if you have new money to invest today, I'd move cautiously."

With that in mind, make a small investment now and then sit back and watch what happens to equity REIT yields. You can track those yields at http://www.nareit.org/. Click on the tab marked "NAREIT indexes" and then head to "domestic indexes." Make sure you look at the data for equity REITs.

Alternatively, hunt through the Journal's Money & Investing section for the small table labeled "Dow Jones Specialty Indexes." Note that the yield on the Dow Jones Equity REIT index is somewhat higher than the yield on NAREIT's index.

If REIT yields hit 7%, I would invest enough to reach your full 5% or 10% portfolio weighting. What if share prices fall even further? Add more dollars, so you maintain your target weighting, and even consider overweighting the sector.

"At 6%, there's nothing wrong with owning a small amount of REITs," reckons William Bernstein, an investment adviser in North Bend, Ore. "But at 7.5% or 8%, you would want to overweight them, because their expected return would be higher."

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