By JACK HOUGH
Real-estate investment trusts have racked up handsome gains, leaving the sector looking pricier than usual.
That isn't necessarily a reason to exit the REIT market, but investors should favor the pockets that still look affordable.
Think warehouses, not apartment buildings.
REITs buy mostly income-producing property and avoid paying taxes on the income so long as they pass the bulk of it to shareholders as dividends. With REITs, investing in a diversified pool of real estate is as easy as buying shares of stock.
This column made a case for REITs last year (REITs Don't Fail Me Now," Oct. 1). Financing rates for property buyers are low, and in many markets, demand from tenants is strong and supply is growing only modestly.
Since then, the MSCI U.S. REIT index has gained 30%, not including dividends, versus 22% for the Standard & Poor's 500-stock index.
Now, it is time to re-evaluate.
One way to tell whether REITs are expensive is to compare their share prices with their "net asset value" per share, or analyst estimates of what their property portfolios are worth after subtracting debt. REITs now trade at a 17% premium to their NAVs, according to an analysis by J.P. Morgan Asset Management (jpm)
Investors are keener than usual on REITs because of their relatively juicy yields. The 10-year Treasury note recently yielded just 1.5% and the Finra/Bloomberg Investment-Grade U.S. Corporate Bond index yielded 3.4%. The average yield for REITS is also 3.4% -- and REIT dividends, unlike most bond payments, tend to increase over time as rents rise.
Plump valuations don't necessarily mean REITs will produce poor returns relative to other assets, says Michael Hudgins, a strategist with J.P. Morgan. One reason is that bond yields are likely to remain stingy. The Federal Reserve has indicated it will keep interest rates exceptionally low at least through at least 2014 as part of an effort to stimulate the economy.
Another reason: dividend growth. REIT payments will increase 6% a year over the next five years, Mr. Hudgins predicts. "Prices for REITs look safe because cash flow for real estate has only recently started to grow again," he says. If rising dividends lure more income buyers, they could lead to rising share prices.
If there is a part of the market to avoid now, it is residential REITs, says Rich Anderson, an analyst with BMO Capital Markets. The fundamentals are strong, with rising rents and few vacancies, but investors have chased share prices too high, he says.
Consider two of the largest REITs by stock market value: Equity Residential (EQR)
Mr. Anderson likes industrial REITs, which include warehouses and distribution centers, because "demand is picking up and they haven't yet gotten too popular with investors."
His team recommends DCT Industrial Trust (DCT)
Health-care REITs hold diverse types of property, including hospitals and nursing homes. Those with exposure to doctors' offices could benefit as the new health-care law forces more Americans to buy insurance, says Mr. Anderson. One of his favorites is Healthcare Realty Trust (HR),
Many REIT investors have bought in through index funds that weight issues by market value, like Vanguard REIT (VNQ),
To his point, the ETF's dividend yield is 4.6%, versus 3.3% for the Vanguard ETF, but there is one main difference between them apart from REIT size. The IQ portfolio has 26% in mortgage REITs, versus none for the Vanguard portfolio.
Be careful about relying too heavily on mortgage REITs, which are nothing like property-buying REITs. Their managers use short-term leverage to buy long-term mortgage securities, making these portfolios more of a bet on financing trends than on the performance of hard assets -- and volatile, too.
Another alternative for small REITs is the PowerShares KBW Premium Yield Equity REIT Portfolio (KBWY),
Another option is to buy property directly. Not everyone has the means to bid on apartment buildings and warehouses. But judging by the high premiums being paid for REITs, those who do are getting relatively good deals.—Jack Hough is a columnist at SmartMoney.com. Email: email@example.com