IT S HARD TO
imagine two investors more different than Warren Buffett and Burton Malkiel. Buffett is living proof that it s possible to beat the market big time. Malkiel, the Princeton economist and author, stands for the proposition that it s foolish even to try. But these guys aren t always in opposite camps, and this month I m going to explore a corner of the financial landscape where they both see opportunities: real estate investment trusts.
Let s take Buffett first. In April he made headlines by spending $50 million to buy stakes in four small REITs. Given his wealth, that s chump change. Buffett doesn t explain his moves, but it s fair to assume the values were just too tempting. The industry was coming off its worst-ever year because of last fall s credit crunch, posting negative returns of 18%. Even now, after a minor Buffett-inspired rally, REITs offer near-record yields. Many firms have barely budged from their 12-month lows, and the industry trades at 5% below the market value of its assets.
|Location, Location, Location A conservative REIT portfolio|
|Bradley Real Estate
*Price divided by estimated adjusted funds from operations for the year ending 12/31/99.
Prices as of 7/9/99.
Industry estimates as of 6/22/99.
Data: Realty Stock Investor; Zacks Investment Research>
Now look at things through Malkiel s eyes. In the new edition of his book, "A Random Walk Down Wall Street," he has lots of good things to say about diversification -- the more the better. He likes REITs because they allow investors to own assets (apartments, office buildings and shopping centers) that can t be duplicated elsewhere in the financial markets. Malkiel recommends keeping at least 10% of your portfolio in REIT shares, and considerably more as you get older and need income.
In the real world, however, REITs have a bad name. The past is full of scandals. The accounting is funny. Companies are obscure. And the folks who get rich in real estate always seem to be Wall Street smarties or Trump-like developers. In what follows, I argue that much of this is misperception -- the kind that creates opportunity. Which is why this is a wonderful time to shop for REITs.
Compare REITs with utilities, where individuals traditionally looked for high dividends and a hedge against inflation. Today the typical REIT yields about 8% -- a full three percentage points more than the typical electric utility. Both industries are in transition. But I think REITs are getting more mature and predictable, while utilities are getting riskier. At the same time, REIT earnings multiples are lower (8.7, versus 13.9), and projected earnings growth is higher (8.9%, versus 4.8%). Still, the masses haven t caught on; REITs tend to be held by institutions and insiders rather than by regular folk. Consider that Equity Residential, among the biggest REITs around, has a market value of $6 billion and 6,100 shareholders; Potomac Electric Power, little more than half that size, has 71,000.
I m not advising that you sell all of grandma s utilities and buy REITs. But you re missing out if you don t understand them. REITs date from the Eisenhower era. They re corporations but are tax-exempt if they pay out 95% of their income as dividends. The first REITs tended to be lenders, often parking places for someone else s bad loans. Today most are "equity" REITs. I think of them as closed-end funds that own and manage property.
Thanks to a spate of IPOs, the industry grew rapidly in the early '90s. But it s still surprisingly small. There are roughly 200 publicly traded REITs with a total market value of $140 billion, not much larger than Buffett s Berkshire Hathaway. REITs, of course, borrow money. So they own property that s probably worth more than $250 billion.
If you buy Malkiel s argument that it s wise to diversify, REITs look even more appealing. In theory, they offer total returns over time that are similar to those of conventional equities, but because REIT cash flow comes from rent and not earnings, REITs move in their own unique cycles. Add them to your portfolio and you lower its overall risk. Early studies, however, were confusing. REITs tended to act like small stocks, which limited their diversification advantage. More recently, REITs have been behaving the way theory predicts -- good news for long-term investors.
Regardless of where you fall on the Buffett-Malkiel spectrum, don t buy just one REIT. They tend to specialize, and it s wise to spread your holdings among the industry s major sectors: apartments, offices and retail stores. Try to spread your holdings geographically, and stay away from companies that contract out property management -- often a magnet for self-dealing. Finally, be careful about REITs in hotels and health care. Profits there depend on things like business travel and government policy, setting these companies apart from the rest of the industry.
The table is my idea of a conservative REIT portfolio. These aren t companies with the highest yields or the steepest discounts. Instead, I looked for steady growth and modest leverage: below-average payout ratios and comfortable interest coverage. I also like REITs that create value. Kimco, for example, has a history of taking over older malls and upgrading them.
Note that my usual value yardsticks are missing. REITs report conventional earnings, but analysts prefer a number called "funds from operations," or FFO, which excludes depreciation. (The rationale is that real estate tends to appreciate over time, making conventional accounts misleading.) I ve added a twist by using adjusted FFO. Leases typically raise rent over time, but accountants require that REITs report income as if it were collected in equal segments. AFFO approximates actual cash flow. Skeptics should note that this isn t an audited number, and there s disagreement about how it s calculated -- another reason to be cautious when shopping for REITs. I ve also looked at interest coverage, seeking companies with enough cushion to easily cover their debt payments. And I ve tossed companies with above-average payout ratios, a warning sign that a REIT s dividend may go down.
My list is biased toward high-barrier-to-entry companies. AvalonBay and Essex, for example, own upscale apartments in places like Northern California, where zoning makes it tough to build. And media heavy Mort Zuckerman s Boston Properties has prestigious center-city space that can t be duplicated. I like big, too: Equity Residential has 200,000 rental units nationwide, which brings significant economies of scale.
On the retail front, I prefer local centers anchored by companies like Kroger or Wal-Mart. That s the specialty of Bradley (Midwest), JDN (Southeast) and Weingarten (Texas). CenterPoint, meanwhile, is a powerhouse in Chicagoland warehouse and light-manufacturing space. Duke-Weeks (largest tenant: GE) has similar expertise in other midwestern cities and is expanding in the South. Then there s Sun. It operates more than 100 mobile-home parks in 15 states. With 93% occupancy and minimal turnover, you can expect steady rent increases.