Problems in the real estate market may make you want to run for the hills, but there are still some investment opportunities to be found. According to Arthur Oduma, a senior equity analyst with Morningstar, the Chicago-based fund research group, investors may want to look at real estate investment trusts, or REITs. He suggests specifically looking at REITs that operate office buildings, industrial parks, shopping malls, hotels, hospitals, and a host of other commercial properties.
REITs own and manage properties and generate earnings from rents and long-term leases. By law, REITs are required to pay out 90% of all taxable income to investors in the form of dividends. Currently, the average annual dividend yield for REITs is 6.3% compared with 2.0% for the S&P 500. Over the past 10 years the average dividend yield has been as high as 7.9% in 1999, prior to last year’s low of 4.0%.
Now may seem to be an odd time to look at real estate because the subprime mortgage crisis has panicked investors of all stripes. Consider that as of mid-October the broad FTSE National Association of Real Estate Investment Trusts (NAREIT) All REIT index was down more than 6% while the S&P 500 was up more than 10%. The good news, says Oduma, is that many well-managed REITs, though positioned clear of the debacle, saw their share prices drop. The upshot: This means that investors have an opportunity to buy sound companies with fat dividend yields at a discounted price.
What qualities do the best REITs have in common?
Solid management is high on the list. When the industry is down like this, we advise investors to look for REITs that know how to pick assets and great locations but that are also skilled at managing cash flow and investing capital. We also look for diversified holdings, because real estate is cyclical. A portfolio spread across regions or various segments of the business sector can often withstand a slowdown in any one portion of operations.
There are market factors that are important, too. We look favorably on companies that own existing property in markets that have barriers to entry–such as the costs and time needed to develop a property–because they help to keep competition from encroaching very quickly. Between zoning clearance and construction time, a large downtown office building or apartment complex can take up to six years to complete.
Which sectors of the REIT universe look the best right now?
We think the industrial sector, which includes companies that own warehouses, cold storage, and distribution facilities, can withstand a slowdown and at the same time benefit quickly whenever the economy turns up in the future. One factor that benefits these REITs is that owners can construct extra capacity quickly–in six months rather than waiting several years to build an apartment complex. There’s a considerable overseas opportunity too, now that the global economy is pushing storage capacity in Asia and Europe. Hospital or healthcare REITs are a group that stands to benefit from the aging of our society.
What do you recommend among the industrial REITs?
We like First Potomac Realty Trust (FPO), a small regional firm based in the Washington, D.C., area that is one of the best managed in the group. First Potomac operates flex buildings that can be converted for various uses–as a bulk warehouse or office space. The adaptability makes its income stream more stable. They also enjoy a high tenant retention rate–90% of their leaseholders opt to renew. What’s more, the rents on re-signed leases have increased an average of 10%, compared with rents on expiring leases. That tells us several things, including that renters don’t have many options in the company’s prime locations in the Mid-Atlantic region. Although the company is small, it’s the largest owner of industrial and flex property in Washington, D.C. First Potomac’s dividend yield of 6% looks stable as well.
If healthcare is an attractive part of the REIT landscape, what do you like there?
Ventas Inc. (VTR) is one of the largest owners of senior housing and long-term care assets in the country. Ventas owns 500 properties in 42 states, including nursing homes, independent and assisted living facilities, and hospitals. Management has done a very good job squeezing returns from assets. Over the past year, Ventas boasts a return of 15%, which is higher than the REIT universe’s 10% average. Because Ventas is nationwide, it isn’t vulnerable to a downturn in any one region. On top of that, there is an important plus: A growing portion of the company’s rental stream comes from a private care or private pay patient base rather than Medicare or Medicaid. Ventas currently offers a dividend yield of 4.4%.
Do you recommend avoiding office buildings altogether?
We’re neutral on office building companies. We actually think landlords that control suburban office space can benefit from the wave of tenants and back-office operations that are priced out of markets like Manhattan. Mack-Cali Realty Corp. (CLI) is our favorite suburban office REIT, and again management is key. They have reined in leverage–their debt-to-asset ratio is 38%, while the same figure for privately owned commercial real estate can run as high as 75% to 80%. Most of Mack-Cali’s debt
With all that said, what types of REITs would you avoid?
The apartment group is the least attractive. We think apartments remain overvalued even after the REIT group’s decline this year, and we think they should remain so for the next 12 to 24 months. During the same period we expect there to be an excess supply of housing on the market. The market is cooling as many condo buyers opt to rent. We see an oversupply of units on the market and very weak pricing power.
Oduma’s Picks
| Â | 52-week Price Range | Â | Â | Â | Â | |
| Company (Ticker) | Price | Low | High | 2008 Est. EPS | 2008 P/E Ratio | Comment |
| First Potomac Realty Trust (FPO) | $23.80 | $18 | $32 | $1.87 | 12.7 | The largest owner of industrial and flex property in the Washington, D.C., area. |
| Mack-Cali Realty Corp. (CLI) | $43.84 | $37 | $57 | $3.62 | 12.1 | The Edison, New Jersey, commercial office space REIT benefits from management’s focus on reducing debt. |
| Ventas Inc. (VTR) | =”TOP”>$44.79 | $27 | $48 | $2.78 | 16.1 | Revenue of the Louisville, Kentucky, healthcare REIT is becoming less reliant on Medicaid funding. |
Data as of 10/9/07 Source: Yahoo Finance