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It may not be 2006 again, but commercial real estate is back in business. Income streams are rising for property owners as they hike rents for offices, apartments and mall space. And investors are cashing in — sending real estate investment trusts (REITs) up 14.9% this year.
While those are big gains, there may be more ahead. Real estate recoveries typically last five to nine years, says Brian Jones, a veteran real-estate fund manager with Neuberger Berman. And business is looking up in a variety of property categories as occupancy rates and cash flows rise. Even if we're in the second or third year of a rebound, Jones says, REITs may still generate strong, long-term returns.
One rallying point: The Federal Reserve has signaled to the markets that it's determined to boost real estate by keeping interest rates low — even after the economy recovers. Many property owners are now bolstering their finances by refinancing debt at lower rates. Lower costs of capital usually translate to higher profits. And if the Fed succeeds at lifting the economy, commercial real-estate fundamentals are likely to improve in the next one to two years, says Steven Marks, managing director at Fitch Ratings.
Granted, REIT share prices have shot through the roof, making the market look frothy. The MSCI US REIT index (.RMZ) has soared 32.4% in the last year while its yield has fallen to 3.4% (like bonds, prices and yields for REITs move in opposite directions). REIT valuations are now above average by most measures, and if the economy slows REIT share prices could tumble.
Yet for long-term investors, REITs can still be a good alternative to traditional stocks and bonds. REITs are required by IRS rules to pay at least 90% of taxable income as dividends. That creates steady cash flows for investors. And the underlying returns of REITs track long-term private real estate returns, according to research from J.P. Morgan, making REITs a good way to diversify a portfolio of stocks and bonds.
When interest rates eventually do rise, REITs are likely to perform well too. There have been six periods of rising rates since 1992, and REITs returned an annualized average of 16.6% in those periods, according to research from Chilton Capital Management, an investment advisory firm in Houston.
REITs may fall when rates first spike, but investors eventually return to the asset class because REIT cash flows typically rise when the economy is growing, supporting both share prices and dividend growth, says Matthew Werner, a REIT analyst with the firm.
For most investors, actively managed funds offer a good way to get into the REIT market. These funds have research teams that scour the REIT universe to find the best values, and a few have beaten the market over long periods — in some cases with lower volatility than the broader market.
Fidelity Real Estate Income Fund (FRIFX), for example, holds a mix of REITs, common stocks, preferred shares and bonds. It yields 4.4%, well above the REIT average, and has gained 22% in the last year. Over the last five years, the fund beat 97% of peers with a 7.3% annualized return, according to Morningstar. Its expense ratio of 0.90% is also well below the category median of 1.2%, according to Morningstar.
One benefit of the fund is that its fixed-income holdings make it much less volatile than the S&P 500 (.SPX). Manager Mark Snyderman invests mainly in shorter-duration, lower yielding debt that is less interest-rate sensitive. That hurt the fund's performance as rates came down dramatically in recent years, but if rates rise, the fund may outperform. "It's a conservative way to keep your money working," says Snyderman.
For more direct REIT exposure, investors may consider Neuberger Berman Real Estate Trust (NBRFX). The fund's 20.2% annualized return over the last three years beat 87% of peers, according to Morningstar. Nearly 90% of the fund's assets are in REITs and it focuses on large, high-quality names such as mall owner Simon Property Group (SPG) and office REIT Boston Properties (BXP).
These big REITs have relatively low yields, and the fund overall yields just 1.8%. Nonetheless, co-manager Jones argues that big, stable REITs look well-positioned financially and operate in attractive areas. Simon Property Group, for instance, owns upscale malls, a segment that has remained healthy and could generate higher returns as spending by wealthier Americans picks up.
Several exchange-traded funds also offer broad, low-cost exposure to REITs. One of the largest and cheapest REIT ETFs on the market is the $14 billion Vanguard REIT ETF (VNQ). The ETF tracks the MSCI US REIT index, yields 3.4% and has a rock-bottom 0.10% expense ratio.
Other ETFs have slightly higher fees but may generate higher returns by tracking different indices. One ETF with a foreign flavor: the iShares FTSE EPRA/NAREIT Developed Real Estate ex-U.S. Index Fund (IFGL). The ETF tracks REITs in developed markets such as Hong Kong, Japan and Australia. It yields 3.1% and has returned 26.8% this year, beating the Vanguard REIT. Annual expenses are on the higher side at 0.48%.
Investors who want higher yields usually have to delve into dicey areas: REITs with low-quality assets or weak financial positions. But there are some exceptions.
Digital Realty Trust (DLR), for example, owns data centers in 32 global markets and has reported annual revenue growth above 15% over the last three years. The stock has slumped lately due to concerns that growth is slowing and data center competition is heating up.
But Digital Realty trades at a discount to many slower-growth REITs, according to Raymond James analyst William Crow. The REIT has an "attractive combination of superior earnings and dividend growth prospects," he wrote in a recent note. It yields an above-average 4.2%.
In the apartment space, one REIT that's chugging along nicely is Mid-America Apartment Communities (MAA), according to Cantor Fitzgerald analyst David Toti. The REIT owns more than 48,000 apartment units in the Sunbelt, targeting young urban renters — one of the fastest-growing demographics.
With occupancy rates above 95% across its properties, it has managed to boost rental income this year and reported a 6.5% gain in net operating income from existing properties in the second quarter. It's also been paying down debt and recently received a new investment-grade rating. The stock trades at a discount to other apartment REITs, notes Toti, and yields 4.1%. "We like their assets and valuation," he says.
Also in the bargain bin: AmREIT (AMRE), a smaller REIT that owns shopping centers in Texas and other states. The REIT went public this summer and trades at a 25% discount to the net asset value of its real estate, according to analyst Werner at Chilton Capital. The REIT is paying out slightly more in a dividend than it's generating in cash flow, but it will cover the dividend by the fourth quarter of 2013, says Werner, and it has a diverse tenant base with only one tenant accounting for more than 5% of rental income.
With a stock market value of only $232 million, AmREIT may be too small for some investors. But it's planning to increase the shares available to the public next year. That will boost liquidity in the stock and may lure more institutional investors, lifting the share price, says Werner. Plus, the 5.4% yield looks attractive in today's market.
High-quality REITs yielding more than 7% are rare these days. But one name in the health-care space — Omega Healthcare Investors (OHI) — looks attractive, according to fund manager Jones, who owns Omega in Neuberger Berman Real Estate Trust (NBRFX).
Omega owns 432 skilled-nursing facilities and it counts on Medicare and Medicaid for more than 90% of revenues. With health-care spending cuts on the horizon, some facilities may see slower revenue growth. But Omega's tenant base generates more than enough cash to cover the rent even if revenues fall, says Jones. Omega's cash flows have been growing and the stock trades at a discount to other skilled-nursing providers, he adds. The kicker: Its dividend yield is 7.4%.
Daren Fonda is Senior Writer and Investing Columnist with Fidelity Interactive Content Services, a provider of objective investing content on Fidelity.com. He does not own any of the securities mentioned in this article.
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