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The stocks of companies that own office buildings, shopping malls, apartments and other commercial real estate have taken a thumping in recent weeks, but that doesn't mean they're cheap.
Real estate investment trusts, or REITs, have zoomed ahead at a 24%-a-year clip over the past five years, dwarfing the 9.1% return of the S&P 500 Index ($INX). That includes the 11% dive REITs have taken over the past month.
So what looked like a great investment a month ago doesn't look so hot now. And that leads me to offer what may look like contradictory advice: If you have owned REITs for a while, it's time to sell. If you don't have any real estate exposure in your portfolio, it's time to buy -- a little.
Let me explain. Investors who have been in this space for a while are likely sitting on huge profits, and there's a good chance those investments now account for an outsize piece of your equity holdings. Having 10% of your portfolio in REITs was probably a good idea when you first bought into the sector five years ago. Having 20% of your portfolio there now is not.
But if you have zero REIT exposure, you're missing out. Commercial real estate has established a history of high single-digit returns, which is as much as stocks have delivered this decade. And while the correction in property stocks has coincided currently with a broader downturn in equities, most of the time the two cousins travel different roads. REITs' official correlation, as statisticians call it, with the S&P 500 is 0.4, meaning they don't typically travel in the same direction.
"You should look to get in on dips, and the last month has been one of them," says John Coumarianos, an analyst with Morningstar. "This is a decent place to start a very small position."
Three and a half options
But where? Mutual fund investors have numerous choices among portfolios that invest in this realm. I will focus on three of them, or actually 3½, because one choice is between competing index funds.A straight shooter: The deans of mutual fund property investing are Robert Steers and Martin Cohen. Their flagship Cohen & Steers Realty Shares (CSRSX) has the highest return among real estate funds with a 15-year track record, an annualized gain as of Jan. 31 of 17%.
"They do as deep or deeper research than anyone," says Coumarianos. Most recently, the firm scored a coup when Blackstone Group bought Equity Office Properties for $23 billion, plus $16 billion in assumed debt. Equity Office was the fund's top holding as of Dec. 31, with 7.3% of its $3.6 billion in assets.
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The fund has 50% of assets in the two categories, office buildings and apartments, that the managers expect to fare best in coming months. That is half again the weighting of the NAREIT (National Association of Real Estate Investment Trusts) Index. The fund is most concentrated on real estate companies with operations on the East and West coasts, where rents and land prices are highest.
Cohen & Steers is also a particularly good portfolio diversifier. It has only a 0.3 correlation with the S&P 500.
Steady income: The problem with direct exposure to commercial property is that substantial price swings are chronic, and risk-averse investors are apt to be spooked by them. There have been six sharp pullbacks or corrections in the group since the spring of 2004, says Barry Vinocur, editor of REIT Zone Publications.
In April and May 2004, REITs plunged 18.6%, "the biggest down (move) so far" this decade, Vinocur says. In those two months, however, Fidelity Real Estate Income Fund (FRIFX), was down only 3.6%.
This fund insulates itself from most of the volatility of its group by owning senior securities such as bonds, convertibles and preferred stock, all of which stand higher in a company's capital structure than common stock.
This mix produces a much higher yield than most REIT funds, currently 5.1%, according to Morningstar. The typical REIT yield is around 4%, and Cohen & Steers at Dec. 31 was yielding 2.6%.
Income investors, therefore, will be particularly interested in this fund, although they give up most of the capital appreciation the sector offers. The fund's one- and three-year returns, of 10.9% and 8.5%, respectively, as of March 7, rank it among the bottom 3% of similar funds in total returns.
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For indexers: By far the largest REIT mutual fund is Vanguard REIT Index (VGSIX), whose $11.18 billion of assets are triple those of Cohen & Steers. It tracks the Morgan Stanley REIT Index, one of the most widely followed benchmarks, and delivers returns that are average for the category; just over 15% annually for the 10 years ended Jan. 31.
Though returns are only average, the fact that the fund faithfully follows its benchmark means that its performance is pure -- attributable only to the stocks it owns, not the unpredictable decisions an active manager might make. Vanguard diehards value nothing more highly than blind obedience to an index.
If you are not a purist, a better indexing choice is iShares Cohen & Steers Realty Majors (ICF, news, msgs). This exchange-traded fund follows a custom index devised by this premier firm to represent the industry's best players, not all of them.
This fund's returns over the past one, three and five years trump Vanguard's: 27.9% vs. 24.2%, 25.5% vs. 22.2% and 23.6% vs. 21.5%, respectively.
Morningstar warns that these gains come at the price of above-average volatility, and that the fund's concentrated holdings are among the priciest in an expensive group.
But if your strategy is to build a position in real estate by buying on dips, this fund can be expected to dip a lot. In the month ended March 7, it was down 11.8%, 2.5 points more than its average rival.
Getting in
If you goal is to build, say, a 10% position in a REIT fund, now is a good time to buy the first quarter of that amount, with the other three installments to be purchased on dips to come.Real estate took off when stocks crashed in 2000, partly because these stocks generate rich dividends from rents, and are required to pay them out to investors. The group has become so popular, however, that average yields are low.
The current coupon of 4% is less than you can earn from a 10-year Treasury bond, which is nearly risk free. And since yields are the inverse of price, this yield is evidence prices are high. At the end of 2001, average REIT yields were more than 7%.
So the double-digit returns of the past six years aren't likely to be repeated in the next six. But with a coupon of 4%, it takes only 3% in capital appreciation to achieve the 7% return such oracles as Warren Buffett and Jack Bogle expect to be the norm for stocks.
As risky as they are, REITs actually reduce the overall risk of any portfolio because of their low correlation with stocks and bonds. The portfolio protection is valuable in its own right, and you don't pay extra for the diversification.
At the time of publication, Tim Middleton didn't own any securities mentioned in this article.
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