Opportunity abounds in real estate trust market
When a seasoned real estate investor like Ross Meredith admits to being scared, you know it's time to do your homework before leaping back into a battered market.
Meredith, a 63-year-old retired bank examiner from Salt Lake City, has traded shares of real estate investment trusts for more than three decades. REITs are companies that own, and often operate, income-producing real estate. If you own REIT shares, you can buy into the commercial real estate market, without worrying about keeping tenants or wheeling and dealing in huge sums like Donald Trump.
Meredith is a self-described "dividend-aholic" who relies on REITs' quarterly payouts to supplement retirement savings and earn spending money for travel. After all, REITs are mostly about dividends. To escape corporate taxes, REITs must distribute at least 90 percent of their taxable income to shareholders each year.
Meredith was savvy enough to scale back his REIT holdings in 2006 when he saw property values and REIT share prices continue rising even as the industry took on too much debt.
Now, with commercial real estate teetering, the good times are long gone. Real estate mutual funds, which mostly hold REITs, have been the worst-performing domestic stock fund category of late. They're down more than 50 percent over the past 12 months, including 15 percent year-to-date, according to Morningstar Inc. Real estate funds are middle-of-the-road based on five-year performance, with an average annual loss of 3.9 percent.
But these days, Meredith mostly likes what he sees in REITs - even if he finds it "terrifying" to try sorting those most likely to rebound from the ones that will continue foundering.
"The prices of some pretty well-run companies have dropped significantly," he said. "But boy, you have got to be real selective - real selective."
REITs boast particularly attractive dividend yields - the amount of the dividend paid divided by the share price. (For example, if a company's annual dividend is $1.50 and the stock trades at $25, the dividend yield is 6 percent.)
Historically, REIT dividend yields average around 5 to 6 percent. The yield now? About 8 percent. As recently as February, before REIT shares managed a modest comeback, the average was an even loftier 11 percent.
If you find current yields too enticing to pass up, you'll probably do OK if you're a long-term investor. But good luck if you're looking to get in and out of a REIT fund or stock quickly, or aren't willing to examine the lingering debt and other troubles that cloud the outlook for many REITs. "The industry faces refinancing risks, falling rents, and continued dividend cuts on top of high leverage," said Rob Ivanoff, an analyst with fund industry tracker Financial Research Corp. in Boston. "Investors should stick to REITs that have stronger balance sheets and high-quality assets."
Any investor looking to get into REITs now should also be aware that the currently attractive yields are something of an illusion. Both components that go into the yield equation appear certain to shift in ways that will bring yields back down.
As for stock prices, experts believe REIT shares have been beaten down so much that they're likely to rise - at least eventually - from prices that are near 10-year lows. That expectation assumes the government's efforts to ease the credit crunch will continue gaining traction.
With respect to dividends, yields are inflated because they're based on the level of payouts over the past four quarters. So if a REIT cut its dividend just last quarter, its current yield reflects a combination of the current payout level, and the higher level in the three quarters before the cut was made. Most REITs that cut recently aren't expected to return payouts to the old levels anytime soon.
The reality is that current dividend levels are in many cases unsustainable - debt troubles will eventually compel more REITs to cut payouts so they can shore up balance sheets.
While such cuts should help a REIT maintain long-term health, REITs must not cut so deeply that they jeopardize their tax-favored status. Many pay out greater than 100 percent of taxable income as dividends, so they've still got some room to cut.
The industry ran into so much trouble last year that its trade organization, the National Association of Real Estate Investment Trusts, persuaded the Internal Revenue Service to give REITs a new option for meeting the 90 percent rule. REITs can meet the requirement mostly by giving investors new shares of stock, rather than paying out only in cash.
At least seven REITs have paid dividends in part stock and part cash this year, including shopping mall owner Simon Property Group. Such a step reduces the value of existing shares because more are out there in the marketplace - known as dilution.
Meanwhile, Meredith, still likes REITs overall as good sources of income - even if many of the first-quarter numbers that REITs begin reporting this month will be accompanied by dividend cut announcements.
Mark Jewell writes about personal finance for the Associated Press.