REITs of Passage Econoday Focal Point 4/15/00 By Evelina Tainer, Chief Economist

An investment alternative for more restful nights

These days it has become redundant to mention stocks and volatility in the same breath. Whether we are looking at the high tech market in the NASDAQ composite index or the old blue chip Dow Jones Industrials, volatility has a whole new meaning. In the old days, stock market risk was associated with price fluctuations on a daily, weekly or even monthly basis – not minute to minute. Anyone following the market on Wild Tuesday (April 4) saw a 700-point variance in the Dow!

Some behavioral finance experts have suggested that tolerance for risk has changed, that investors appear less risk averse. Perhaps it isn’t that today’s investors are less averse to risk than they are unaware of the historical pattern of fluctuation. The 1990s bull market generated an environment in which RISK is, or at least was, no longer a four-letter word when applied to the stock market. Prices "always" seemed to go higher and dips were "always" viewed as a buying opportunity.

Intraday stock variation has indeed accelerated in these early months of 2000. Some investors who may not be accustomed to the sharp volatility may find that a daily dose of this boom-bust cycle will give them indigestion. Perhaps it is worth suggesting that investment alternatives (other than boring, low-yielding bonds) do exist!

The REIT Alternative
At the same time that the NASDAQ composite index plunged 13 percent recently and the Dow Jones Industrial index fell nearly 4 percent, the Morgan Stanley REIT Index was down a mere 0.6 percent. By the end of the day, the NASDAQ and the DJIA were clearly in negative category, but the Morgan Stanley REIT Index eked out a 0.1 percent gain for the day.

What’s a REIT and what does it offer investors? REIT stands for Real Estate Investment Trust. It is a company dedicated to owning income-producing real estate. These include shopping centers, office buildings, warehouses, and apartment buildings. In most cases, (equity) REITS also operate income-generating real estate and some (mortgage) REITS finance real estate. To be a REIT, a company must pay 95 percent of its taxable income to shareholders each year. As a result, REITS generate a lot of fully taxable dividend income and are considered by many to make better investments in tax-deferred accounts.

Did You Know? Congress created REITS in 1960 in order to enable small investors to make investments in large-scale income-producing real estate. REITS played a limited role until The Tax Reform Act of 1986 allowed REITS to operate as well as own real estate.

According to the National Association of Real Estate Investment Trusts (NAREIT), the real estate investment trust is the best way for small (and large) investors to gain entry to the commercial real estate market. REITS combine the best features of real estate and stocks. They give investors a practical and efficient means to include professionally managed real estate in an investment portfolio. Some analysts might say that small investors are heavily invested in their own home and don’t need more real estate exposure. But for the most part, homeownership is not an income-generating asset. REITS offer exposure to the commercial side of the market that does generate income flows for investors.

Though REITS got off to a slow start, the Tax Reform Act of 1986 and the booming real estate cycle of the 1990s have spurred this investment vehicle. According to NAREIT, modern REITS offer three important qualities that were previously unavailable: liquidity, security, and performance.

The chart above compares annual rates of return in the S&P 500 to the returns for all (equity, mortgage, and hybrid) REITS using the returns from the NAREIT index. Notice that the returns don’t necessarily move in tandem. This makes for a more diversified portfolio because higher returns from REITS might offset losses or lower stock market returns and vice versa. The NAREIT compares returns to the Russell 2000 because these returns tend to be higher than the S&P 500 on average. (We compare the REIT index to the S&P 500 in order to show a longer history; the Russell 2000 history is not available for the entire period here.)

What is the economic underpinning of REIT performance?
REITS were pummeled in the past couple of years, and many analysts believe the time has come for this market sector to shine in 2000. Indeed, earnings of REITS (backed by real properties) have gained even as share prices have eroded (at the same when tech stocks with no earning streams and none on the horizon were skyrocketing – until lately anyway).

Some investors did indeed turn to REITS in the past couple of weeks trying to shelter themselves from the rocky high tech road. According to analysts, earnings are growing 7 to 8 percent a year and dividend payouts are increasing. The average dividend yield is roughly 8.5 percent these days. Furthermore, analysts believe that REITS are undervalued by 10 to 20 percent.

None other than market guru Abby Joseph Cohen, chief investment strategist for Goldman Sachs, recommended this market sector as a good investment alternative when she downsized her asset allocation towards stocks, and particularly downgraded her overweighting in the tech market.

Despite Ms. Cohen’s recommendation, it still begs the question: Why invest in REITS today when interest rates are rising?

A standard economic rule of thumb is that real estate and interest rates are inversely related. That is, when interest rates rise, real estate is less desirable and vice versa. Why would anyone invest in real estate in today’s environment that promises only additional rate hikes by the Federal Reserve Board?

It appears that the relationship between real estate investment trusts and interest rates is not quite as straightforward as the inverse relationship between housing demand and interest rates. After all, a REIT is concerned with the income-producing aspect of the investment, watering down the importance of interest rates alone. For example, REITS suffered in the late 1980s/early 1990s with the glut of office buildings and retail strip malls.

Consider this scenario: If interest rates are rising and choking off single family home sales, it may mean households will turn to apartment living. This means that REITS in the residential sector may benefit.

Office buildings
Among REITS that primarily invest in office buildings, we look at Cornerstone Properties, which is the third largest in market capitalization in the industrial/office property sector. Clearly, one would like to see how this REIT fares in changing interest rate environments. Ideally, one would look at the changing relationship over at least one entire business cycle. Unfortunately, data is only available from April 1997. During this three-year period, interest rates do appear inversely related to this REIT’s net asset value. (The net asset value is the market value or share price. Similar to a mutual fund, the NAV is calculated by taking the market value of all securities owned plus all other assets such as cash, subtracting all liabilities, then dividing the result (total net assets) by the total number of shares outstanding.)

The chart below depicts the relationship between yearly changes in spending on office buildings (a component of construction expenditures reported monthly by the Census Bureau) and the share price for Cornerstone Properties. Heavy construction in the industry tends to boost the share price, while light construction is generally associated with a lower net asset value for this REIT. Yet in an interesting contrast, the share price has increased dramatically in the past couple of months, but construction of office buildings has weakened considerably.

Retail Shopping Malls
The chart below compares the net asset value of Weingarten Realty Investors to the yield on the 10-year Treasury note. (Weingarten is the fourth largest REIT by market capitalization in the retail sector.) Lower interest rates do tend to boost share prices. Once again, we see an inverse relationship between net asset values and interest rates.

The chart below compares the share price of Weingarten Realty Investors to the annual growth in non-auto retail sales. Between 1991 and 1997, yearly growth in non-auto retail sales appeared to move in tandem with the share price of this REIT. Then non-auto sales slipped in 1997 and 1998 – partly reflecting lack of inflationary pressures – but the REIT price continued to grow. In the past six months, this REIT’s net asset value depreciated sharply even as non-auto sales grew rapidly. Even though interest rates are edging higher, the strength in the retail sector could suggest a price reversal for this REIT.

Residential Property
The next two charts show how two different REITS in the same category compare with interest rate changes over the past seven years. Apartment Investment & Management Company (AIV) is the third largest REIT in this residential property sector by market capitalization; BRE Properties (BRE) is the seventh largest by market cap. The first chart below shows that in the mid-1990s, the share price of AIV was inversely related to interest rates (measured by the yield on the 10-year Treasury note). However, even as interest rates fell sharply through 1998, the net asset value of this REIT didn’t improve. Since 1999, the net asset value has fluctuated between $35 and $45 dollars even as interest rates were rising. Thus, the sensitivity to interest rates was hampered by other factors – perhaps related to the fundamental value of this particular real estate trust.

The chart below shows that BRE Properties behaved somewhat differently in the past few years relative to the Apartment Investment and Management Company. Indeed, BRE appears more sensitive to interest rate movements as the share price of this REIT stumbled more sharply as interest rates rose. Indeed, the net asset value of this company began to fall in 1997 even as interest rates were falling. Recent data for the past two months suggest that this real estate trust is on the mend.

This comparison suggests that not all REITS move in sync with each other – or are not affected by macroeconomic factors to the same degree. For instance, the economic conditions set the stage for a certain pattern of behavior, but the underlying company fundamentals can differ from one REIT to the next. It is a good idea to analyze them in some detail before deciding which REIT would make a good investment.

THE BOTTOM LINE
Several influential analysts have recently pointed to REITS as favorable alternative investment. Our inclination that real estate investment trusts are likely to be negatively impacted by interest rates has borne through the rudimentary analysis of the charts above. However, one should not discount entirely the fact that this investment asset class has been beaten up in the past couple of years at the same time as earnings and dividend values have increased. Since REITS are tied to physical income-producing assets, they make good investment alternatives in order to diversify a portfolio. April has shown quite a bit of volatility in the stock market – particularly in the high tech area. Investors might sleep better at night by diversifying their investment portfolio.

Last updated April 15, 2000