CONCLUSIONs
Although now may seem like it’s a little late to enter the REIT market, the alternatives for income-producing investments are not better: the 10-year treasury yields 4.16%*, a 5-year corporate A-rated bond yields 3.85%*, a 5-year CD yields 3.65%*, and money markets and savings accounts yield less than 1%.

If you are considering an individual REIT, the retail group has the most going for it right now. The consumer has been driving the economy, and it’s the biggest shopping time of the year. If stores in shopping malls and outlets increase sales, the percentage rent to REIT landlords increases too. If funds from operations increase, so too might the dividend.

While my two REIT picks currently have yields lower than the historical REIT average, I think they both have potential for increasing their dividends. Vornado has been selling office properties, the proceeds from which are being used partially for special dividends and for acquiring retail properties. S&P anticipates “a superior return over the next 12 months.” The case for Chelsea’s dividend to increase is not difficult to make, as their revenues grew 31% in the third quarter due to acquisitions, new outlet centers, and expansion of existing centers.

Choosing one of the ETFs is also a sensible way to gain exposure to the real estate sector. The 5% yield is not a bad choice for that semi-safe portion of your portfolio.

USING EXCHANGE TRADED FUNDS TO BUY REAL ESTATE
There are three exchange traded funds (ETFs) that are comprised of REIT companies:

• iShares Cohen & Steers Realty Majors Index (ICF)



• iShares Dow Jones Real Estate Index (IYR)



• streetTRACKS Wilshire REIT Fund (RWR)

An ETF is a basket of companies, in this case all REITs, that can be purchased like an individual stock, including paying a commission when buying and selling. An ETF, which follows an index, is more cost efficient than a managed mutual fund in which the holdings change, incurring transaction costs. It is a good way to “own a sector” without having to choose the best stock.

These three ETFs are quite similar: each has the same top six holdings (by percentage of portfolio), although not in the same order. The biggest difference is that Cohen & Steers holds only 30 stocks, while the Dow Jones iShares has 75 stocks, and the streetTRACKS has 88. Dow Jones iShares’ current yield is about 5%, Cohen & Steers’ is about 4.80%, and streetTRACKS about 4.59%.

Like the underlying REITs, each ETF is currently at its 52-week high.

Runners Up:

• Boston Properties (BXP) – owns office buildings primarily in Boston, San Francisco, Washington, D.C., and New York City. If office space absorption improves in its key geographies, and rental rates for new leases increase, this would be my first choice among office REITs. During this down time for office buildings, it has managed its debt well and sold non-core properties, reinvesting the proceeds in its more attractive, core market places. BXP’s tenants are low-risk—the largest tenant is the U.S. government—and low lease turnover is anticipated.
  
• Archstone-Smith Trust (ASN) – owns high-rise and garden-style apartments in locations where a limited amount of land is zoned for apartments, such as Washington, D.C., and southern California. The multi-family apartment situation is weakened by low interest rates, which allow many renters to buy homes, and also by weak employment which has forced some renters to seek less expensive housing. This REIT is well-positioned when employment improves and interest rates rise.
  
• Catellus Development (CDX) – owns, develops, and manages predominantly industrial rental properties and some office properties in California. The land was inherited in 1990 from Santa Fe Pacific Railroad, so it is located along major transportation corridors. Since then Catellus has developed it into a large portfolio of leasable properties, increasing it by 80% in the last five years. The company is converting to a REIT on January 1st and will be paying a $.30 quarterly dividend.

THE BEST OPPORTUNITIES IN THE REIT SECTOR
I have come up with a few REITs that I consider worthy as investments, even now with share prices rather high and revenues of some property segments struggling, while the economy begins its recovery. To glean my picks from a larger list of companies, I ruled out any companies that a) are rated “Avoid” by Standard & Poor’s, b) yield less than 5%, c) have a payout ratio that exceeds 100%, d) have a P/E much higher than that of the S&P 500, which is 23, and e) have a debt/equity ratio greater than 50%. I came up with two REITs that I like now and three worth watching and maybe buying later:

Vornado Realty Trust (VNO) – This trust owns a diversified group of properties including retail, office buildings, merchandise showrooms, warehouses, and a hotel. Its office properties, which accounted for 62% of EBITDA (earnings before interest, taxes, depreciation, and amortization), are located in New York City and the Washington, D.C., area, the two metropolitan areas with the lowest office vacancy rates.

In addition to its regular dividend of $2.84/share, a yield just over 5%, Vornado will pay special capital gain dividends of $.16/share later this month and again in January, as a result of a Park Avenue property sale. Vornado’s dividend and its revenue have increased every year for the last 10 years. At $54 the stock is at its 52-week high. This REIT is rated “Buy” by Standard & Poor’s.

Chelsea Property Group (CPG) – As an owner of factory outlet centers, this trust benefits from double digit rent growth and 98% occupancy because of solid retail sales and generally positive consumer sentiment. Chelsea also collects percentage rent, based on its tenants’ sales. Their upscale “Premium Centers” are strategically located near major metropolitan areas, such as New York City, Boston, San Francisco, Los Angeles, Washington, D.C., and Tokyo.

With a rather low yield of around 4%, this REIT is more of a growth play, and I made an exception from my 5% yield criterion. Funds from operations are anticipated to increase more than 10% in 2004 over 2003, according to Standard & Poor’s. Dividends would then rise in tandem with growth, increasing the yield. The stock is trading near its 52-week high of $56.69. S&P has a 12-month target price of $60, representing a 7% increase, and they rate the stock a “Buy”.

 

CAN THE YIELDS AND RETURNS FROM REITS CONTINUE?
The commitment to hold a bond for three years for a small yield is accompanied by the security of knowing exactly how much income and profit you will make. Can we feel secure that REITs will continue to pay a 6 – 8% dividend yield? And can they continue their growth trend—share prices of REITs in the National Association of REITs Index are up 17% for 2003.

The high dividend yield is the result of the federal tax exemption they qualify for if they distribute at least 90% of their taxable income to investors each year. So the high dividend payout is somewhat assured. As long as the revenue stream from tenants remains strong, the 90%+ payout will yield a consistent, healthy dividend to shareholders.

Before investing in a REIT, the outlook for the company’s revenue stream can be determined to some extent by examining a) its payout ratio: the percentage of free cash flow, or funds from operations (FFO), it must use to pay its dividend—generally not considered healthy if it is consistently greater than 100%; b) the health of the geographic region of its properties; c) the outlook for that kind of property, e.g. residential, office, shopping mall, etc.; d) the length of the leases—longer leases providing more assurance of consistent cash flow; and e) who the tenants are—look for quality and diversity.

The growth trend in REIT share prices has been so strong, it’s difficult to believe that it could continue. The stock prices of all of the REITs that I have researched are at or near their 52-week highs. According to a Morningstar article on 10/24/03, “It's unusual for a REIT's stock price to trade more than 15% to 20% above or below the market's estimate of its net asset value.” The REITs on average are in that unusual place, according to a 9/22/03 Forbes article: “. . . the average REIT stock trades for a 15% premium to the net per-share value of its underlying assets, more than three times the average 4.3% premium that has existed since 1993.”

And yet, the currently improving economy will benefit property owners, setting up even better times for real estate companies. (See related article “REITs as a Recovery Play”.) There is evidence of a pickup in retail spending, which increases payments to the retail landlords; the same can be said about entertainment property owners. With employment finally improving, the residential REIT sector should see vacancy rates decline. S&P believes that even office space rental is firming. REITs have outperformed this last year mostly because they offered safety and reasonable income. Now ingredients are in place for their earnings to catch up to their stock price multiples. There could still be growth in REIT stocks.

Still, REITs are not usually purchased for their growth; the main reason for buying a REIT is usually for the income. I believe there are several good REIT opportunities now

REITS AS AN INCOME INVESTMENT
With interest rates so low for so long, it’s been nearly impossible to find bond-like investments with reasonable yields for those portions of the portfolio allocated to fixed income or otherwise conservative investments. Money markets are yielding less than 1%, and to get as much as even 4% yield from a bond, you must hold the bond for at least 3 years. What other choices are there?

REITS MAY BE AN ALTERNATIVE TO INVESTING IN BONDS NOW
If you want fixed income, you have to buy a bond. If you want more yield than bonds currently offer, but you want an asset class other than stocks in your portfolio, real estate might be a good alternative. Real estate is considered a fairly safe investment. REITs (Real Estate Investment Trusts, which own various kinds of property) can be used as the vehicle to owning real estate without actually buying the properties yourself. They trade in shares like stocks do, but their share price is not typically as volatile as “regular” stocks; so the risk factor is somewhere in between stocks and the more conservative bond investment.

REITs do not pay a fixed income amount, but they pay a substantial dividend every quarter. The dividend yield from REITs has averaged about 6-8% annually, plus you might get additional growth in the share price. In fact, in the past five years, REITs have outperformed both stocks and bonds, indicating that REITs have been a good option for income in an investment portfolio. But can these kinds of returns continue?