Think Stocks Are Volatile? Look At REITs!
Equities are among the most growth-oriented investment assets from which you can choose. Almost all well-diversified portfolios include some degree of investment in stocks of one kind or another. What is less well-known is that there’s another asset class that has experienced explosive growth since 2009: publicly traded real estate investment trusts, or equity REITS. These funds invest in the stocks of companies that develop or own commercial real estate in its various forms such as apartment buildings, hotels, hospitals, shopping centers, storage facilities, offices, and industrial properties. In 2014 these REITS on average returned 27% compared to 13% from the S&P 500. Is this an asset class in which everyone should be investing? Keith Jurow, a real estate analyst and author of the Capital Preservation Real Estate Report, says no.
Jurow believes that valuations in this asset class have reached bubble proportions. Although many equity REIT prices today have not yet attained pre-crash peaks, they have reached levels that are not supported by their fundamentals. He believes one reason has been the willingness of regulators to undermine the standards that forced impaired loans to be written down in order to avoid massive foreclosures in the wake of the credit crisis. Another is the relatively high dividend yields of REITs as compared to bonds. Returns of close to 30% together with a 5% dividend yield are certainly compelling, and investors have been responding, pouring over $130 million into these REITS since 2013. But investors may not realize just how volatile this asset class can be, and need to look under the covers before jumping in.
One example Jurow cites is General Growth Properties (GGP), which owns more than 125 domestic shopping malls in the U.S. and in Brazil. Its shares reached an all-time high of $50 in March 2007. But by November 2008 the price had plunged to 18 cents! Investors began pouring in at that point, driving the price all the way back to $31 by the end of last year. But reported revenue has been flat and outstanding debt far exceeds the fund ability to cover its dividend. Despite such financials, the fund’s P/E ratio currently stands at 78. Jurow questions how such a high P/E ratio can be justified.
Another example is Vornado Realty Trust (VNO), an owner of office and retail properties located mainly in New York City and in Washington, D.C. In its 2014 Annual 10-K Report Vornado reported that operating income was down from 2013 and its income from continuing operations was also substantially lower than in the past three years. In addition the company was only able to pay the $628 million owed in dividends through borrowing. Its P/E ratio of 80 is unwarranted according to Jurow.
During periods when stock prices become volatile, many REITS act like stocks on steroids. Take May 2013, when the fed announced that it was thinking of tapering off its quantitative easing program the following year. Interest rates spiked and stocks dropped by over 5% that month. But that was nothing compared to REITs, which plunged by almost 15%.
Real estate is and has always been a very good asset class to include in a well-diversified investment portfolio. Unfortunately the extreme volatility of commercial equity REITS is not for the faint of heart. And Jurow believes that today’s REIT euphoria is just as widespread and just as dangerous as it was in 2007. As he puts it, “Equity REITs have been pushed up to unsustainable heights by herd thinking and by hordes of cash from yield-seeking investors. Shares are headed for a major fall.”
Are there any alternatives? You can of course invest in an individual residential property and rent it out. The downside of such an investment, besides the high capital requirement, includes the hassle of dealing with the tenants and the maintenance, a regulatory environment that heavily favors tenants over landlords, and the risk of an unexpected and expensive problem occurring with the specific property (non-systematic risk). Investing instead in an individual commercial property avoids the regulatory challenges but not the cost nor the non-systematic risk. A third alternative is a non-publicly traded REIT, which invests not in the stocks of companies but rather directly in a pool of operating leases and/or commercial properties. But such REITs offer only limited liquidity – they can’t quickly sell properties in order to fund withdrawals – and undergo less regulatory scrutiny than publicly-traded REITs, adding to investor risk. Of interest are a few new types of non-publicly traded REITs that offer daily liquidity (with some restrictions) by maintaining a certain percentage of their assets in liquid investments. The ability to directly invest in pooled commercial real estate while maintaining liquidity and avoiding the volatility associated with the stock market is appealing. Stay tuned.