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Thursday, February 12, 2009

A Primer and a Forward View on REITs

At the Retirment Advisor, we do not recommend chasing the "hot performing" sectors. This is what typically burns investors. In February 2007, we took up the issue of Real Estate Investment Trusts, at a time when many advisors were advocating that fixed-income investors use them as a key part of their portfolios. We chose not to. Here is an excerpt from our newsletter at the time:

A Primer and a Forward View on REITs

For retirees who are interested in squeezing a little bit more income from their retirement portfolios, Real Estate Investment Trusts (REITs) have historically offered dividend yields that are higher than what longer-term Treasuries have offered, with the additional benefit of them being an inflation hedge (which Treasuries or bonds do not provide).

REITs (based on its benchmark, the FTSE NAREIT All REIT Index) have also performed wonderfully, beating the S&P 500 seven years in a row starting from 2000 (its last year of negative return was 1999). In the current environment, is an investment in REITs still appropriate for retirees?

What are REITs?

Before we go further, let us take a “time out” and discuss what REITs really are. For individuals who want to diversify into real estate but don't want to directly invest in properties or who want to remain relatively liquid, the best way to invest in real estate is through indirect means, such as through buying shares of REITs (they are traded on the exchanges), real estate exchanged traded funds (ETFs), real estate service companies, or mortgage-backed securities. Today, the global REIT market is approximately $750 billion, with the U.S. making up the majority of the
market at $400 billion.

Congress established the framework for REITs in 1960 as a way to allow the public to more easily invest in a diversified portfolio of real estate properties. REITs are essentially companies that own and manage income-generating real estate, such as office buildings, shopping centers, apartments, manufactured homes, and self-storage facilities. REITs are also highly liquid investment vehicles, most of which are traded on the national stock exchanges.

Forward View

As we previously mentioned, the performance of REITs has literally been “on a tear” ever since 2000. The obvious question is: What kind of performance can we continue to expect, and is investing in REITs appropriate for retirees or those who expect to soon retire going forward?

As we mentioned previously, one of the historical advantages of investing in REITs have been the higher dividend yields that were offered relative to what longer-term Treasuries have offered. With the exception of a brief 18-month period from late 1996 to early 1998, REITs have historically provided a yield that were 0% to 3% higher than ten-year treasury yields from 1990 to 2005. Not coincidentally, REITs subsequently lost 18.8% in 1998 and an additional 6.5% in 1999. Since the beginning of 2006, REIT dividend yields have been below those of ten-year Treasuries. In fact, REIT dividend yields are now 100 basis points (1%) lower than ten-year Treasuries – representing the most negative spread in history. In other words, REITs are no longer a good investment for income purposes.

Finally, it is no longer obvious that REITs will provide a good inflation hedge for retirees going forward. No doubt, rental prices will generally rise with higher inflation, but keep in mind that the value of REITs has appreciated tremendously in recent years despite a generally low-inflation environment from 2001 to 2006. In other words, there are many other factors which have a greater impact on the prices of REITs, including factors such as foreign investment, a greater ease of financing deals (given the financial innovations in recent years, such as in the mortgage-backed securities markets), and a generally low interest rate environment. Buyers beware.

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1 comment:

  1. David, thank you for the primer on REITs. Your article has good information about REITs that I didn't know before reading it. ~ Ed