This sector is ready for an explosive rebound

10:30 AM explosive, ready, rebound, sector No Comments

| By James K. Glassman, Kiplinger's

Largely left out of the 2013 rally, real estate investment trusts offer better yields than most income alternatives. And with demand building, investors will reap big rewards if the economy roars back to life.

When I look for stocks to buy, I try to avoid industries that everyone else loves. Rather, I like to look at the sectors that have lagged the most.

Here's an example: At the end of September, the average large-company stock fund had returned 20 percent for the year. Of the 14 mutual fund sectors Morningstar surveyed, all but one had shown a positive return. The exception was precious metals funds, down a whopping 41 percent. But because I have a lifetime aversion to owning anything connected to gold, I looked at the next-worst performer; it was up a measly 2 percent.

That sector was real estate. Most real estate stocks these days come packaged as real estate investment trusts, or REITs. A REIT is a company that owns a portfolio of properties that generate income from rentals plus capital gains when they are sold. A REIT must pass on at least 90 percent of its profits to investors in the form of dividends. A total of 171 property-owning REITs trade on the New York Stock Exchange, with a total market value (shares times price) of $657 billion.

Most REITs specialize in a particular kind of property: Office buildings, apartments, hotels, shopping centers, industrial buildings, medical facilities and self-storage units are the major categories. (Other REITs invest in mortgages, but my focus is on property-owning REITs.)

A big appeal of REITs these days is their dividend yields -- on average, 4.1 percent at a time when a ten-year Treasury note yields 2.7 percent. Of course, because REITs depend on their own earnings to fund payouts to investors, those dividends aren't guaranteed. In 2009, for instance, one of the largest REITs, Vornado Realty Trust (VNO), which owns offices and retail space, cut its annual dividend rate from $3.52 per share to $1.52. Since then, the payout rate has inched back up to $2.92. Vornado's stock, which I like, peaked at $137 in February 2007 and plunged to $27 by March 2009, before recovering to its current price of about $90. (All prices, yields and returns are as of Nov. 15.)

It's no secret why Vornado's price fell. Real estate values soared in the early and mid-2000s, then collapsed starting in 2007, triggering a sharp recession. The S&P Case-Shiller index of home prices rose moderately from 70 in 1988 to 100 in 1999, then rocketed to nearly 200 in 2007 before dropping to about 125.

The values of homes and other kinds of real estate aren't always linked, but the collapse of residential prices affected commercial property values, too. For instance, shares of the average REIT that owns retail space fell 45 percent in 2008, compared with a 37 percent plunge for the Standard & Poor's 500 Index ($INX).

Residential housing prices have been climbing back over the past two years. They are up 12.4 percent in the past year alone, and other real estate sectors are up, too. The CoStar General Commercial index, for instance, shows that prices of office buildings sold in the past year have risen by 8.7 percent.

Investors have anticipated the rebound. Shares of Equity Residential (EQR), a giant apartment-building REIT, rose 58.1 percent in 2010 and 12.8 percent in 2011. But as investors looked forward, their enthusiasm waned. Equity Residential rose a mere 2.5 percent in 2012 and has fallen 9 percent so far in 2013, trailing the S&P by a mile.

Vacancy rates for apartments nationwide are now a low 4.3 percent, and average rents have been rising steadily. But it's the future that counts, and real estate experts worry that the market is softening.

Why? Three reasons. First and foremost is the economy, which is still running a low-grade fever. It just can't seem to regain robust health, and spending and household formations are suffering.

Second, low interest rates in recent years and the lack of new construction have inspired developers to build more. In the apartment sector, for example, a lot of units will be coming online in 2014 and 2015 (though still at only about half the rate of 2000-2007). If the economy comes back, things will be fine; there will be plenty of renters to occupy those units. Otherwise, it may be hard to raise rents and fill properties.

Third, although interest rates are still low (inspiring developers to build now), they are rising -- making mortgages more expensive and discouraging consumers.

So where do we go from here? I am optimistic enough to be willing to buy, though I'd feel more comfortable if REITs fell another 10 or 20 percent.

Here is the case: Demand is building up in the economy, and when it is released, it will explode -- maybe even as much as it did right after World War II.

Young Americans want to move away from their parents, businesses want to expand and retailers want to open new shops. But the economy has them scared. If the U.S. continues to grow at just 2 percent a year, then interest rates won't rise much, and REIT yields in the 3 to 4 percent range will continue to look attractive compared with other income alternatives. Meanwhile, if the economy comes roaring back, REITs will be huge beneficiaries.

Vanguard REIT Index (VGSIX), a mutual fund that tracks the MSCI REIT index, is a solid choice. It charges just 0.24 percent per year and has returned 9.2 percent annualized over the past ten years with a portfolio that includes the works: apartment, office, retail and specialty REITs. Its biggest holding is the largest REIT, Simon Property Group (SPG), which owns about 325 shopping malls.

For an actively managed fund, the best is Cohen & Steers Realty (CSRSX), run by a firm that specializes in real estate stocks. Its annual expense ratio is higher, at 0.98 percent, but its record over the past ten years is a bit better: an annualized return of 10.2 percent. Simon Property is also this fund's top holding, but the rest of the portfolio looks very different from the index. One drawback is its $10,000 minimum investment.

As for individual REITs, look for those with yields that are above the industry average. Washington REIT (WRE), with a 4.9 percent dividend, is a well-run company with a mix of office buildings, shopping centers and apartments in and around the nation's capital. (I recommended the stock in a February article on ways to get annual income of 4% or more.) Glimcher Realty Trust (GRT) offers a 4 percent yield and owns regional malls, such as Colonial Park in Harrisburg, Pa., while Healthcare Trust of America (HTA) pays a 5.4 percent dividend and owns medical office buildings.

Over the past ten years, the REIT subsector with the best record is self-storage, with annualized returns of 18.4 percent. Rather than buying a bigger house, some people rent a storage unit for their stuff. I am a big fan of Public Storage (PSA), the largest REIT in the category, with a market value of $28 billion, and its 3.4 percent yield. Public Storage shares got clobbered in 2007, but they have risen in each of the past six years, including 2008 (a rare stock that climbed during that calamitous year) and 12 percent so far in 2013.

Uh-oh. Should a contrarian be wary of a stock Mr. Market likes so much? Well, yes, but I am willing to make a few exceptions for great companies.