REIT Investments Should Be Reevaluated After Strong Performance in 2010

Includes: GGP, WPG
by: Avi Morris

REITs keep muddling along in the mediocre US economic recovery. My IRA has shares in a marginal one which illustrates the REIT story during the recession.

Over 12 years ago I bought Glimcher Realty (GRT), a large REIT (owning commercial properties) with high leverage, because it was yielding 12%. The dividend was kept flat at $1.92 for most of this period. The stock rose over many years and reinvested dividends gave me a nice gain (almost 4 times the original investment at its high). But when the recession hit, dividends and the stock price collapsed. At the market depths 2 years ago, the stock fell to under $1. It has rebounded to $3 at the beginning of 2010 and today is $6. Because GRT has continued paying dividends (at a sharply reduced rate), my shares have climbed to almost 4 times the original purchase. The current market value is about 1/3 above my original investment while the dividend continues at a modest level. Being a lower quality REIT, this story illustrates the highs and lows for REITs in recent years.

In the early phase of the financial collapse REITs did well. The Dow Jones REIT peaked at just over 300 in September 2007. For the next 12 months, the index drifted lower but was spared major selling that the rest of the stock market saw. 2 years ago in September, Lehman collapsed and all stocks plunged. The REIT index plummeted from 270 to under 100 in just 3 months (a time when other securities such as MLPs also sold off badly). The index recovered to 200+ where it has spent much of this year. The index is up 12% YTD versus a flattish Dow performance.

I was first attracted to REITs because of double digit yields and many had records of dividend growth. Those yields rivaled or exceeded yields on junk bond funds. That relationship has changed. Yields for most REITs have dropped to 3-5%, largely attributable to dividend cuts which ended streaks of higher dividends. GRT, a marginal REIT, yields less than 7%. Yields on junk bond funds are substantially higher, around 9-10%.

REITs have generally gotten through this difficult financial period in good shape. General Growth Properties (NYSE:GGP) was the only failure of a major REIT, but its stock has done quite well. In the last year it's recovered from 4 to 15 and is scheduled to emerge from bankruptcy next month (General Motors stockholders would envy such a performance).

Early recognition of financial problems from higher vacancy rates got REITs to cut expenses and dividends. Interest is generally their biggest expense and a low interest rate environment allowed them to refinance loans at attractive rates and take out new mortgages at low rates.

Going forward, vacancy rates on the revenue side and low interest rates on the expense side are the key ingredients for success at REITs. Lower vacancy rates will be a function of economic growth. Low interest rates benefit them and their clients, tenants. Higher interest rates are coming, even though that still looks to be a long way off. Then marginal tenants along with REITs will be squeezed. A stronger economy should improve financials for tenants and also add to interest expense for REITs as mortgages are refinanced. Lower yields will place greater emphasis for investors on capital growth to provide a fair annual rate of return. With current attractive prices for REITs, this is a good time to reevaluate yields and future capital appreciation expectations. The period for making easy money simply by collecting dividends from high yields on REITs is over.

Disclosure: Long GRT