No sector in the U.S. market -- not one -- has done as well as real estate investment trusts since the bull market began just about two years ago.
REITs, publicly-traded vehicles which own commercial property and pay out 90% of their income to shareholders, have beaten financials, consumer discretionary stocks -- even gold -- during the big rally from the market's bottom in March 2009.
A popular exchange-traded fund, the Vanguard REIT Index (NYSEARCA:VNQ), which tracks the MSCI U.S. REIT index, tripled from its bear-market low through last Friday's close. Its amazing 200.6% move topped gains of SPDR ETFs following the Standard & Poor's financial (up 186.3%), industrial (158.6%), and consumer discretionary (152.9%) sectors.
|Sector ETF||Ticker||From March 2009 Low||2010 Performance|
|Vanguard REIT Index ETF||VNQ||200.6%||28.4%|
|Financial Select Sector SPDR||XLF||186.3%||11.6%|
|Industrial Select Sector SPDR||XLI||158.6%||27.4%|
|Consumer Discretionary Select Sector SPDR||XLY||152.9%||27.2%|
|Materials Select Sector SPDR||XLB||133.6%||20.3%|
|Energy Select Sector SPDR||XLE||109.0%||21.4%|
|Technology Select Sector SPDR||XLK||110.0%||11.0%|
REITs also set the pace strongly in 2010, with a 28% gain. That trailed only gold and small-cap growth stocks, which have been right in the market's sweet spot.
And REITs have performed spectacularly over the long term. According to San Francisco-based Callan Associates, the FTSE NAREIT All Equity REIT index gained 10.8% annually over the 10 years ending December 31, 2010. Only gold and emerging-markets stocks did better during that "lost decade" for the S&P.
So can REITs continue their spectacular run? Certainly not at the pace they've set for the last couple of years, but I think they can still do well. An improving economy, tight supply in commercial real estate markets, and REITs' history of multiyear runs should tilt the scale towards the bulls. But REITs' current high valuations will keep me from buying more until the inevitable pullback occurs.
Behind the Magic
Why have REITs done so well? Partly because they did so poorly in the bear market, when the FTSE NAREIT All Equity index lost 19% in 2007 and another 41% in 2008 -- much worse than the S&P's plunge.
"Real estate is a very capital-intensive business. As a result, REITs were a casualty of the financial meltdown," explained Jim Sullivan, director of REIT research at Green Street Advisors, a Newport Beach, Calif. firm specializing in real estate.
Since those dark days, however, "Capital has become more plentiful and more reasonably priced -- and public owners of commercial real estate have been primary beneficiaries of the recovery," he continued.
And they've had a huge edge over private owners, who until recently have been frozen out by banks unwilling or unable to lend.
"Public REITs have more access to a variety of capital," Sullivan said. And they've taken advantage of it.
According to Cohen & Steers (CNS), a New York-based money-management firm focusing on real estate securities, REITs have raised more than $150 billion globally in total capital since 2008. They've used it to buy depressed property, clean up their balance sheets, and do other good things.
Also, the problems plaguing the housing market -- foreclosures, short sales, unemployment -- have been good for REITs that own apartment buildings.
According to the U.S. Census Bureau, the home ownership rate dropped to 66.5% in the fourth quarter of 2010, the lowest figure since 1998. Meanwhile, the rental vacancy rate fell to 9.4%, its lowest level since 2003.
With more people renting, demand for apartments has been strong, and landlords have raised rents. As a result, apartment REITs have been top performers, along with hotels, which "cut expenses quickly and severely" in the recession and bounced back nicely with the recovery, Sullivan explained.
"No doubt a recovering economy is essential to commercial real estate in the long run," he added.
And there are recent indications of a return of private lenders to commercial real estate projects.
What Could Keep REITs Going
Charles McKinley, a senior vice president for Cohen & Steers, thinks continued strong growth in emerging markets and a decent recovery in developed markets will lead to good earnings and dividend growth for REITs. (They currently yield in the mid-3% area, on average.)
"Rarely have REITs operated with such attractively aligned tailwinds.," he wrote in a recent report.
Cohen & Steers, which invests in real estate worldwide, says the U.S. is in a good spot, as REITs already have seen strong growth in several sectors and face a very favorable supply/demand balance.
"Unlike previous commercial real estate cycles, the most recent was marked by low levels of construction relative to existing housing stock, which has resulted in far less of the problematic oversupply that currently plagues residential markets in some countries," McKinley wrote.
Sullivan agreed that the limited supply could give commercial landlords more pricing power as the economy recovers.
McKinley puts the U.S. midway between the trough and peak of a typical real estate expansion cycle, as shown on this chart, which we reproduce with Cohen & Steers' permission.
[Click to enlarge]
That means this could go on for a while. "Commercial real estate recessions have historically been followed by multiyear expansions," McKinley wrote. "Each of the three major U.S. downturns since 1973 has been followed by an expansion lasting 7-12 years. During these periods, total returns for REITs averaged 22% per year."
That sounds ambitious to me -- I'll take the 10%-plus they earned annually over the last decade.
And there are reasons to be wary, Green Street's Sullivan said. Before the recent market retreat, REITs were changing hands "at a pretty meaningful premium [to] what their assets would be worth" in the private market, he told me.
They're also "trading at much higher multiples" than stocks, he said -- 20 times earnings for REITs, vs. 13 times for the S&P 500. On the other hand, "REITs look a little bit cheap compared with bond yields," he pointed out.
The bottom line: "REITs appear fully priced at this point, but they could have some room to run."
I agree, which is why I'd wait for a correction -- like the current sell-off? -- to buy more. Historically, REITs have added diversification to a portfolio, although in the current bull market they have appeared highly correlated with stocks. I think they should comprise about 5% of your portfolio, maybe a bit more, depending on your age and risk tolerance.
Spreading Your Risk Is Key
Rather than buy individual REITs, which tend to be concentrated in one segment of the market, I'd look at funds and ETFs like VNQ, which I mentioned above. It has a low expense ratio of 0.1%. (Its mutual fund cousin, which I own in my retirement account, has the ticker symbol VGSIX.)
Actively-managed funds with good long-term track records and relatively low expenses include Neuberger Berman Real Estate (NBRFX) and First American Real Estate Securities A (FREAX). Dividends paid by REITs don't get the favorable tax treatment other stock dividends do, so I'd recommend them for retirement accounts.
A global real estate ETF is SPDR Dow Jones International Real Estate (NYSEARCA:RWX). It owns property companies that are not necessarily REITs, but give you exposure to real estate in markets like Europe and Japan, which are lagging our own now but could outperform later.