Desperately Seeking Yield Through Equities: Part 5 - Equity REITs

by: Philip Mause

Before turning to Equity REITs, looking at some of the comments on this series, I feel that I should give readers a bit of an overall perspective on what this series of articles is trying to accomplish. First of all, I am definitely of the view that interest rates will stay low for a long time and investors must explore strategies for obtaining more yield than is available in the fixed income sector.

Each part of this series deals with a different type of security and each type of security has its own advantages and disadvantages. I generally recommend a diversified portfolio including some securities from each of these types with a weighting toward the larger, more liquid names. While I have identified pitfalls associated with each type of security, I generally am of the opinion that each of these types has important advantages and that a mix provides an investor with helpful diversity. And, of course, and perhaps most importantly, the entry price is important - at the right entry price, the disadvantages associated with any of these securities has already been priced in and the risk/reward ratio can be attractive.

We have already discussed mortgage real estate investment trusts (MREITs); they are flow-through entities for tax purposes and must pay out 90% of earnings as dividends. They generally do not pay income taxes but investors generally must pay ordinary income tax on the dividends they receive (though there are important exceptions). Because Equity REITs are subject to the same legal rules, everything we said about the tax treatment of MREITs is applicable. The big difference between mortgage REITs and Equity REITs is that Equity REITs actually own properties whereas mortgage REITs generally own mortgages. This difference creates some important valuation and investment strategy considerations.

First of all, to a greater degree than many other flow through entities, Equity REITs offer substantial opportunity for appreciation in value. As the value of the properties they own appreciates and as the rents they charge increase over time, Equity REITs can achieve impressive appreciation in value. Equity REITs generally own the properties subject to mortgage so that they use a fair amount of leverage. As a result, the value of the equity in the Equity REIT can grow faster than the value of the properties. Of course, leverage works both ways - when property values decline, Equity REITs can take an ugly hit. Mortgages on commercial properties are very different from the typical residential mortgage. A very important difference is in the term - commercial mortgages are generally of much shorter duration than the typical 30 year residential mortgage. Thus, there is always a risk that a maturing mortgage will create problems due to the difficulty of obtaining new financing.

Another important distinction is in valuation. Book value is not a very good indicator of Equity REIT value; properties are acquired and then depreciation is applied at a certain rate regardless of changes in the market value of the property. This means that the book values of the properties may have little relation to the actual market values. Net income also has its limits. Equity REITs usually have a lot of depreciation and it depresses income but is not necessarily reflective of any decline in economic value. Cash flow or funds from operations are generally better indicators. I believe that the SEC should consider requiring Equity REITs to have their properties appraised once a year and put the results in the annual report. This would give investors a useful valuation tool.

There are a wide variety of types of Equity REITs and there are too many names in the sector to provide a complete list here. Office building REITS, health care REITs, self-storage REITs, residential property REITs, industrial property REITs, retail oriented REITs, and diversified REITs are generally viewed as the important categories. Some REITs are virtually national in geographical reach; most focus on a region.

I am listing some representative names of which I own and recommend two - I do not necessarily advise against the others. It is a huge sector and it is very hard for an investor to have a meaningful handle on all of these stocks. What is vitally important is that an investor understand the risks and potential upside of owning equity in property and have some understanding of the accounting and valuation issues associated with this sector. In each case, I will provide the symbol, Thursday's closing price and the current yield.

1. Vornado (NYSE:VNO), (90.57) (2.9%)

2. Home Properties (NYSE:HME), (59.69) (4%)

3. LTC Properties (NYSE:LTC), (26.71) (6.2%)

4. Washington Real Estate (NYSE:WRE), (31.30) (5.4%)

5. HCP (NYSE:HCP), (36.53) (5.1%)

6. MPG Office Trust (NYSE:MPG-OLD), (2.73) ( - )

HCP and LTC are health care REITs and seem to have weathered the storm pretty well. LTC was a purchase of mine fairly early in the recovery because it had little or no debt and I was scared of leverage. It has continued to perform reasonably well. It is a very good choice for a relatively risk averse investor in this sector.

WRE is regional and, in fact, pretty much confined to the Washington, D.C., metropolitan area where it has mostly office buildings. It has a conservative, shareholder-friendly management and, again, is a relatively safe bet because of the recession resistant nature of the DC economy.

VNO is considered a diversified REIT but it is a very big player in the office building market in DC and NYC. If NYC has a strong recovery, rents will move up and VNO could be a big winner.

HME is a residential REIT and owns primarily apartment buildings. We are now reaching the point at which the prolonged period of reduced housing construction is starting to create somewhat of a tight market in some parts of the country as people get tired of living with their parents, relatives, etc. I dabble in stand up comedy and 4 years ago, I had a bit which started with my announcing that, at age 63, I was still living with my parents. I used to get explosive laughter because everyone knew I was kidding. Now all I get is a sympathetic grimace. I think that the United States is beginning to get "cabin fever" and this may translate into a very strong rental market. Of course, this will vary enormously from region to region. HME has a lot of properties in the Northeast and could benefit.

MPG is a speculative play here. It controls some major office buildings in downtown LA but has big problems with its lenders. Because many of its mortgages are non-recourse, it may be able to emerge with a "core" of very valuable properties and would have enormous potential for appreciation from this price if it can survive "lender hell" without losing too many key assets or experiencing too much dilution. Needless to say, there is substantial risk.

There are many, many other names in the sector and many of them will do very well if the economy recovers.

Disclosure: I am long LTC, WRE.

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