Growth in Real Estate Funds Doesn't Look Sustainable
November 18, 2002
Real Estate Investment Trusts, or REITS, have been the shining stars of this protracted bear market, pulling in billions in assets at a time when fund companies have been suffering month after month of net outflows.
Since 1999, assets REITS have nearly doubled, from $7.9 billion to more than $16 billion as of Sept. 30, according to Lipper.
But can the growth last? Is the real estate sector headed for a meltdown a la the technology stock implosion of 2000?
Many say that REITS won't be able to sustain this level of growth in 2003, largely because of potential problems within the sector, as well as the preferences of fickle investors (see "Bear Market Could Drag On While Longer," page one).
Peter Doyle, chief investment strategist at Kinetics Asset Management of White Plains, N.Y., for example, has abandoned his position in at least one notable real estate company because he believes a softening economy will damage the real estate market.
"Just walk down the street, and see the empty office space," Doyle said. "The outlook for REITS is not good. There are much better investments out there right now."
Real estate vehicles have proven attractive to investors partly because of stellar past performance. Real estate funds yielded returns of 26.8% in 2000 and 9.5% in 2001, according to Morningstar. The funds have posted returns of 0.84% year to date.
But in this bear market, it's the dividends that REITS yield, which hover around 7% or more, that are most alluring to investors. Leo Wells, president of Wells Real Estate Funds of Atlanta, said that REITS, by their nature, must pay out 90% of their net income in dividends. That means that, even in a bear market, investors whose portfolios include REITS can afford to employ a buy-and-hold strategy with stocks, he said. And, on an even more practical note, the funds provide income - and more of it than fixed-income products, which can pay less than 2%.
For years, Wells said, few investors focused on dividends, but with stocks continuing to swoon, investors are again turning to dividend-yielding investments. Wells said that his investors have told him, "If it hadn't been for this, I couldn't have taken our grandchildren to Disney World."
Still, "there's the potential for some trouble on the horizon," said Whitney Dow, an analyst with Financial Research Corp. in Boston. "Most likely, a lot of investors are getting into the real estate market at, conceivably, the top. There are a lot of investors who are looking into REIT funds for the wrong reasons."
Dow said that the strong dividends REIT funds provide have prompted many investors to abandon more stable fixed-income products. As a result, "people have fundamentally changed their risk profile," he said. REITS are riskier than bond funds, Dow said, largely because they are more susceptible to market volatility and general economic factors.
"REITS don't do well during periods of economic weakness," Dow said. "If economic conditions are not favorable and companies are looking to save money by downscaling, [there will be] more businesses going out of operation - and more vacancies. Real estate companies can't sustain the rents they have in the past. REIT funds are likely going to have to cut their dividends."
Wells said his portfolios, which include a REIT index fund, mitigate those concerns by leasing to Fortune 500 companies and diversifying geographically. In addition, he said that Generally Accepted Accounting Practices (GAAP), stipulates that companies must pay their rent before other expenses, which helps ensure that REITS perform, even during slumping economic times.
"That's the part of the food chain that we want to be on," Wells said. "If they don't pay their rent, they're dead."
Don DeWaay, who runs DeWaay Capital Management in West Des Moines, Iowa, has worked with real estate investments for years. He points to nearby Kansas City, where many offices have gone vacant. Those circumstances often force property companies to negotiate cheaper leases with new tenants, he said, which can damper the performance of REITS.
In addition, real estate funds may suffer outflows as equities come back into favor, he added. "These things will be yesterday's news at some point," DeWaay said. "You've just got to be careful that you're not the last one at the dance."
Real estate investments can suffer large sell-offs, as well, even when the products are yielding decent performance. "Wall Street has a habit of feast or famine on these types of things," DeWaay said. "In the late 1990s [REITS] were the ugly step sister. It was only the stock market going in the tank that served as an impetus."
Don Cassidy, an analyst at Lipper, said that real estate funds may, indeed, be propping up the real estate sector as a whole, thus creating a vulnerable bubble. As of Sept. 30, real estate funds owned about 9.8% of the total market cap for the REIT sector. That compared to financial services funds, which account for 4.1% of the market cap for that sector, and health care and biotechnology funds, which account for only 1.8% of the sector's total market cap.
Still, even if there is a real estate bubble waiting to burst, Cassidy said the effects won't likely be as dramatic as when tech stocks started to fizzle in 2000. For one, Cassidy said that the buzz about real estate isn't nearly as strong as it was for the technology sector. "It's not a topic of cocktail party conversation," he said.
For another, any income yielded by REIT dividends may prove alluring enough, even after equities begin their recovery. "I think it will probably slow down, [but] it may be a while before we see an abandonment of interest in things like bonds and real estate," Cassidy said. "A dollar in hand is worth a promise."