Don't make the mistake of letting this year's powerful rally by real estate investment trusts deter you from considering an allocation to real estate at this point in the cycle.
Shunning REITs right now, even after a 110% gain from the March low, means ignoring both the unfolding opportunities in commercial real estate and the growing use of real estate as a portfolio diversification tool.
Instead of pulling back, investors might even want to consider increasing their allocation to select REITs.
To put recent performance (a 24% gain year-to-date through Dec. 15) in perspective, it is important to remember that REITs, as measured by the FTSE Nareit U.S. Real Estate Index, declined by 37% last year and 18% in 2007.
Popular thinking among analysts is that the recovery has lifted the REIT market to a level of fair value, limiting the near-term upside.
But though the current cycle's low-hanging fruit might have been thoroughly picked over, it is important to consider that about $1 trillion in commercial-real-estate loans will be maturing over the next three or four years.
That means a lot of the properties acquired during the past five to 10 years by public and private real estate funds will need to be refinanced or sold.
Considering the reality of tighter credit restrictions and the now-depressed value of anything bought recently, the most likely scenario involves what amounts to a fire sale for any well-capitalized real estate fund.
“A year from now, a lot of real estate will start flushing through the system,” said John Wenker, who manages $2.5 billion in the real estate division of First American Funds Inc.
BARGAIN SHOPPING
The key is identifying the funds that are best poised to shop for bargains because a lot of funds are in no condition to take on new debt.
The recent bankruptcy filing by General Growth Properties Inc., a public REIT, illustrates how much risk there is in the area.
But some publicly traded REITs, which own only about 10% of the commercial-real-estate market, can profit from their greater access to capital and generally stronger balance sheets.
Most of the properties that will hit the market will come from overleveraged private real estate funds and other private investors that are unable to refinance or meet balloon payments on short-term loans.
Many public REITs that are structured with more conservative leverage limits have been able to build up sizable cash positions.
“Since the beginning of March, more than 60 REITs have raised $20 billion worth of public equity, and a couple dozen more companies have raised $7 billion worth of unsecured debt,” Mr. Wenker said.
According to Morningstar Inc. analyst Todd Lukasik, a good place to start when it comes to evaluating the health of a REIT's balance sheet is to look at the percentage of debt compared with gross property, and plant and equipment equity.
With a target rate of 55% and below being healthy, Mr. Lukasik identified such examples as Federal Realty Investment Trust (FRT) at 44%, Realty Income Corp. (O) at 40% and Tanger Factory Outlet Centers Inc. (SKT) at 39%.
In addition to identifying those funds that can take advantage of the looming fire sale, there is the wild card of how the banks will treat many of the upside-down loans inside a lot of real estate funds.
Some lenders have a policy of “extend and pretend,” in which they postpone balloon payments as long as the minimum interest payments are being made.
So far, the banks have been unwilling to force sales, but over the next few years, as more loans mature and banks start marking property values to the real market price, the well-capitalized public REITs will be ready to pounce.
Beyond the specific real estate opportunities, there is also the broader consideration of real estate as a portfolio diversification tool.
According to a new study from the University of Iowa's Henry B. Tippie College of Business, real estate is underutilized as a portfolio diversifier, largely because smaller investors tend to follow the lead of institutional investors, which typically allocate about 4% to real estate.
LIMITED BY SIZE
What is missed here is that institutions are limited in their real estate exposure by their sheer portfolio size, which moves them beyond the liquid REIT market to physical properties that can be less liquid and tend to come with high transaction costs.
In a perfect world, according to the Iowa research, most diversified portfolios would allocate between 15% and 19% to real estate.
During the 21-year period through 2008, the study found that a consistent allocation of at least 15% to real estate increased the Sharpe ratio of a diversified portfolio by 5%.
“The benefits of real estate work in both good times and bad, but the improvement is more pronounced in times like these when investors really care about reward and risk ratios,” said University of Iowa finance professor Ashish Tiwari.
Questions, observations, stock tips? E-mail Jeff Benjamin at [email protected].
