PRINT
EMAIL
COMMENT
BUZZ UP
DIGG THIS
My list of the past century's half-dozen greatest financial inventions for small investors reads like this: the stock mutual fund, the money-market fund, the 401(k) plan, Treasury Inflation-Protected Securities (or TIPS, which are Treasury bonds indexed to inflation), the exchange-traded fund and the real estate investment trust. Do real estate investment trusts really belong on such an honor roll of grand achievements? Yes, indeed. REITs allow even the smallest investors to own diversified portfolios of hundreds of properties, spread across the country or the world. Before REITs, the alternative for small investors was expensive, fee-laden limited partnerships in one or more properties that seemed to benefit the broker and general partner first and the investor last.
The downturn. For REITs, however, these are unhappy times. An index of 117 REITs compiled by the industry's trade association lost 13% of its value in the first seven months of this year, falling almost 8% in July alone. Part of the problem is the severe slowdown in the residential market. But there's a broader difficulty as well.
The tax laws treat REITs differently than regular corporations. A REIT passes nearly all its profits straight through to its shareholders in the form of dividends, which means the shareholders pay the income taxes, not the REIT. The only problem with this system is that for a REIT to grow, it needs to purchase new properties, and because it sends its profits to the shareholders, the REIT doesn't have internally generated cash it can use to grow. So it has to issue new stock or borrow. This past summer, troubles in the market for mortgage debt to subprime, or relatively risky, borrowers spread to other parts of the credit universe, and REITs, too, found themselves facing higher rates, or even a credit crunch.
REITs come in many flavors. Most specialize in a sector -- for example, apartment buildings, medical facilities, shopping centers or hotels. About two dozen REITs concentrate on commercial office buildings. Although commercial developers are having a harder time borrowing money to build, their plight is far less dire than that of residential developers.
A recent report by money-management and research firm Sanford C. Bernstein points out that over the past few years, commercial real estate has especially benefited from financing innovations, including both the rise of REITs and the public trading of debt using commercial mortgage-backed securities. In addition, private-equity firms, which get their money mainly from big pension funds and wealthy investors, have jumped into commercial property in a big way.
These changes have led to lower-cost financing for developers, which, in turn, has "been a major driver of the recent boom and has supported much richer valuations." Between 2002 and 2006, the annualized return for commercial real estate was 18%, compared with 10% for hedge funds and slightly more than 6% for Standard & Poor's 500-stock index.
The question of whether commercial real estate will keep climbing at such a spectacular rate seems to have been resolved in the negative this summer. A better question is whether it will settle back to its historical rates of return, which are nice enough. Between 1987 and 2006, the asset class returned 9.4% annually, of which 3.5% was capital appreciation and 5.9% was income from dividends.
That return is two percentage points lower than the S&P's over the same period, but commercial real estate had about half the volatility. Bernstein calls commercial property a "happy medium." I agree. It's a good split between appreciation and income, return and risk.
Lagging yields. But is it the place to put some of your money right now? If commercial real estate has benefited from financial engineering, then the gains of 2002Ð06 -- and perhaps even of 1987Ð2006 -- could be one-time events. The value of income-producing property depends on rents, and here the story is not encouraging. A remarkable chart in the Bernstein report shows that in 12 of 13 top metro markets, rents over the past 20 years have increased at a rate slower than inflation. In one market -- Houston -- rents increased at the same pace. And this trend has occurred during a great period for the economy.
In 2006, the yield on commercial real estate -- that is, the income that the average property throws off -- declined to just 7%, the lowest point in at least the past 40 years and 2.6 percentage points below the average yield (also called the capitalization rate) since 1965.
Reprint Article
