The Sector That Keeps on Ticking

By Andrew M. Gordon

Institutional investors are in a fix. Mutual funds, private equity funds, pension funds, endowments, and various foreign investment funds are loaded with cash, but they can’t seem to pull the trigger – at least not often enough.

They’re sitting on a mountain of money and they can’t figure out what to do with it.

If they make the wrong choice, they could quickly make the plunge from great heights to the great abyss, much like what happened to hedge fund, Amaranth Advisors. They lost $6 billion from making an ill-advised bet on natural gas futures.

Private-equity funds alone have raised more than $200 billion since the start of 2005, but have spent less than $60 billion of that sum, according to Thomson Financial.

In these uncertain times... where the hot money has (temporarily) fled the commodity markets... where long-term bond yields have remained stubbornly low... and high-tech doesn’t seem quite ready for prime-time... there’s been a surge of institutional money into one particular sector that is considered safe, full of great bargains and pays unusually high dividends.

The sector I am referring to is Real Estate Investment Trusts. REITs are great hedges against inflation and provide portfolio diversification. By law, they have to distribute 90% of their taxable income to shareholders. In return, their income – unlike other companies – goes untaxed. Uncle Sam can’t touch it until it gets into the hands of shareholders. So 35% more cash is available to distribute to shareholders.

REITs have been around since 1960, so they have a bit of a track record. And what that record indicates is that REITs consistently outperform the market. The following chart shows how they compare to the broad markets over the past five years and it’s not even close.

As you can see from the above chart, REITS (the Dow Jones Equity REIT Index in blue) don’t mimic the broader stock markets (the Dow in green and the S&P 500 in red). In fact, according to the National Association of REITs, the correlation between REITs and other investments has declined over the last 30 years.

In 2000, the Dow lost 6.2%. REITs gained 25.9%. In 2002 the Dow lost 16.8%. REITs rose 5.2%. And when the market rebounded beginning in 2003, that’s when REITs really took off.

This year, while the Dow and the S&P are up 11% and 8% respectively, the MSCI U.S. REIT Index and the Dow Jones Equity REIT Index are both up around 24% (and don’t forget this is at a time when the housing bubble is deflating).

Real Estate Investment Trusts are the sector that investors flee to – not from – when the clouds of uncertainty gather over the market. And nowadays there’s a lot of uncertainty out there.

By all indications, there should continue to be a great deal of money flowing into REITs. Let’s take a look...

According to TheStreet.com, 14 REITs have been taken private since the beginning of 2005, via purchases totaling $35 billion. The premiums to take these trusts off the market have averaged 9% more than their 52-week high.

Add a wave of public mergers to this privatization activity, and it’s clear that REITs have become an incredibly hot sector.

In other words, REITs have remained very attractive investments even as their prices have climbed and their valuations have grown higher. According to the market, REITs should be valuated at least 9% higher than their peak valuation points.

Private Equity Real Estate Magazine states that real estate oriented private equity funds have $38 billion in the coffers right now, with plans to raise an additional $45 billion in the near future.

And that, of course, doesn’t include billions of dollars that institutional and pension funds want to invest.

Going strongest so far this year are apartment REITs, followed (in order) by office, hotel and industrial REITs, with retail (its return rate is still a not-too-shabby 16%) bringing up the rear.

It is often said that all good things must come to an end, but considering the large amount of institutional money looking for a home, it doesn’t appear that day will come anytime soon for the REIT sector.

If you want a comprehensive list of REITs, you can find 293 of them listed in the Dow Jones Equity REIT Index. Apartment REITs would be a good place to start. As housing gets less affordable, rents are going up and the REITs that own and/or operate apartment buildings will generate more revenue.

Good Investing,

Andrew Gordon