Publically traded real estate investment trusts (REITs) have much in common with other stocks, but seem to blur the line between debt instruments and equities due to their unique characteristics. In that regard, REITs have many similarities with hybrid securities, such as preferred shares, and often draw comparisons with utility stocks because of their yield-oriented nature. But from the perspective of the typical income-minded investor, real estate investment trusts are most closely linked with U.S. Treasuries, widely regarded as the benchmark of REIT performance. While they have many things in common, REITs and Treasuries have their own strengths and weaknesses, making each more suitable for a specific type of investor.
The question is: How do REITs stack up against 10-year Treasuries? With respect to yield, the rate on Treasuries is currently about 3.6%, but generally falls within the long-term historical average for REITs of 4%-6%. On one hand, REITs also offer the prospect of growth, the capital-gains potential that might be unlocked with share price appreciation. Thus, REITs will usually best Treasuries in terms of total return. But on the other hand, Treasuries have one feature that REITs cannot provide: The promise of full repayment of principal at maturity, backed by the full faith and credit of the U.S. government. But what does that mean in practical terms? And how does each segment of the real estate market measure up to Treasuries? We take a closer look below.
At its core, the operation of a typical REIT is a pretty straightforward affair. With few exceptions, most specialize in one type of property, since liquidity, equity requirements, and the level of hands-on management all tend to vary depending on market segment.
For instance, office developments require a moderate level of liquidity and upfront equity, but demand active, highly-professional management, especially in top-tier markets. Indeed, office landlords in primary cities, such as Vornado (VNO) and Boston Properties (BXP), often face stiff competition for trophy buildings, driving up property values and making leverage all the more critical. As a result, payout ratios for office REITs, at roughly 4%, are generally low by industry standards, with share prices usually determined by the quality of a company’s real estate portfolio, its long-term strategic direction, and the relative strength of its core markets. With so much `value’ derived from the promise of future returns, it’s no surprise that office REITs generally appeal more to growth-minded investors than the industry as a whole.
Retail properties, such as regional malls and community shopping centers, typically require low levels of liquidity and upfront investment, and a modest amount of hands-on management. This segment has an average yield of about 4%, on par with the long-run average for Treasuries. However, results here are prone to swings, since consumers are liable to cut back on spending during tough economic times, making the sector less comparable to Treasuries on a risk/reward basis.
Starting in the mid-1970s, two developments came along that permanently changed the retail landscape: The advent of large regional shopping malls and the rapid growth of ‘’big-box’’ discounters such as, Costco (COST), Home Depot (HD – Free Home Depot Stock Report), and Wal-Mart (WMT – Free Wal-Mart Stock Report). Among mall operators, Simon Property Group (SPG) is king. A global enterprise with over 340 properties spread across seven countries, Simon is the largest real estate company in the United States, with a market value that nearly doubles that of either Boston Properties, Public Storage (PSA), or Vornado, three of this country’s premier REITs.
Realty Income (O) is widely regarded as the leader in the "big box’’ category, boasting one of the largest portfolios in the country in terms of number of properties. While many of its peers suffered during the recent recession, Realty’s operating results remained a model of consistency. As a case in point, Realty’s funds from operations (FFO)—the most widely used measure of operating performance in the REIT industry—only regressed slightly during the recession, before bouncing back and achieving an all-time high in 2010. In fact, over the company’s decade-plus history, it has increased its payout every year while maintaining one of the highest dividend yields in the sector. Consequently, of the 25 REIT stocks within the Value Line universe, Realty Income most closely resembles a 10-year Treasury, in terms of its risk/reward dynamic.
On a smaller scale, neighborhood shopping centers are usually built around a supermarket and a drugstore, filled out with basic services, such as dry cleaning, takeout food, and a barber shop or beauty salon. Within this group, Federal Realty (FRT) has arguably been the steadiest performer. Most of its counterparts were forced to slash their distributions during the downturn in a bid to conserve capital, as occupancy levels, rents, and FFO tumbled. But that wasn’t the case with Federal; the company’s operating performance barely skipped a beat and Federal actually raised the dividend in 2010. While the yield on these shares is fairly modest by industry standards, this REIT should appeal to investors seeking a decent, reliable payout, which ought to be well supported by the company’s high-quality, well-located properties.
Federal Realty’s two closest competitors are Kimco Realty (KIM) and Weingarten Realty (WRI), both owners of substantial shopping center portfolios. Although both feature more generous yields, their operating results tend to be more volatile, making them less ideal selections for conservative accounts.
Residential REITs occupy a unique space within the world of real estate, since they tend to perform relatively well in both good and bad economic times. In turn, this segment of the market typically offers lower payout rates than the broader REIT industry, with an average yield of about 3%. But on a risk-adjusted basis, residential REITs have much in common with U.S. Treasuries.
Apartment owners benefit when the economy is expanding, as jobs are created and household formations accelerate. Conversely, tougher lending standards and higher mortgage rates are not uncommon during a downturn. In turn, home sales usually contract during a recession, driving up demand for apartments and helping residential landlords to weather tougher times better than their more industrial-focused counterparts.
Equity Residential (EQR)—currently the largest publicly traded owner of multifamily properties in the country—is a prime example of a successful residential REIT. During its forty-plus years, the company has amassed nearly 500 properties, comprised of more than 137,000 apartment units, with a book value more than double that of its nearest competitor. As would be expected, Equity’s operating results took a step back during the downturn, but held up better than most of its peers’ nonetheless. Although the size of EQR’s portfolio is impressive, what makes it an attractive investment is the quality and diversity of its asset base, concentrated in well-established cities with solid growth prospects including New York, Boston, San Francisco, and Washington, DC.
Another big player in those markets is AvalonBay Communities (AVB), which managed to navigate the downturn relatively well. While it cannot match Equity in terms of size, AVB has been more selective in its use of debt, and tends to focus more on high-end luxury properties. However, there is a downside to successful apartment REITs and their recession-insulated results: Valuations for upper-echelon landlords like Equity and AvalonBay are generally rich, and their payouts—although well supported—lag the industry as a whole.
We would be remiss if we didn’t mention Annaly Capital (NLY) and Public Storage. The former owns and manages a portfolio of mortgage-backed securities, and features the most generous yield of all the REITs we cover, and one of the highest among any stock in the Value Line universe. The catch is that Annaly’s payout is highly dependent on prevailing interest rates, which could make the dividend hard to maintain at its lofty level if rates rise significantly.
Public Storage may lack the cache of Vornado or Boston Properties, but remains one of the steadiest operators in real estate. The company owns and operates self-storage facilities in the United States and Europe, and performed admirably through the worst of the recent recession. What’s striking about the level of profitability PSA consistently achieves is the low degree of leverage employed. In fact, though PSA’s yield may seem a bit light by comparison, its dividend is among the most well supported in the industry.
Which brings us back to the question: How do REITs stack up against 10-year Treasuries? There’s no easy answer here. But as a general rule of thumb, if capital preservation is paramount, the 10-year U.S. Treasury wins decisively. If, however, a balance of current income and long-term capital gains is more to your liking, REITs more than hold their own.
At the time of this article’s writing, the author did not have any positions in any of the companies mentioned.