Is It Time to Invest in Real Estate?; REITs Are on Rebound; Real Estate Investment Trusts Are Outperforming the Market in Return Rates

Article excerpt

Skimpy bond yields and a swooning stock market might tempt investors to put their money in something solid - like brick and mortar.

Shareholders in real estate investment trusts, or REITs, have fully recovered from their spectacular tumble in 2008. This year, they are outperforming the stock market, with a total return of 14.9 percent, as measured by the FTSE NAREIT Index, against 9.5 percent for the S&P 500 stocks.

An average 3.5 percent dividend yield contributes to that performance, and therein lies much of the argument for real estate investment.

It goes like this: Americans frozen out of the home market are filling up apartments. Retailers are slowing filling vacant storefronts in shopping malls, and aging baby boomers should mean a growing market for health care REITs. The office market is still troubled, especially in the suburbs, but a few big cities are seeing revival.

Put all that together and it spells rising profits for landlords and rising payouts for REIT shareholders. Dividend yields today vary, mainly between 2 and 6 percent.

That's the upside. On the downside, REITs in recent years have proved just about as risky as stocks. Since shareholders buy them for their dividend, they could be at risk if interest rates turn upward and income-loving investors switch back to bonds.

"As long as interest rates stay low, we'll be bullish on REITs," says John W. Guinee III, analyst at Stifel Nicolaus & Co. "If interest rates go up appreciably, you don't want to be in REITs."

REITs used to be a good way to diversify an investment portfolio. They moved a little when stocks moved a lot, giving investors a smoother ride over all.

That's not true anymore. There's now a fairly strong correlation between the stock market and REIT prices. Part of that is because big stock indexes began including REITs.

REITs matched the market during the great meltdown of 2008, falling 37 percent, dividends included. Then they bounced back, returning 28 percent in 2009, and again at 28 percent in 2010, and then 8 percent last year.

The 2008 crash had its roots in a real estate bubble. In normal market pullbacks, expect REITs to fall less than stocks, Guinee says. That 3.5 percent dividend yield gives them a cushion as money runs to safety. On the other hand, expect REITs to underperform a bit when stocks are on a roll.

REITs buy real estate, using borrowed money to do it. Some are generalists, while others concentrate in segments - office, industrial, retail, apartments, health care, self-storage, hotels, even timber.

By law, REITs must pay out at least 90 percent of their profits in dividends to shareholders, so rising profits tend to go directly to investors' pockets rather than the corporate treasury or share buybacks.

But Uncle Sam wants his cut. REITs pay no federal income taxes, passing that burden on to investors. As a result, investors pay ordinary income tax rates on REIT profits distributed as dividends. They don't get the lower rate afforded to stock dividends. However, a small portion of the REIT dividend may come in the form of capital gains and return of capital, which gets kinder tax treatment.

The average investor isn't a real estate expert, notes analyst John Sheehan of Edward Jones in Des Peres. "The typical investor finds it hard to be a sector picker," says Sheehan.

So, he recommends Realty Income (ticker symbol O, yield 4. …

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