Seeking Shelter in Real Estate


The concept of asset allocation -- diversifying investments across stocks, bonds, cash, and other assets -- was tossed out the window in the late 1990s. The most exciting growth was in technology, and that was where investors put their money. But in 2000, diversity proved its worth as the Internet bubble burst and technology stocks fell out of favor. Real estate in particular showed it could serve as an antidote to the tech wreck.

Real estate investment trusts (REITs), publicly traded companies that manage portfolios of real estate holdings, posted a total return of 27% in 2000 while the tech-laden Nasdaq dropped 39%. Professional investors looking to dodge the sliding Nasdaq were probably the main beneficiaries of the gains in REITs, says Barry Vinocur, editor of Realty Stock Review.

PROPERTY PROTECTION. Now, the rest of the investing world has an opportunity to make up for past sins and diversify assets more broadly. Yes, concerns about the economic slowdown could translate into less than a banner year for REITs in 2001. But they could again provide some protection from another sharp sell-off in tech stocks. One very attractive feature: REITs are required by law to pay out 90% of taxable gains annually to investors, so they have high dividends -- about 7% a year on average currently.

It's too simple to conclude that you'll be safe if you flee aggressive growth stocks and head for REITs. This asset class was in a bear market as recently as 1998 and 1999, when equities were soaring. Indeed, lots of investors shied away from REITs in 2000 because they had performed abysmally in the previous two years. Individual investors put just $365 million into real estate mutual funds in 2000, vs. a withdrawal of $2.6 billion from them in '98 and '99, according to research firm AMG Data.

"My sense is that if you're looking for the kind of returns we had [in 2000], you're probably not going to get them," says Morningstar senior analyst Kunal Kapoor. However, he adds: "You do have a good shot at getting more normalized returns." That probably means you could expect respectable returns as opposed to huge losses.

With the Federal Reserve still in an easing mode, the stock market still rocky, and a high level of uncertainty about whether a recession can be averted, REITs are probably less risky than stocks or bonds at this point. And some analysts argue that REITs are still undervalued because they weren't bid up to reflect the soaring property values of the late '90s.

FLAT START. Analysts expect the REIT sector to turn in a performance of 12% to 20% in 2001, which may prove to be quite attractive depending on how the broader market does. But here's the rub: The higher your expectations for the Nasdaq, the worse the outlook is for REITs. So far this year, tech stocks have rebounded, and the Morgan Stanley Dean Witter REIT index is basically flat. David Fick, who heads Legg Mason's real estate investing group, expects REITs to return 12% to 15% this year. "If the Nasdaq continued a downward slide, I would be a lot more bullish," he says.

Jay Leupp, who heads Robertson Stephens' real estate equity research group, thinks REITs will deliver 17% to 20% returns, largely because investors will continue to seek their high yields and low valuations (REITs trade at about a 10% discount to the underlying value of their holdings). But "we're at the bullish end of the Street," he admits.

Real estate, like the economy in general, is considered to be near the end of a record 10-year expansion. So analysts aren't looking forward to big increases in lease incomes going forward. But the industry is in a good position to weather an economic slowdown, primarily because supply and demand are in better balance than they typically have been in the past at the end of a long cycle.

At the same time, even if property values aren't rising, office REITs can still build income as long-term leases expire and are renegotiated to reflect current property values, says Leupp. Since the only way out of a lease is to declare bankruptcy, the economy would have to truly tank for REITs to be in distress. "If the economy really slows, our group would not be totally immune," says Steve Sakwa, a REIT analyst with Merrill Lynch.

DIVERSIFIED PICKS. But even a short and shallow slowdown will hit some regions of the country harder than others. For that reason, investors should stick with big, liquid, geographically diverse companies. Large-office REITs top many analysts' lists. Here, the blue-chip name is Office Equity Office Properties (EOP), which has a $9 billion market cap. Sakwa likes Spieker Properties (SPK) and Boston Properties (BXP). Vinocur's top pick for the year is Vornado Realty Trust (VNO), which he says is a bit riskier than most REITs but has visionary management. Fick also likes Duke Weeks Realty (DRE), Prologis Trust (PLD), and CarrAmerica Realty (CRE).

In apartment REITs, the top name is Equity Residential Properties Trust (EQR). Sakwa also likes Archstone Communities (ASN) and AvalonBay Communities (AVB). Leupp is focusing on mid-price apartment REITs, like AIMCO (AIV), which he says are "almost recession immune."

Retail is a riskier category for REIT investors. Sakwa says he's concerned about industry fundamentals since so many retailers are announcing store closings. But Fick believes that this year isn't much worse than the usual retail cycle and points to high occupancy rates in malls. He recommends Simon Property Group (SPG), which is inexpensive and has a high yield. He also likes Weingarten Realty Trust (WRI), an outfit that operates shopping centers anchored by grocery stores, which he thinks will hold up well even in an economic downturn. Vinocur's favorite is Regency (REG), and he also likes Chelsea Property Group (CPG), which owns factory-outlet centers.

Long-term, REIT investors should expect low double-digit returns "hopefully with less volatility," says Sakwa. Fick agrees. Over the long haul, the sector will benefit from aging boomers who will want the predictable income and stable returns REITs offer, he says. "The aging investor is a very important long-term trend," predicts Fick.

PORTFOLIO BUILDING. Choosing a diversified mutual fund is probably the easiest way for most investors to get exposure to the real estate sector. Kapoor's favorite funds include Security Capital U.S. Real Estate (SUSIX), Columbia Real Estate Equity (CREEX), and Third Avenue Real Estate Value (TAREX). Unless you need the current income, he suggests buying the fund for a tax-deferred account.

Which brings us full circle to the benefits of asset allocation. Vincur suggests 8% to 10% of assets is an appropriate real estate allocation for most investors. Investors can't making up for not having done it in 2000, but it's no excuse for not being better diversified this year. Stone is an associate editor of BusinessWeek Online and covers the markets in our daily Street Wise column.

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