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By Michael Grupe and Charles DiRocco

Improving stability in Real estate investment trusts (REITs) are outperforming most other sectors
the real estate of domestic equity markets so far this year following two years of negative
market, compelling returns. The NAREIT (National Association of Real Estate Investment Trusts)
composite index of total returns for all publicly traded equity, mortgage, and
market values, and hybrid REITs through the end of September was up 21.6%.
the search for less What has changed?
volatile investments Short-run investment performance may be affected by many factors. How-
in a turbulent market ever, long-run performance eventually must reflect the level and growth of
environment have all corporate earnings and the discount rate applied to those earnings.
Changes in the real estate market have produced an improved view of the
prompted investors overall stability of the real estate sector. Investors appear more convinced that
to give REITs a the commercial real estate sector is less prone to episodes of speculative
second look. building. For years, commercial real estate was almost entirely owned and
financed by private investors, including partnerships, pension funds, and
wealthy individuals, and proprietary information often held the key to suc-
cess. However, in the early 1990s, property owners turned to public markets
for capital, and the decision-making process became more transparent and
subject to the scrutiny of analysts, investors, and regulators.
In addition, the commercial real estate economy has recovered from the
collapse of real estate prices in the early 1990s and by 1997 entered a period
of relative equilibrium. REIT earnings growth slowed in 1998 and 1999, and
price-earnings multiples contracted, but average earnings growth remained
positive. Earnings reports in 2000 suggest that the slowdown of earnings
growth has stabilized, and year-over-year earnings growth picked up on
average in the second quarter of 2000.
The current volatile market environment has also shifted investor attention
to companies characterized by more predictable cash flows, higher dividends,
and lower multiples.
Finally, investors have responded to the values that shares of REITs and
other publicly traded real estate companies offered in late 1999. The average
dividend yield of all equity REITs reached 9.28% on December 16, 1999, its
highest level since December 1990, and nearly three percentage points above
the yield on 10-year Treasury securities. Since then, share prices of equity
REITs on average have increased 23.7% through the end of September.
All of these factors have prompted many investors to take another look at
REITs and publicly traded real estate companies. However, these firms have
distinct investment characteristics that individual investors should become
familiar with when evaluating prospective REIT investments.


REITs and other publicly traded real estate companies are total return
investments that provide high dividends plus potential for moderate, long-

Michael Grupe is vice-president and director of research and Charles J. DiRocco is

director of industry analysis, both at the National Association of Real Estate Investment
Trusts (NAREIT), a national trade association for REITs and publicly traded real estate
companies. NAREIT is based in Washington DC. More information on REITs can be
found at the website

AAII Journal/November 2000 9


FIGURE 1. LONG-TERM RETURNS: computer chips or light bulbs, or

REITS VS. OTHER MARKET SECTORS providing services like banking or
insurance, REITs deliver real estate
services to individuals and busi-
(Average annual total returns through August 2000) nesses. Thus, all of the skills that
45.0 individual investors use to evaluate

the stocks of public companies in
general can easily be used to evalu-
ate the stocks of REITs.
30.0 28.7 Most REITs should not be viewed
as closed-end funds, that is, passive
vehicles for collecting rents on a
17.5 17.2
portfolio of properties and passing
16.1 16.4

15.0 15.0 those rents through to shareholders.
Although REITs were originally
9.7 9.3 9.8
7.8 prohibited from both owning and
5.0 operating their properties, that
restriction in most cases was re-
Equity REITs NASDAQ Composite S&P 500 S&P Utilities Russell 2000 Bonds moved in 1986. Today, investors
should evaluate REITs and other
publicly traded real estate companies
as genuine operating businesses. As
such, REITs both own and operate
term capital appreciation. because the correlation of REIT their properties, actively manage
Because of their high dividends returns with the returns of other their liabilities to reduce their costs
and moderate growth potential, the market sectors is relatively low. of capital, exploit scale economies
long-term total returns of REIT Individual investors also should and other efficiencies in order to
stocks should be somewhat less than recognize that homeownership is not expand operating margins, and
the returns of high-growth stocks necessarily a substitute for commer- develop additional sources of
and somewhat more than the returns cial real estate in a diversified revenue by delivering new services to
of bonds. Because most REITs also portfolio. A house is an expenditure their tenants and others.
have a small-to-medium equity as much as an investment, particu- Like other public companies, the
market capitalization, their returns larly when financed with a sizable corporate officers and professionals
also should be comparable to other mortgage. It does not produce that manage REITs are accountable
small- to mid-sized companies. income, but rather requires monthly both to their boards of directors as
Figure 1 compares the average mortgage interest payments and well as to their shareholders and
annual returns of different invest- other occasional expenditures to be creditors. In addition, most REITs
ment sectors over the period 1975 properly maintained. Some houses in became public companies within the
2000. Stocks in the Nasdaq Com- some markets over certain periods past 10 years, often transforming to
posite index recorded the highest have appreciated greatly in value. public ownership what previously
average annual returns over the However, an index of house prices had been private enterprises. In
entire period. The average return of published by the Federal Home Loan many cases, the majority owners of
stocks in the NAREIT Equity REIT Mortgage Corporation shows that these private enterprises became the
index fell between the returns of house prices on average across the senior officers of the REIT and
large-cap stocks and bonds, and U.S. increased over the past 25 years rolled their ownership positions into
were about the same as the returns by a compound annual rate of only shares of the new public companies.
of small-cap stocks and utilities. 5.6% (ignoring both the benefits and Thus, the senior management teams
Day-to-day, as well as long-term costs of mortgage financing). of many REITs today own a signifi-
performance of REITs and publicly cant portion of the companys stock.
traded real estate stocks can be REIT OPERATING BASICS
REITs are public companies that,
PORTFOLIO DIVERSIFICATION in most respects, operate like all Historically, income-producing
other public companies, and the commercial real estate often was
Investing in REITs and other shares of most REITs are listed on financed with high levels of debt,
publicly traded real estate companies the New York Stock Exchange. both because the properties provided
also provides diversification benefits However, rather than manufacturing tangible security for mortgage

10 AAII Journal/November 2000


financing, and because the rental these components may be taxed at a estate business. For example, REITs
income from those properties was a different rate, all public companies, operate according to certain provi-
clear source of revenue to pay the including REITs, are required to sions of the U.S. tax code. Therefore,
interest expense on the loan. Prior to provide their shareholders early in changes to those provisions pose
the real estate recession of the early the year with information clarifying greater risks for REITs than they do
1990s, it was not uncommon for how the prior years dividends for most other companies. In
individual properties to carry should be allocated among these addition, state and municipal
mortgages of over 90% of their components for tax filing purposes. governments may from time to time
estimated market value or cost of This information is distributed by change property tax rates or land-
construction. Occasionally, loan-to- each company to its list of share- use policies that pertain to commer-
value ratios went even higher. holders on IRS Form 1099-DIV. cial real estate.
Today, properties owned by REITs A return of capital distribution is Specific risks also include changes
are financed on average with far less defined as that part of the dividend in management or strategic direc-
debt. The average REIT debt ratio that exceeds the REITs taxable tion, accounting irregularities,
(total debt divided by the sum of income. At first, some investors are mergers and acquisitions, and other
debt plus common equity market puzzled that any company can pay economic events.
capitalization) never moved much out more than its income in the form The economics of owning and
above 50% even as stock prices of dividends. However, because real managing commercial properties
declined in 1998 and 1999, and it estate depreciation is such a large also may be affected by develop-
has moved lower this year as stock non-cash expense that likely over- ments in other industries. For
prices have risen. states the decline in property values, example, the Internet is likely over
Investors also commonly evaluate the dividend rate divided by funds the long run to affect how consum-
a companys ability to meet its debt from operations (FFOa measure of ers shop for goods and services,
obligations by dividing its cash flow, income unique to the real estate thereby affecting how retailers
as measured by earnings before industry that well cover later in this conduct their businesses. New
interest, taxes, depreciation and article) is used as a more appropriate communications technologies,
amortization expenses, by either its measure of a REITs dividend-paying including broadband communica-
interest expense or interest expense ability. Thus, a dividend rate that is tions services, will change to some
plus other fixed charges such as 80% of FFO can easily exceed degree the nature of how office
dividends on preferred stock. For 100% of earnings and profits. space is occupied and managed.
REITs, these coverage ratios on A return of capital distribution is However, such changes are common
average currently exceed 2.5 and not taxed as ordinary income. in our dynamic economy, and all
3.0, respectively. Rather, the investors cost basis in companies must respond to them
REITs are required by law to the stock is reduced by the amount from time to time.
distribute each year to their share- of the distribution. When shares are
holders at least 95% of their taxable sold, the excess of the net sales price ECONOMIC RECESSION
income (although this will be over the reduced tax basis is treated
reduced to 90% starting in January). as a capital gain for tax purposes. A slowdown in the economy is
Thus, as investments, REITs tend to Alternatively, if the distribution likely to affect all public companies
be among those companies paying exceeds the shareholders tax basis in to some degree, including REITs and
the highest dividends. The dividends the stock, the excess is treated as a publicly traded real estate compa-
come primarily from the relatively capital gain. As long as the appro- nies. When economic growth slows,
stable and predictable stream of priate capital gains tax rate is less growth in the demand for space may
contractual rents paid by the tenants than the investors marginal ordinary slow or decline, causing building
who occupy the REITs properties, income tax rate, a high return of occupancy rates to drop and market
and since rental rates tend to rise capital distribution may be especially rents to weaken. However, such
during periods of inflation, REIT attractive to investors in higher tax developments are unlikely to affect
dividends tend to be protected from brackets. all REITs equally. Some geographic
the long-term corrosive effect of regions may experience greater
rising prices. REIT RISKS economic weakness than others, and
the businesses of some tenants may
DIVIDEND DISTRIBUTIONS Like all public companies, REITs suffer more than others. Thus,
face the general risk that overall certain REITs may withstand the
For REITs, dividend distributions market conditions will drag down all effects of a temporary economic
for tax purposes are allocated to stocks. slowdown more effectively than
ordinary income, capital gains and REITs also face industry risk that other REITs.
return of capital. Because each of is specific to the commercial real For example, tenant leases for

AAII Journal/November 2000 11


AND THE S&P 500 (1994-2001) company press releases and at
company Web sites. Further infor-
mation pertaining to FFO, including
links to individual company Web
Ratio sites, is also available at
18.0 S&P 500 Price-to-Cash Flow Multiples
NAREIT Price-to-FFO Multiples

12.0 Rapid earnings growth is an

important attribute of successful
companies. However, consistent
earnings growth is also important
and highly valued by investors.
4.0 When buying common stocks,
2.0 investors should focus on future
earnings growth, as much as on past
1994 1995 1996 1997 1998 1999 20001 20011 performance, and ask themselves
Based on consensus analyst estimates from First Call.
Source: National Association of Real Estate Investment Trusts , Salomon Smith Barney.
where future earnings growth will
come from.
In REITs, growth in funds from
office and industrial properties are market value of the firm, and they operations typically comes from
usually written for longer periods provide the cash flow required for several sources, including higher
than for other types of properties, paying dividends. revenues, lower costs, and new
thereby providing some protection Like all other public companies, business opportunities. The most
from a sudden and unexpected REITs report their net income and immediate sources of revenue
decline in market rents. Retail earnings per share using generally growth are higher rates of building
property REITs often structure their accepted accounting principles occupancy and increasing market
leases in a manner that enables the (GAAP). However, GAAP requires rents. As long as the demand for
REIT to participate in store revenues commercial property owners to new properties remains well bal-
if such revenues exceed certain depreciate the cost of their proper- anced with the available supply,
preset levels. If an economic reces- ties to zero even though well-located market rents tend to rise as the
sion reduces these revenues, the and well-maintained properties economy expands. Low occupancy
REIT may be adversely affected. continue to be highly valuable after rates in under-utilized buildings can
20, 30, or 40 years. Therefore, most also be increased when skilled
EVALUATING REIT STOCKS REIT analysts and investors consider owners upgrade facilities, enhance
this measure of net income to be building services, and more effec-
In most respects, investors evaluate inadequate for properly evaluating tively market properties to new types
the stocks of REITs and other the operating performance of real of tenants.
publicly traded real estate companies estate companies because the large Property acquisition and develop-
using the same tools and techniques depreciation charges are widely ment programs also create growth
they use to assess the stocks of other believed to significantly overstate opportunities, provided the eco-
public companies. Commonly used expenses and understate earnings. nomic returns from these invest-
indicators of performance and value To account for this shortcoming, ments exceed their cost of financing.
include earnings growth rates, NAREIT in 1991 adopted funds Today, for example, some industrial
earnings multiples, dividend yields, from operations (FFO), to promote REITs are developing specialized
and net asset values. However, there an industry-wide measure of REIT processing and distribution facilities
are certain issues that are unique to operating performance that would that more effectively meet the
the evaluation of real estate compa- not have this drawback. FFO is business and location requirements
nies that individual investors should intended to be a supplemental of new Internet-based companies.
be aware of. measure of earnings and adds back Like other public companies,
Corporate earnings are one certain depreciation and real estate REITs and publicly traded real estate
measure of how efficiently a com- amortization charges to net income companies also grow earnings by
pany uses its resources to create while it excludes gains (or losses) improving efficiency and taking
economic value for its shareholders. from property sales. advantage of new business opportu-
They also help to determine the Investors may obtain current and nities. Investors should look for

12 AAII Journal/November 2000


companies that increase their operat- multiples calculated as the ratio of the cushion available to meet current
ing (profit) margins by running their stock price divided by four-quarter dividend rates.
businesses more efficiently and by trailing cash flow per share, a more
taking advantage of economies of appropriate proxy than earnings per NET ASSET VALUES
scale. share for FFO.
Investors should also watch for Investors often judge the relative
companies that effectively develop DIVIDEND YIELDS value of a stock by dividing the
new business activities in conform- market price of the stock by the
ance with the recently enacted REIT Investors often look at the book value per share of the com-
Modernization Act. The laws under dividend yieldthe dividend rate pany. A companys book value is the
which REITs operate limit them to divided by the share priceto difference between the companys
providing only those services that compare the income-producing assets and liabilities or the sum of
were long accepted as being usual ability of alternative investments or retained earnings plus other items
and customary landlord services, to determine which sectors or under stockholders equity. In its
and they were restricted from offer- individual stocks are relatively over- simplest terms, this yardstick is used
ing more cutting-edge services or undervalued. At the end of to determine how much more or less
provided by other landlords. The September 2000, the average investors are willing to pay for the
REIT Modernization Act, which goes dividend yield for all equity REITs book net worth of the company and
into effect January 1, 2001, allows was 7.4%, roughly 1.6% above the the earnings capacity that the net
REITs to create subsidiaries that can yield on 10-year Treasury securities. worth represents. When the price-to-
provide the important, competitive As share prices this year have book ratio exceeds 1.0, the stock is
services that many of todays tenants increased, the yield spread has said to trade at a premium to book
desire. narrowed but remains wider than value. When the ratio is below 1.0,
its 0.80 percentage point average the stock trades at a discount. Stocks
PRICE-EARNINGS MULTIPLES since the beginning of 1990. that trade at a discount often are
Of course, an extraordinarily high viewed as offering investors more
Another measure commonly used dividend yield may be a sign that, value than stocks priced at a pre-
by investors to compare individual owing to certain problems facing a mium, although investors are well-
stocks is the ratio of the stock price particular company, investors advised to be especially cautious of
to the companys most recent or demand an additional risk premium stocks trading at unusually large
projected annual earnings per share. in their required return. Thus, when premiums or discounts.
When evaluating REIT stocks, the evaluating the dividend yield, Most REIT analysts and investors
appropriate ratio is the stock price investors should inquire about a consider price-to-book value ratios
divided by FFO per share. companys long-term capacity to as inappropriate when evaluating
The price-earnings ratio (or price generate sufficient revenue both to REITs. Because a REITs real estate
multiple) measures how much current meet and consistently grow its assets are valued at their original
buyers of the stock are willing to pay current dividend rate. REIT divi- purchase price less accumulated
for each dollar of expected earnings. dends have grown at an average depreciation, book value accounting
In general, companies with more annual rate of 6.6% since 1992, a may significantly understate the
rapid or consistent earnings growth rate that has exceeded the rate of current market value of the REITs
tend to be rewarded with higher consumer price inflation each year. properties and the genuine earnings
stock price multiples. Stocks trading REIT analysts and investors also capacity of the company. Thus, most
at lower multiples are often viewed look at the payout ratiothe ratio REIT analysts and investors use
as providing investors with better of the dividend rate divided by FFO current real estate prices to estimate
value because each dollar of earnings per shareto determine how much a REITs net asset value as a surro-
can be purchased for a lower price. of a companys available cash flow gate for book value. Many of these
Figure 2 shows the average price- is being used to pay the dividend. analysts also argue that a REITs
to-FFO per share multiple for REIT REIT payout ratios on average have stock ordinarily should be priced
stocks using end-of-year stock prices declined from more than 85% in above its net asset value to reflect
and annual FFO per share for the 1994 and 1995 to 65% in the the franchise value created by
previous four quarters. The data second quarter of 2000. While management. For individual inves-
show that REIT stock-price multiples maintaining a dividend rate of at tors, however, estimating net asset
contracted in 1998 and 1999 as the least 95% of taxable income during values for a REIT would be ex-
pace of REIT earnings growth this period, REITs have been tremely difficult. Although there is
slowed. The data also compare REIT reducing the proportion of total no cost-free source for net asset
stock price multiples with those of available cash flow they use to pay value, price-to-net asset value figures
companies in the S&P 500, with S&P their dividend, thereby increasing are available through the industry

AAII Journal/November 2000 13


publication Realty Stock Review, how well-balanced the supply of WHAT TO LOOK FOR
(published by Rainmaker Publica- new buildings is with the demand
tions, 732/493-1999; $269/year). for new space. When new construc- What should individual investors
tion adds space more rapidly than it seek in a REIT?
SECTOR COMPARISONS can be absorbed, building vacancy The market usually rewards
rates increase and rents and property companies that demonstrate consis-
For each major property sector of values decline, thereby depressing tent earnings and dividend growth
the REIT industry, Table 1 summa- net asset values. with higher price-earnings multiples.
rizes the various quantitative mea- In a strong economy, growth in Thus, investors should look for
sures commonly used by analysts employment, capital investment, and REITs and publicly traded real estate
and investors to evaluate REIT household spending increases the companies with the following
stocks. Sector comparisons provide demand for new office buildings, characteristics:
investors with a starting point when apartments, industrial facilities, and Look for companies with a
screening for individual stock retail stores. Population growth also demonstrated ability to grow their
selections. boosts the demand for apartments. earnings in a reliable mannerfor
Individual investors can find However, the economy is not always example, companies with proper-
current information on investment equally strong in all geographic ties in which rents are below
performance and operating funda- regions, and economic growth may current market rents. Such
mentals, at both the sector and not increase the demand for all properties provide upside potential
company level, in NAREITs property types at the same time. in equilibrium markets and
monthly publication, REIT Watch, Thus, investors should compare the downside protection when eco-
AAIIs Stock Investor Pro stock locations of properties owned by nomic growth slows.
database, REIT research reports different companies with the relative Seek firms with management
available from their brokers, and the strength or weakness of real estate teams able to quickly and effec-
financial press. markets in those locations. Informa- tively reinvest available cash flow.
tion on company properties is For firms with the ability to
REAL ESTATE FUNDAMENTALS available at their Web sites, while develop new properties, look for
information on local and regional companies that are able to
Because investors often compare real estate markets is available in the consistently complete new projects
current stock prices to net asset financial press. on time and within budget.
values, investors should be aware of Be alert for creative man-
agement teams with sound
(THROUGH SECOND QUARTER 2000) new revenue opportunities
FFO Debt NAV FFO Dividend Payout Dividend under the REIT Moderniza-
2000 Growth Ratio Premium* Multiple** Yield*** Ratio Growth tion Act.
Property Sector (thru 9/29) (%) (%) (%) (X) (%) (%) (%) Finally, investors should
Industrial/Office 30.1 11.7 45.4 na 9.3 6.5 62.6 8.8 look for companies with
Office 32.2 10.9 46.7 25.0 9.0 6.4 62.9 9.8 strong management and
Industrial 26.2 12.9 43.3 5.9 9.9 6.2 62.9 3.6 operating characteristics.
Mixed 27.2 13.0 42.9 19.7 9.1 7.0 61.1 11.4 Such characteristics include
Retail 13.4 7.5 54.0 na 7.7 8.5 68.9 3.8 effective corporate gover-
Shopping Centers 9.9 4.0 47.7 na 8.1 8.9 72.4 4.3 nance procedures, conserva-
Regional Malls 19.0 11.7 61.4 17.2 7.3 8.1 64.9 3.1 tive leverage, widely
Free Standing 5.9 5.0 42.7 na 7.9 8.8 81.4 na accepted accounting
Residential 24.9 12.4 45.2 na 9.9 6.6 66.9 7.1 practices, strong tenant
Apartments 26.5 12.9 45.5 16.0 9.9 6.5 66.3 7.1 relationships, and a clearly
Manufactured Homes 7.7 6.9 41.2 17.0 9.8 7.2 73.2 na defined operating strategy
Diversified 20.4 0.1 45.4 16.4 8.9 9.5 69.5 5.3 for succeeding in competi-
Lodging/Resorts 35.9 9.2 55.0 31.1 5.6 10.1 48.3 0.0 tive markets.
Health Care 25.4 3.7 50.3 na 6.7 9.9 84.3 5.4 All of these characteristics
Self Storage 10.0 0.2 45.6 26.5 8.8 5.8 50.1 0.9 inspire confidence in the
Specialty 18.7 1.8 31.1 na na 7.0 na 9.6 marketplace and are the
*As of first quarter 2000.
same characteristics that
**Based on annual 2000 FFO analyst estimates and prices as of August 31, 2000. individual investors should
*** Through September 30, 2000.
Source: National Association of Real Estate Investment Trusts, Salomon Smith Barney, First Call.
use when evaluating all

14 AAII Journal/November 2000