Daily Interview: Burned by Tech? How About REITs?

Now that the dizzying era of uber-growth and nosebleed valuations in high-tech and dot-com stocks seems to have come to a sobering end, Daily Interview has gone out in search of things we never before thought we'd miss: stability, consistency and safety.

Steve Brown, co-portfolio manager for (CSEIX)Cohen & Steers Equity Income Fund, discusses real estate investment trusts, otherwise known as REITs, as an increasingly important part of a well-diversified portfolio, given their ability to combine safe and relatively high levels of current income with earnings-per-share growth. Cohen & Steers is the largest money manager focused exclusively on real estate securities with about $5 billion under management.

Steve Brown Co- portfolio Manager Cohen & Steers Equity Income Fund

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REITs own income-producing commercial real estate and do not pay federal income taxes. To qualify for this benefit, REITs pay out 90% of their net income to shareholders as dividends, which leads to high dividend yields in the range of 7% to 7.5% on average.

REITs performed poorly in 1998 and 1999 but began to recover after the first quarter of 2000. With the Nasdaq hitting 5000, non-REIT money managers came in looking for value and shelter from volatile parts of the market, according to Brown, and REITs were up about 25% by year's end. So far this year, the performance of REITs has been flat.

Why should investors consider REITs now?

Brown: REITs are a simple story of current income plus earnings-per-share growth. They're now offering 7.5% in current yield, and we expect about 8% share growth this year, which represents a total return in the low- to midteens with low volatility.

REITs are trading at a historically low range of 8.5 times funds from operations [funds from operations is a common benchmark for valuing REITs and are roughly equivalent to free cash flow]. And not only are the REIT dividends high, but they're also safer. The payout ratio today has declined to about 65% from 90% on average, providing more cushion in terms of supporting the dividend and substantially improving the safety of dividends over the last five years.

We see REITs assuming a role of greater importance in investors' view on total return going forward: In the go-go growth days of the late 90's, earnings growth or the expectation of earnings growth were emphasized, while current income was given little weight in terms of importance within overall investment decisions. Now that the growth rates are coming down, current income will again matter and will factor into investors' decisions of what to invest in going forward. REITs offer a high level of current income that is growing and relatively safe. The average REIT dividend yield as measured by the National Association of Real Estate Investment Trusts is about 7.5%.

REITs will garner more attention also because asset allocation is coming back into style: It was obsolete for the last couple of years when investors overweighted large-cap growth stocks and the Internet and forgot about asset allocation. But with the highly volatile performance of some sectors in the last 24 months, we are seeing more financial advisors as well as independent financial planners shifting back to the asset allocation model, which stipulates anywhere from 50 to 65% in common stocks, about 20% in bonds and 10% in real estate. REITs are a good portfolio diversifier, because they have a very low correlation to the S&P 500 and Russell 2000. REITs are most highly correlated to commercial real estate fundamentals.

Rock Steady REITs have been outperforming the S&P 500 recently.

What is your outlook in the second quarter and the second half of 2001?

Brown: There will be increasing commitment to the industry by investors, as they see that the REITs are delivering their projected earnings in the first quarter and the next, and that they offer high income and solid and consistent earnings-per-share growth. What's driving the earnings is the fact that the real estate fundamentals are in good shape: Supply and demand are in balance, and most of the property types have long-term leases, which protects them from a sudden change in their earnings.

Do you have a lot of confidence about the ability of REITs' management to forecast their earnings while visibility has become a rare commodity in the market?

Brown: Yes, because REITs don't have sales but rental revenue, which is contractual by nature. The visibility is very high in REITs, because there is a high degree of predictability in long-term leases. Also absent are inventories, backlogs of orders or financing of new sales. So one can have confidence in the stability of REITs' earnings growth over the next 12 to 24 months. Unless we go into a prolonged recession of up to six to eight quarters, REITs should be able to sustain their earnings growth.

Which sectors and names in those sectors do you like?

Brown: We like health care facilities, regional malls and hotels within the REIT industry.

Health care REITs are companies that primarily own nursing homes. In the past, health care facility operators were decimated by poor fundamentals such as low reimbursement rates for Medicaid and Medicare and rising labor costs. Now the fundamentals have significantly improved and supply has been restricted. They have had a good run so far this year, but there is more money to be made in this sector. This is one part of the REIT industry that is now the best buyers' market in the last five to 10 years with the dislocation of property and ownership of nursing homes. A good example of a company that's thrived in this sector is Health Care Property Investors (HCP).

Regional mall REITs have also done well. The performance of these companies has been somewhat tied to that of their retail tenants. When the Federal Reserve started cutting interest rates, which is deemed to be positive for the economy and the consumer, retailers did well, and regional mall REITs have benefited as well.

These stocks were also very cheap in the fourth quarter of 2000, just coming off of a period of rising interest rates and declines in consumer confidence and spending. Regional malls will continue to do well in the next six to 12 months, as a result of rate cuts, not only because of stimulated consumer spending but also due to the reduced cost of debt. Regional malls are usually the most leveraged and have the most debt per share among property REITs. We like CBL Associates (CBL) in this group.

In the hotel sector, construction and supply aimed at 2002 have dropped off for low- to middle-range hotels. And the economy will be stronger in 2002 than it has been this year. This group is very cheap, operating at six times earnings. We believe that Host Marriott (HMT) and FelCor Lodging Trust (FCH) will be able to take advantage of economic growth going forward.

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