Real estate profits without the headaches

You don't have to be a landlord to enjoy steady income. Here's how to join the party.

By Dennis Murray
Senior Editor

Unless you're familiar with local real estate values, purchasing a house, commercial space, or a piece of land can be a crapshoot. If you don't do your homework, you might overpay by thousands of bucks and, worse, get stuck with something you can't easily resell—like a contaminated lot that will cost you thousands more to clean up.

There are less risky, easier—and cleaner—ways to invest in real estate, and they don't even require you to come up with a wad of cash. Yet you'll still have a good chance of realizing market-beating returns, while at the same time diversifying your portfolio.

How? Through shares of a dividend-paying real estate investment trust, or a mutual fund that invests in REITs. There are approximately 200 publicly traded REITs and more than 60 mutual funds that specialize in real estate, many of which are sold without commissions.

If you don't own any real estate stocks or funds, you may want to consider shifting as much as 10 percent of your assets into a basket of them. As evidenced by their poor performance in 1998 and 1999, as well as their strong showing in 2000, these equities often zig when the rest of the market zags. So if the stock market continues to underperform in 2001, REITs and real estate funds may well shine. Realize, however, that you're not buying something that's likely to double or triple in value in 12 months. You need to be patient and willing to ride out the boom-and-bust cycles that can be triggered by lower rents and higher construction costs, among other factors.

"These are essentially growth-and-income investments," says Darryl M. Scopes, vice president of investments with Prudential Securities in Paramus, NJ. "If you're not going to commit to them for at least five years, look elsewhere."

Why REITs may be right for you

Newsweek financial columnist Jane Bryant Quinn says REITs are "for potatoes who want to own properties without leaving their couches." That's an apt description, but there's certainly no shame in desiring to own real estate without the hassles of evicting bad tenants, repairing leaky pipes, or dealing with power-hungry partners.

"REITs have a corporate structure that's very different from the old real estate partnerships that a lot of physicians got trapped in, where a single swashbuckling entrepreneur called all the shots," says Mark O. Decker Sr., senior vice president at Ferris, Baker Watts, an investment banking and brokerage firm in Washington, DC. "REITs have professional managers who have to answer to securities regulators, stock analysts, and individual and institutional investors, so they're subject to a lot of accountability."

And last year, they rewarded investors. Publicly traded REITs were up 26.2 percent, according to the National Association of Real Estate Investment Trusts (www.nareit.org), a Washington, DC-based trade group.* A major reason for this success is a general drift of investors' money away from technology stocks to safer havens, including income stocks. REIT shares, which were cheap early in 2000, are being recognized by Wall Street and are now trading closer to their true value.

But if REITs are so promising today, why did they stumble in 1998 and 1999? "A combination of reasons," Scopes explains. "People flocked to the Ciscos and Intels of the world and away from income stocks. And in 1998, crises in Asia and Russia created a credit crunch here, which made it more difficult for certain REITs to secure construction loans. There were also fears about an overheating US economy and the possibility of a recession, which would have hit REITs especially hard."

Plus, there was concern in some markets about weakening demand and excess supply, according to Chris Lucas, vice president and senior real estate research analyst with Ferris, Baker Watts. "Growth did slow somewhat in 1998 and 1999, but many REITs were still posting close to double-digit earnings increases," he says.

Olivia Barbee, a senior stock analyst with Morningstar, the mutual fund rating service, adds, "The stocks were down, but the companies' underlying fundamentals were quite sound."

Where the action is: Equity REITs

There are three basic types of REITs:

• Equity REITs own real estate and make their money from rents, leases, and sales of buildings. They own apartments, malls, nursing homes, offices, hotels, mobile homes, and shopping centers, among other properties.

• Mortgage REITs lend money to developers and pass the interest income on to shareholders.

• Hybrid REITs dabble in both real estate and mortgages.

As of Jan. 1, all REITs must pay dividends to shareholders on 90 percent of their taxable income, meaning they're a good choice for investors who want current income. (Most REITs pay quarterly dividends.)

Previously, REITs were required to distribute 95 percent of taxable income, but experts consider the decrease good news for investors. "REITs will still enjoy the same federal tax advantages—they get a dollar-for-dollar deduction for the amounts they pay in dividends—but now they'll be able to free up more cash for expanding existing properties or purchasing new ones," says Darryl Scopes. "You're still going to see a healthy dividend yield—6 to 7 percent, typically—and a chance for greater capital appreciation."

Of the three types of REITs, equity REITs provide the greatest opportunities for 2001, say the experts we spoke with. Mortgage and hybrid REITs, on the other hand, could suffer from interest rate volatility and offer less of a pure real estate play.

"An equity REIT that owns apartments or offices in California, metro DC, Boston, New York City, or the Pacific Northwest is one of the few businesses in this economy that has tremendous pricing power," says Lucas. "Rents are very high in these areas, and that's translating to strong annual earnings growth—near 20 percent, which is fabulous for real estate."

The experts offer their picks

Among the 165 equity REITs, our experts especially like the following half-dozen. All are multibillion-dollar companies, and their earnings are expected to grow 8 to 12 percent annually over the next five years.

AvalonBay Communities. This financially solid REIT owns apartment buildings in 12 states plus the District of Columbia. Several of the company's projects are upscale townhouse communities that include swimming pools and health clubs. The company also boasts forward-thinking management. "AvalonBay has made some very smart, creative uses of computer technology," says Decker. "For instance, through its Web site, you can view a specific luxury apartment and complete an application and credit check—all without ever leaving your computer." In 1999, when most REITs had negative returns, AvalonBay gained 7.5 percent; last year, it gained 52.4 percent.

CarrAmerica. CarrAmerica, which nationwide owns about 22 million square feet of office space, repurchased $90 million in shares last year, and expects to buy back $60 million more in 2001. That's a clear vote of confidence in its prospects. The stock's price-earnings ratio is little more than half that of the Standard & Poor's 500 Stock Index. With annual sales growth averaging 46 percent over the past three years, it's no surprise that Morningstar gives CarrAmerica Realty high marks for growth and financial health.

Equity Residential Properties Trust. This REIT owns approximately 226,000 apartment units throughout the US. "It's one of the larger, more established REITs," says Morningstar's Olivia Barbee, "the closest a REIT comes to being a blue-chip stock." It returned an impressive 13.5 percent in 1999, and was up 40.3 percent in 2000. Its prospects hinge in part on mortgage interest rates: If rates climb, fewer people will be able to afford homes and will continue to rent. According to a report from the Joint Center for Housing Studies of Harvard University, rental housing demand will indeed increase, with the number of renters younger than 25 expected to rise 20 percent by 2015.

ProLogis Trust. "ProLogis owns and operates temperature-controlled warehouses and other industrial storage facilities that it leases to supermarkets and food distributors," says Barbee, who thinks the company is poised to do well long term. Morningstar gives ProLogis high marks for growth, and seven analysts who follow the company recommend it.

Simon Property Group. Simon is the king of malls and shopping centers, with some 250 spread over 36 states. The jewel in its crown is the Mall of America, one of Minnesota's tourist attractions. "Like AvalonBay, Simon Property Group is working on e-commerce initiatives," says Barbee. "One goal is to create Web sites that will have links to all of the stores in a mall or shopping center, to allow people to check the sales at each store. Another initiative, which will be launched this year, lets shoppers scan the prices of all of their purchases into a handheld device, then pick up the items at one central location when they're ready to leave, or have the items delivered."

Spieker Properties. Spieker will continue to boost revenues from higher rents on its hundreds of West Coast office buildings and corporate parks, many of them located in pricey Silicon Valley. The valley accounts for a good chunk of Spieker's income, a fact that troubles some analysts. Others think those concerns are overblown and that Silicon Valley will be an industrial hotbed for years to come, leaving Spieker in a prime position to influence rents in that area. The stock is also relatively cheap, with a low P-E relative to the S&P 500's.

A tip: If you plan to buy shares of any individual REIT, pay close attention to who else is interested. Specifically, look for REITs whose executives or board members are buying shares; that can indicate confidence in the direction the REIT is headed. Information on purchases is available at www.morningstar.com. Enter the ticker or name of the REIT at the "Quicktake" box, and click on "Go." Then click on the left side of the screen under "Ownership." There you'll find which officers are purchasing and selling company stock and in what quantities.

Mutual funds offer diversification

Can't be bothered researching individual REITs, or don't have a broker who's familiar with them? Then purchase shares of a real estate mutual fund. Here are three low-cost no-loads worth examining:

Security Capital US Real Estate Fund. "This is my favorite real estate fund," says Kunal Kapoor, a senior analyst at Morningstar. It has the advantage of having an established real estate firm, Security Capital, as its parent company. That, says Kapoor, gives the fund's management team access to a tremendous pool of data and analysts to help it make smart decisions. As a result, the $99 million fund has returned an impressive 33.5 percent over 12 months. Its three-year annualized return of 5 percent is modest by comparison, but it still places Security Capital in the top 2 percent of REIT funds.

Security Capital US Real Estate has been around only since 1996, but don't let this short track record spook you. "The parent company has experience managing private money," Kapoor says. "So the investment processes are there, and they've been successful."

Columbia Real Estate Equity Fund. This 6-year-old fund used to be a sleeper, but no more. Its five-year average annualized return of over 14 percent is more than four percentage points higher than the real estate category average. That has caught investors' attention, but Kapoor says total assets are still low enough ($386 million) for manager David Jellison to find plenty of good places to invest. "If it grows to $1 billion quickly, I'd be concerned," Kapoor says. "But I don't see that happening. Real estate funds aren't that sexy."

Columbia Real Estate is also less volatile than most of its peers, which is one more factor that makes this fund an excellent choice.

Fidelity Real Estate Investment Portfolio.This is one of the oldest real estate funds, created way back in 1986. A mere six real estate funds are more than a decade old, and this one boasts a 10-year annualized return of 13.6 percent. Moreover, its expense ratio is under 1 percent, which means more of its earnings go into your pocket and not into Fidelity's coffers. "Size-wise, it's kind of big," says Kapoor, of the $942 million fund. "That's my greatest concern. But so far manager Steven Buller has shown he can handle the inflows."

Indeed. Fidelity Real Estate Investment Portfolio's 12-month return is 30.4 percent.

One caution: If you're looking for a five-star real estate fund, don't bother—you won't find one. Morningstar has awarded most of them only one or two stars over most periods, but those ratings reflect the dismal 1998 and 1999 that many REITs experienced. If, instead, you're looking to diversify your portfolio with income investments that carry the potential of market-beating returns, then REITs and real estate funds fit the bill.

^*All individual REIT and stock performance numbers are through Dec. 27, 2000; REIT mutual fund figures are through Nov. 30.

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Dennis Murray. Real estate profits without the headaches.

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