REITs
Offer Investors An Opportunity For High Income, Solid, Growth Potential
And Portfolio Diversification
REITs,
or Real Estate Investment Trusts, are becoming increasingly popular
and for good reason. Created in 1960 as a result of legislation
passed by Congress, REITs are designed to put investment real
estate within the reach of individual investors. REITs offer
an attractive combination of high income, solid growth potential
and diversification giving them widespread appeal and making
them a solid foundation for most investment portfolios.
Although interest in
REITs has increased steadily over the past decade, they remain
a relatively little known investment option. In this interview,
Jeffrey Caira, Portfolio Manager of Pioneer Real Estate Shares,
discusses the benefits of REITs and shares his thoughts on why
he believes REITs are a smart investment choice now. Caira has
more than 17 years of experience in the real estate investment
business, including nearly three years as a REIT analyst and
15 years in property development and management.
Q. To begin,
could you describe what a REIT is?
A. In its simplest form, a REIT (Real Estate Investment
Trust) is a company that must generate the bulk of its income
from investments in real estate. Today, most REITs are equity
REITs, or companies that generate the majority of their income
from the direct ownership of property and the collection of rent.
Other types of REITs include: mortgage REITs, which produce income
through loans backed by real estate, and hybrid REITs, which
combine elements of both equity and mortgage REITs.
To qualify as a REIT,
a company must be widely held, can't be controlled by a small
number of investors, and most importantly, must distribute the
bulk of its taxable income to shareholders each year.
REITs also enjoy an
advantage over other types of equities: the avoidance of double
taxation. Unlike most public companies, REITs do not pay taxes
at the corporate level on earned profits. Taxes are due only
at the investor level on any dividends. An added benefit of the
EIT structure is that some dividends may be considered either
capital gains or return of capital, and therefore, may be taxed
at a lower rate or have taxes deferred.
Q. What other
benefits do REITs offer investors?
A. Because
REITs are required to pay out 95% of taxable income (dropping
to 90% on January 1, 2001) and have generally predictable growing
earnings streams, REITs are ideal income investments. In fact,
dividend yields on REITs tend to be significantly higher than
those on many other equities, and are among the highest available
in public equity markets.
As of September 29,
2000, the average dividend yield for equity REITs was 7.45%,
which compares favorably to the average 5.82% yield on 10-year
U.S. Treasuries.
A. Absolutely not. Unlike fixed income investments, REITs should be able to increase income levels or rents in portfolio properties over time. As a result, REITs offer the potential for generally rising dividends, which can provide a hedge against inflation.
REITs also offer attractive growth potential. Companies can improve operations on existing properties, recycle capital into higher-yielding investments, develop or acquire additional properties, or provide ancillary services. Finally, because REITs tend not to move in tandem with other equities, they are great portfolio diversifiers.
Q. Many investors are unfamiliar with REITs. Can you provide us with a brief history?
A. Certainly, although REITs have been around for 40 years, they maintained a fairly low profile for their first 30 years. Initially, REITs were designed to be passive owners of property and were not permitted to perform real estate-related services, such as property management or leasing.
In the early years, the industry was also dominated by mortgage REITs, which made loans to real estate developers. Hurt by a major real estate recession, oil crunch and high inflation in the '70s, however, a number of borrowers defaulted and mortgage REIT share prices declined leaving many investors understandably cautious of REITs.
Yet, the industry is vastly different today than it was several decades ago and REITs have been steadily growing in popularity since the early 1990s. As I mentioned earlier, the industry now is dominated by equity REITs which own tangible assets, and tend to be less risky than mortgage REITs. Most REIT management teams, too, have been cycle-tested they understand how to manage portfolios in good times and bad.
As evidence of REITs' increasing popularity, the size of the industry (based on market capitalization) has grown exponentially. Just under $10 billion at the end of 1992, the market cap of the industry has grown to about $160 billion currently. And the potential for future growth is huge. The industry currently owns on the order of 10% of the total commercial real estate market, and to put it in perspective, the total industry market cap is just one-third the size of general Electric. (Source: National Association of Real Estate Investment Trusts)
Q. The REIT Modernization Act (RMA), which was passed in December 1999 and takes effect on January 1, 2001, makes real estate investment trusts even more attractive. How?
A. The law, which includes several positive changes to existing REIT regulations, provides three primary benefits. First, the law allows REITs to reduce the required income payout from 95% to 90% which probably won't affect dividend payout rates, but does provide REITs with a bit of a cushion against losing REIT status.
A much more important benefit of the law, however, is that it allows REITs to own taxable subsidiaries permitting them to provide a great variety of services, and as a result, helping them generate greater customer satisfaction and potentially increase revenues.
A third and implicit benefit of the legislation is that it serves as recognition by Congress a kind of "stamp of approval" of REITs, giving investors an added degree of comfort by not only affirming the REIT structure, but also making them more competitive with their private counterparts.
Q. Can you provide some example of the types of properties that an equity REIT might invest in?
A. Equity REITs can own a variety of property types including office buildings, apartment communities, industrial buildings, hotels and retail properties. As manager of Pioneer Real Estate Shares, I'm focusing my efforts now on the multi-family and office sectors which are enjoying strong performance and I believe are well-positioned for future growth.
With rising mortgage rates and soaring housing costs, many families are being priced out of the single family housing market. Consequently, the demand for multi-family housing and apartments has skyrocketed. In most cases, rental costs are lower than monthly mortgage payments and obviously there's no down payment to deliver.
In the office sector, we're focusing on what the industry calls high-barriers-to-entry markets markets where demand is generally strong, but it's difficult for competitors to create new supply. For example, in San Francisco, Boston and mid-town Manhattan, where supply has failed to keep pace with the brisk demand, office space is at a premium. So we're seeing historically low vacancy rates which are contributing to above-average rental increases. As office leases turn over, rents can rise substantially, creating a rising revenue stream for many REITs.
Q. That leads me to my next question. What is your investment process?
A. We're basically bottom-up stock pickers. Although we consider the broader economic picture, we focus more on company fundamentals when selecting investments for Pioneer Real Estate Shares. We basically take an issue by issue approach, carefully scrutinizing each company looking for good assets, strong management and low debt.
Q. Can you elaborate?
A. Of course. Before investing in any company, you want to carefully consider the value of underlying assets. It's the same with a REIT. We want to know the investment profile of each property: where it's located, what type of property it is, and what the income-producing potential is.
I'm a big tire kicker. I think you can tell a lot about the quality of assets that a company owns by looking at them and not just staring at rent rolls or tenant rosters, although those things help as well. So we travel extensively gaining first hand knowledge from personal inspections and meetings with management.
I also think the balance sheet of a company is critical. We like to see a healthy balance sheet with manageable debt levels. We want to be comfortable that a company can still pay their dividends and cover debts even if revenues don't increase as much as expected.
Finally, strong management is extremely important perhaps even more so on the downside than on the upside. We look for experienced, committed management company leaders who have a clearly articulated business strategy, who know where they're headed and who align their interests with those of the shareholders. We like to know up front what we're getting that helps us make a judgment on whether the company's investment strategy matches our investment perspective, and helps us measure performance along the way.
Q. Why would an investor choose a REIT over direct real estate investment?
A. For several reasons. First, unlike direct real estate investments, which are often inefficient to buy and sell, most REITs are listed on stock exchanges for easy buying and selling. In addition, with REITs, investment exposure is limited to the amount of the investment with direct real estate, an investor may be liable for other debts.
REITs are also much more affordable than direct real estate investments, which are often out of reach for many individual investors. Finally, REITs offer professional management. And like all SEC-regulated public companies, REITs must provide quarterly and annual financial statements, and are required to provide disclosures about a variety of items that investors can use to make informed decisions.
Q. That said, is now a good time to invest in REITs?
A. I think now is great time to buy REITs. Due in part to an oversupply of REITs in 1998 and 1999, they underperformed the overall stock market during those years, with share prices on many REITs declining. As a result, even with the price appreciation the industry has experienced thus far in 2000, many REITs are currently attractively valued and represent a real buying opportunity.
Investors have recognized this, and cash flow into REIT mutual funds has been positive over the past several months. Performance has also turned around, and year-to-date returns are extremely competitive. For example, year-to-date through September 29, 2000, Pioneer Real Estate Shares posted a total return at net asset value of 24.98%.
In addition, with the economy healthy and the national real estate market generally strong, the demand for REIT properties is up. Revenues have also been increasing, which means that dividends are rising. Plus, the long-term growth potential for the industry is quite attractive in the 7% to 8% range.
Q. To conclude, what should an investor look for in a REIT fund?
A. I think the background of the fund manager is critical. I believe that it is a real benefit if the person responsible for day-to-day management has direct real estate investment experience, including an understanding of the process of developing, acquiring, managing and selling real estate, and what to look for when evaluating company leadership and assets.
In addition, a strong research staff helps narrow investment choices and focus management efforts on the most attractive investment options. The fund should be broadly diversified across sectors and properties to reduce volatility, of course, but also to boost growth potential.
Finally, although past performance is no guarantee of future results, an investor should consider historical returns to see how the fund stacks up against the competition and has fared in different types of markets.
Editor's Note: For information on Pioneer Real Estate Shares or any Pioneer mutual fund, please request a free kit from your investment representative or Pioneer at 1-800-225-6292.The kit includes a prospectus describing charges and expenses, and a quarterly fact sheet containing the latest holdings and fund performance. Please read the prospectus carefully before you invest or send money.
