Saturday, June 16, 2001

The Sophisticated Investor

Investors take bigger risks with real estate funds

By John Waggoner
USA Today

        Certain mysterious cycles govern this island Earth. Every spring, the swallows return to the mission at San Juan Capistrano in California. Every 17 years, the cicadas emerge from their East Coast burrows. And at the end of every economic cycle, the office real estate market slowly and majestically implodes.

        OK, the office market isn't quite that reliable. But it's close.

        If you're considering investing in a real estate fund now, be aware that your above-average yields could come with some above-average risks.

        Real estate funds invest mainly in real estate investment trusts, or REITs. A REIT, in turn, invests in commercial real estate: offices, apartments and shopping centers.

        By law, REITs must pass on 90 percent of their taxable income to shareholders. For the REITs, the law means that few REITs pay much, if anything, in corporate income taxes. For the shareholder, it means bountiful dividend yields.

        The typical REIT pays a 7.09 percent dividend yield. Thanks in part to those dividends, REITs have been more than all right this year: They have been terrific.

        The National Association of Real Estate Trusts (NAREIT), the industry's trade group, says its REITs index has gained 9.9 percent this year, including reinvested dividends. The Standard & Poor's 500-stock index has lost 7.6 percent.

        NAREIT, along with Chicago stock researchers Ibbotson and Associates, produced a study showing that commercial real estate has a low correlation with stock performance. The NAREIT/Ibbotson study implies that adding REITs to your portfolio can reduce your risk and improve your returns.

        So what could possibly go wrong? Well, there's the business cycle. A year ago, commercial office space was tighter than the legroom in an airplane full of giraffes. New technology companies were snapping up new space at high rents. According to Grubb & Ellis, a real estate consultant, technology companies accounted for more than a third of all leasing activity in 1999 and 2000. What went wrong?

        First, the Internet bubble burst and with it went demand for new commercial office space. Vacancy rates across the country soared to 10.3 percent by the start of 2001, Grubb & Ellis says. Some areas have been hit harder: In Los Angeles, for example, it's 20.3 percent. In addition, rents have started to fall modestly, and some landlords are making concessions to attract tenants.

        Then there's the matter of construction. Grubb & Ellis says there's 114 million square feet of office space being built. That's down from 125 million the third quarter of 2000, but still a fair amount.

        Construction could push vacancy rates to 14.5 percent — not as bad as the 18 percent in 1991, but not too far off, either.

        Last year, real estate experts talked confidently of prudence among both lenders and builders. There's some truth to that. The office market is probably not as wacky as it was in 1991, nor is the economy as awful as it was in 1990.

        Jay McKelvey, manager of John Hancock Real Estate fund, recommends avoiding hotel REITs, in part because vacancy rates can head south overnight.

        If you choose to invest in individual REITs, consider REITs with one foot in the oil patch areas of Houston or Dallas, which are booming. Or consider a real estate fund in the chart, above.

        But until the economy stabilizes — and perhaps for some time afterward — don't make commercial real estate your portfolio's foundation.


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