by Cynthia Harrington
Another sector hit the skids with investors as real estate investment trusts gave back some of their multi-year gains.
From a high of 661 on April Fools’ Day, the Morgan Stanley REIT Index sliced 15 percent of its value in three weeks. Both the speed and the magnitude of the decline have forced investors to consider changes in their holdings.
One side says sell what you have and don’t buy more.
“I’ve lowered my allocation to real estate from the range of 5 percent to 7 percent to nothing for many clients,” said Benjamin Tobias, CFP, CPA, CIMA, of Tobias Financial Advisors, in Ft. Lauderdale, Fla. “If a new client walked in today with REITs and could get out without too big a tax burden, I’d advise them to sell too.”
There also are buyers.
“What happens when the pendulum swings is that it never stops in the middle but goes too far to the other side,” said Irvin F. Diamond, CPA/ PFS, CFP, of REDW Stanley LLC, in Albuquerque, N.M. “As a practical matter, we’re looking carefully because there may be some excellent buys out there.”
Some of the opportunities come from the wide swath cut by declining prices. Sellers didn’t discriminate, but sold equity and mortgage REITs wholesale. They can’t all be equally bad. Equity REITs with long-term, fixed-rate financing and mortgage REITs holding adjustable rate loans could be good buys. “Interest rate fears hit the properties financed with adjustable rate mortgages,” said Diamond. “But all REITs took it in the shorts as a result.”
According to Ron M. Donohue, Ph.D., of Hoyt Advisory Services Inc., in North Palm Beach, Fla., the opportunity for advisors is to upgrade quality. “When things are going great, then risk doesn’t matter,” Donohue said. “But when things go bad, risk matters a whole bunch.”
Donohue spends part of his time managing REIT portfolios for institutional and individual investors. He is also one of the professional real estate industry researchers for the Homer Hoyt Institute, the nation’s leading independent real estate research foundation, found on the Web at www.hoyt.org.
“For investors who want to stay with an allocation to real estate, this offers an opportunity to consider the quality of management and not just look for the highest-yielding vehicles,” Donohue opined.
He pointed out that the recent boom made financing easy for trust management. The large premiums to net asset value attracted easy money. Managers’ deal-making skills were the most important thing. “Now that NAVs are closer to true value, expense management and property management skills are those that investors should look for,” said Donohue.
Advisors point to several reasons for the drop in prices. The anticipation of higher interest rates not only impacts the underlying performance of real estate, but also presents competition for investors’ dollars that look for current returns. With risk-less debt investments like bank CDs paying 1 percent, the 6 percent REITs looked very attractive. “Investors knew that REITs were riskier but they reasoned that they weren’t 500 basis points riskier,” said Donohue.
Hot money cools down
Recently, money flowed into the sector from sources not usually in the real estate sector.
Growth and income mutual funds snapped up REIT shares in an effort to provide shareholders with any return. “When this hot money saw the prices start to slide they decided to step away,” said Donohue. “It’s not a big industry, so when that big money left the sector, it had a big effect.”
Despite the boom in prices, long-term real estate investors point to the consistency of underlying fundamentals and say that nothing has changed. In fact, an improving economy means more jobs, and more jobs means greater demand for office space. Real estate still has a place for many investors.
“We add real estate to client’s portfolios if they need current cash flow,” Diamond said. “But we also add REITs to be able to rebalance portfolios that hold a lot of assets in direct real estate investing.”
Buyers need to be picky about their selections. “We look for good diversification of quality of holdings as well as geographically,” Diamond said. “We start with the Morningstar four- and five-star funds, but we look further for a good blend of old cash cow properties with newer properties in the fund.”
If the real estate sector stays under pressure, then separating winners from losers also depends on the quality of management. Trust managers that control expenses and manage properties well will report a good history of solid cash flows, according to Diamond. “We look for managers with a sensible approach to financing, which at this point means long-term, fixed-rate loans. And we want to own REITs that are meeting their cash flow projections.”
Buyers are likely to continue finding bargains. Selling pressure comes from both outside the sector and from long-term real estate investors. Tobias is closing the door on a sector that he has owned since he started his advisory practice in 1988. “I had a significant number of clients in both REITs and direct investment in real estate because of the low correlation to other assets,” said Tobias.
He started lowering the overall allocation to the sector a year ago. He saw the end of the bubble in prices that had been powered by low interest rates and sagging stock prices as stocks gained ground and rates perked up. “I’m not surprised at the drop in REITs,” said Tobias. “I’m just surprised that it took so long.”
For investors who haven’t fully rebalanced their portfolios, Tobias redeploys the freed-up cash within the asset class of small cap value. Rebalanced portfolios have greater allocations to international equities. “I’d been overweighted in international, but I’m even more so now,” says Tobias. “If the euro continues to gain ground and dollars come home, then rates will have greater upward pressure.”
However, sellers don’t plan to be away forever. While some likened the enthusiasm in REIT prices to the technology boom, there aren’t dire predictions of huge losses in the industry. Some sellers may again become buyers.
“I’m personally waiting to buy a condo on the ocean,” said Tobias. “I expect I’ll be able to find one within 24 months at a 60 percent discount to what I’d have to pay today.”
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