Generating Yield – Muni Bonds and REITs

The issues facing munis were discussed earlier in “ The Muni Bond dilemma". In summary, there are several notable risks facing munis which include:

• The pension payment crisis unfolding in many states and communities.
• Increasing budget shortfalls for basic infrastructure projects.
• Reduced tax collection due to foreclosures.
• Rejection of tax increases by voters in communities facing economic stress.
• Probable insolvency of bond insurance firms (ACA Capital, MBIA, Ambac Financial)
• Falling revenue from community projects.
• Impending court rulings about state tax interest deductibility.
• Community investment fund losses (see Will State SIV Funds bankrupt local communities?).
• An increasing number of bond downgrades from rating agencies.

For those investors evaluating new municipal bond investments, the focus should be on quality and the general financial strength of the backing community. Avoid bonds from areas with high levels of foreclosures, projects with single sources of revenue (theaters, stadiums, etc.), and those insured by agencies on the edge of failure.

REITs are in no better shape. The average apartment REIT was down 27% during 2007. Despite the expectation that many people will move from owning homes to renting, apartment REITs are normally the worst performers during a recession.

Many other REIT segments have not fared much better. The outlook for the coming year shows no improvement. Hotel REITs such asSunstone Hotel Investors Inc. (SHO) have recently endured down-grades and sunk to new lows. Office and Industrial REITs have demonstrated slowing growth expectations; capitalization leaders such as Boston Properties Inc. (BXP) are down over 24% over the past year. Retail property owners are down over 20%, the Simon Property Group Inc. (SPG) hit new lows recently. While the drop in price makes the valuation on some REITs appear attractive, there is an increasing risk that the dividend payouts may be cut.

One bright spot is Health Care REITs. This REIT sector has more upbeat outlook than others even in the face of a slowing economy. There is a growing demand for health care office space and the lending credit crunch has not slowed build-out. An article from December outlined some of the leaders - Sector Glance: Health Care REITs Rise.

Another sub-sector of REITs that normally holds up in down markets is apartments for college students. The growing demand for college housing is likely not to be impacted by the economic cycle. One REIT focused on this segment is Education Realty Trust (EDR) with a 7.60% yield.

In summary, Muni-Bonds and REITs have numerous headwinds looking forward into 2008. Other yield oriented investments in the energy and natural resource sectors may offer better performance with lower economic risk (see In Search of Yield) Investors should carefully evaluate the potential risks before allocating money to Muni and REIT investments over the upcoming months.

Disclosure: The author does not have a position in any of the income equities mentioned in this article. The information provided does not constitute a solicitation to buy, or an offer to sell securities.