As the subprime meltdown continues and credit markets swoon, exchange-traded funds (ETFs) focusing on real estate are showing signs of life.
In the past month, real estate's the best-performing category among open-end mutual funds in the U.S., according to Morningstar data. The average real estate specialty fund had returned -0.30% in the past month through Monday. That compares to small value's 7.48% fall and large-cap value's 7.24% slip. (Blend and growth categories in all market-cap sizes are down even more in the past 30 days.)
Funds investing in real estate, typically through real estate investment trusts (REITs), are largely considered value-styled stocks. And most fall on the smaller end of the cap spectrum. So are they simply catching an improving wave from value as a whole?
Step back to the past three months, and REIT funds score only slightly better than most small-cap value funds. But trailing 12-month returns show real estate falling more than seven percentage points behind their more diversified small-cap value rivals.
One month certainly doesn't make for a new trend. What's positive for REIT investors, however, is that valuations are down from much higher levels even a year ago.
"They're not at the lowest they've ever been, but REITs are at a point now in terms of valuations where they can be considered attractive investments," said Anthony Welch, a money manager at Sarasota Capital Strategies.
Last week, the advisor started buying iShares Dow Jones U.S. Real Estate ETF (NYSE: IYR) and iShares Cohen & Steers Realty Majors ETF (NYSE: ICF).
"We're not going in heavily," Welch said. "But we still like REITs as good diversifiers for the rest of our equity ETF portfolios."
Looking Closer At Valuations
Many investors consider price-to-book as a key ratio when comparing REITs. But the industry places emphasis on so-called funds-from-operations, or FFO. It's a valuation measure similar for REITs as earnings per share calculations are for common stocks.
The problem with book valuations is that REITs use a lot of different accounting standards that are unique to their tax structure. One issue with normal calculations is the importance of depreciation on a REIT's books.
Funds-from-operations represent profits excluding gains from sales of property and depreciation. It's viewed as a better measure of ongoing income being generated.
In that regard, Welch says the average REIT price is trading at a multiple of around 17 times its FFO value. "In the last few years, the FFO was above 20," he said. "After the big sell-off in REITs that started in February 2007, that's come down a good deal. Now, they're trading right around their longer-term FFO averages."
The National Association of Real Estate Investment Trusts reported in its latest survey that leading office REIT names are averaging a better-than 8% growth rate in FFO levels in the past 12 months. Industrial REIT companies are up around 7% in that same time frame, while mixed office/industrial firms have seen their FFO rates drop slightly.
With 30-year Treasury yields paying about 4.35% and the average REIT yielding around 5.5% now, he says real estate remains an attractive diversifying tool for long-term investors.
"REITs have been beaten down so much over the past 12 months that their dividend yields have increased to attractive levels," Welch said, pointing out that price and yield move in opposite directions in most cases.
"If you've owned a REIT fund for a long time and stuck with it, now's not the time to be panic selling," he added. "It's too late for that. If anything, people should be considering whether to add to their holdings."
J.D. Steinhilber, a Nashville, Tenn.-based adviser, agrees that REITs should be back on investors' radar screens. He notes that REIT indexes troughed in January 2007 with a yield of 3.8%.
"Relative to 10-year Treasury yields, REITs are trading at a positive yield spread of 150 basis points, the most attractive level in over three years," Steinhilber said. "As a result, the asset class had returned to more reasonable relative valuations."
The Federal Reserve's recent rate cuts also seemingly provided short-term support to REIT funds. After the Fed reduced short-term rates on Jan. 22 by 75 basis points to 3.5%, U.S. real estate benchmarks soared. In fact, the Dow Jones U.S. Real Estate Index moved up by double-digit percentages the next day.
Lots Of Uncertainty Remains
But markets remain in a conundrum of sorts. The latest research from Green Street Advisors indicates that privately held commercial property values still might have room to correct. That's due to a gap between how much private properties are being appraised and sold at today and how much public markets have corrected in the past year.
"Basically what they're indicating is that private appraisal and transaction levels disclosed haven't corrected as much as the public real estate markets," Steinhilber says.
While he believes that valuations on REITs are down, "they're certainly not at historically low levels. We've just returned to median longer-range spreads to Treasuries."
Steinhilber has also started nibbling at REIT ETFs. "They're a good value relative to bonds, but not especially as good of a value compared to the broad stock indexes," he said.
In the past 10 years, REITs have averaged close to 6.3% in yields, Steinhilber notes.
"It's not time yet to put on a full allocation to REITs in our accounts from anywhere between 5-10% of total assets," he added. "We're averaging around 3% right now."
Steinhilber has been buying some Vanguard REIT ETF (AMEX: VNQ). "It has the lowest expense ratio on the market and provides broad exposure to U.S. REITs," he said. "In terms of portfolio construction, it's pretty comparable to IYR."
Credit Crisis Still Looming
Then there's the still-spreading subprime crisis which has hit mortgage REITs hard.
"But it really hasn't made a direct major impact on other REIT sectors," said Robert McMillan, an industry analyst with Standard & Poor's equity research services group. "For example, retail REITs sign long-term contracts with customers. And there are very few retail bankruptcies right now."
For ETF investors, checking to see what different funds hold in each sector of real estate could prove beneficial.
"People tend to put all REITs in the same bucket," McMillan said. "But there are different sectors with different fundamentals. On most of the sectors we're neutral at the moment, but on retail and industrial we're positive."
If job growth slows, office space could slow. But on retail real estate, consumer spending is healthy—even though it's slowing, says McMillan. "Retailers are still expanding, even though at a slower pace," he said. "Retailers are now doing their store planning looking at 2010-2011, when economic prospects should be better."
