Real Estate Investment Trusts (“REITs”)

reit-promo-type-1What do soaring rental markets, high yields and diversity have in common?  Answer: they are all part of the reason that Real Estate Investment Trusts (“REITs”) are booming.  In fact, they just became a new sector in the S&P 500 index.

For the first time since 1999, the S&P 500 index is being reconfigured; breaking out REITs from the financial sector. It makes sense, due to the unique characteristics of REITs. They own or finance property and pay no taxes, but have to distribute 90% of earnings to shareholders.  Their current yield is 3.6% more than double the 1.7% yield offered by a ten-year Treasury bond.

The growth of REITs have been accelerated by increases in renting as more people have decided to rent, not own, their houses.  Rents have increased 3%-6% per year in cities such as New York and San Francisco.  REITs have become very involved with residential real estate.  Some REITs, for example, own and rent groups of suburban single-family houses with gardens and make a substantial return doing it.

REITs have become more and more diverse. The early RE ITs of the 1960s were primarily used to own office buildings and produce a steady stream of rental income.  They were viewed similarly to bonds; drawing little interest in the 80s and 90s when stocks were providing double-digit annual returns.  Today REITs own cell towers and data centers.  Casinos and hotels have sold their properties to REITs and lease them back for their operating business.  Macy’s and McDonald’s have been receiving pressure from activist groups to do the same.

REITs have been one of the hottest investments of the last decade.  They’ve attracted $68 billion in Exchange Traded Funds (“ETFs”) since 2010; the most by any major industry classification, outpacing energy, technology and all the others. They are trading at 23 times earnings, compared with 17 for the S&P5 500 index on average.  With the influx of new cash, they have reduced their debt-to-asset ratio from 70% in 2008 to 31% today.

At DWM, we consider REITs as an alternative; neither a stock nor a bond. REITs have been part of our Liquid Alternatives model for many years.  As such, they currently represent about 7% of our clients’ alternative asset class. There is a small overlap due to the fact that REITs represent about 3% of the S&P 500 Index which clients gain exposure to via our DWM Core Equity model.  Overall, a typical DWM investor would have a roughly 1.5-3% overall allocation to REITs in their diversified portfolio.

With REITs being hot, it comes as no surprise that we’ve received questions recently wondering if now is the time to increase our overall REIT allocation.  We think not.

It’s curious.  Seventeen years ago, the S&P 500 Index added a new sector, technology, by splitting it from industrials.   This was right before the bust in March of 2000.  It took 13 years for the tech sector to return to its 1999 levels.  Similar results occurred with the Dow Jones industrial Average added Microsoft, Intel and Apple.  At the time of admission, all companies were at all-time highs, but once admitted, their values fell and it took considerable time for them to recover to those levels.

No one knows if the REIT breakout will help or hurt this sector. We do know REITs have performed well for our clients, for us and for others. We also know they have relatively high current valuations.  This is a good reason to keep the allocation where it is now and keep monitoring the situation.

European Update: Secession, Tax Evasion, Downgrades, Bailouts

fee-only financial planners, investment managementThe Eurozone continues to struggle. Slow growth, lots of debt and millions of unhappy people. I thought it might be informative and interesting to look at recent anecdotal evidence from four countries. 

Secession is in the air in Spain. Catalonia, the Basque country and other regions are ready to become autonomous nations. The primary issue is… (drum roll)… money. These northern areas don’t want their tax dollars funding poorer regions in southern Spain. Catalonia, the home to Barcelona and millions of Catalans with their own language and culture, held elections Sunday. The results were inconclusive. The pro-independence parties won a majority of seats in Parliament, yet, Catalan President Mas, who has supported independence but also further austerity programs, saw his party lose some power. According to the Wall Street Journal on Monday, Catalans want independence and they don’t want austerity. Sounds like a group of teenagers to me.

Tax evasion has been rampant in Italy, Greece and some other countries for decades. It is estimated that Italy’s underground economy, excluding criminal ones such as drug rings, accounts for $350 billion per year. This is roughly 18% of the GDP. Taxes on that income, estimated at $150 billion, never make it to Rome. Roughly 50% of Italians report an annual income below $25,000, yet hundreds of thousands of these folks have large boats, luxury cars or helicopters. Now, the Italian government is fighting back. They are distributing a “tax-cheat self-test.” This allows people to gauge whether their declared income is in line with what they spend annually. The Italian tax authorities hope people will use this self-assessment tool to voluntarily file correctly in the future. In addition, the government is sponsoring TV ads comparing tax evaders to various animal, fish, wood and intestinal parasites. Two questions: Is it any surprise that Italy has troubles balancing its budget? And, do you think the self-test or calling someone a “tapeworm” in Italian will change their behavior?

France received a bond downgrade last week. Moody’s stripped it of its AAA rating; citing France’s sustained loss of competitiveness, deteriorating economic prospects and its large financial exposure to peripheral Europe. The Economist noted last week, in a special report on France, that the business climate has worsened. French employers pay 30% of labor costs to fund social security. No fewer than 34 laws and regulations start to apply once an enterprise reaches 50 employees. It’s not surprising that researchers are finding that a significant number of French companies have exactly 49 employees. There is now a 75% top income tax rate, unemployment is 10% and over 25% of the young are jobless. Is it any wonder that so many entrepreneurs are leaving the country and/or sending their children somewhere else in the world for a brighter future?

Greece received a bailout on Tuesday. European finance ministers eased the terms on emergency aid for Greece. In fact, Bloomberg reported that the ministers declared that after three years of false starts that “Europe has found the formula for nursing the debt-stricken country back to health.” The ministers cut rates on bailout loans, suspended interest payments for ten years and gave Greece more time to repay the loans. Quite a formula. Greece will get the December loan installment of $45 billion despite the fact that its economy continues to shrink. It is good to see they will make it through 2012 as part of the euro. January will be the next test. Greece needs $12 billion. They will get it only if the EU, ECB and IMF certify that they have implemented a tax reform by that time. Perhaps they can get the Italian tax self-test and the tape worm commercials translated into Greek.