N E W S L E T T E R
February June 2002 2001
CLARION CRA Securities
Real Estate Investment Managers
Real Estate Securities in a Rising Interest Rate Environment
A recent string of strong economic data pointing to growing signs of an economic recovery has made bonds look less attractive given their low yields and principal risk if interest rates increase. In a strengthening economy, real estate securities offer a source of consistent, above average income and potentially better performance in a rising interest rate environment.
Benefits of Real Estate Securities Compared to Bonds
The special appeal of REITs to income-oriented investors.
REITs (Real Estate Investment Trusts) are corporations that own real estate and are exempt from Federal income taxes if they pay a minimum of 90% of taxable income to shareholders as dividends. This unique forced distribution of earnings creates a class of securities that historically has provided investors with significantly above-average yield. Since REIT's taxable income is net of heavy depreciation charges (a non-cash charge), their distributions generally are amply covered by total cash flow. Presently, we estimate that the average REIT dividend represents only a 70% of payout of its cash earnings.
Diversifying into REITs can lower overall risk.
REITs and real estate securities have displayed portfolio-enhancing characteristics in a variety of market environments. As evidenced by the recent Ibbotson Study, Real Estate Stocks Provide Meaningful Diversification Benefits, both equity and fixed income investors can improve long-term investment returns and lower risk by adding REITs to their portfolios. REITs and real estate securities offer diversity through low correlation to other asset classes and are particularly noncorrelated to the bond market as evidenced by the data in Chart I.
Historical REIT returns in a rising interest rate scenario.
According to past academic studies, REIT returns historically have largely been unaffected in a rising interest rate environment, as measured by the 10 year Treasury yield. In fact, REIT returns are generally no more sensitive to changes in interest rates than the S&P 500. Furthermore, REIT returns are generally more sensitive to changes in long-term interest rates instead of the short-term rates which the Federal Reserve changes to regulate the economy.
CHART I
Return Correlation Coefficients Equity REITs vs. Select Asset Classes
S&P 500 3 Years 5 Years 10 Years 20 Years 0.10 0.27 0.26 0.56 Small Cap NASDAQ Stocks 0.22 0.41 0.41 0.60 (0.05) 0.11 0.14 0.47 Bonds Govt./Corp. (0.09) 0.02 0.11 0.12
A sharp rise in interest rates may slightly impact the earnings growth of a few more highly leveraged REITs because of the increased short-term (variable rate) cost of borrowing money. However, most REITs are modestly leveraged at about 45% - 50% debt to total capital. Moreover, most debt is fixed rate and only a small percentage (about 10% - 15%) of debt is variable rate, thus muting the impact of short-term rate fluctuations on REIT earnings. Typically, REITs have done well when interest rates rise because an expanding economy (often the reason for an increase in rates) has a favorable impact on real estate cash flows as improved demand increases occupancies and rents. Clarion CRA examined two periods in the last decade when short-term rates increased by more than 100 basis points. The first occurred in early 1994 when
Source: Clarion CRA Securities as of 12/31/01.
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CLARION CRA Securities
the Fed increased the Fed Funds Rate by 300 basis points over 15 months. The second occurred beginning in July 1999 when the Fed Funds rate increased rates 175 basis points over 12 months. Chart II below shows that in both periods long-term rates rose much less and REIT returns were positive (albeit modest).
CHART II
Benefits of investing in REITs versus Bonds.
There are 4 main benefits of investing in real estate securities compared to bonds. 1. History has shown that the REIT dividend market yield is little impacted by the rise and fall of interest rates com pared to bond yield. 2. All current signs point to a recovering economy, which is inherently good for REIT earnings growth. 3. The current spread of REIT dividend yield versus the 10 year Treasury yield is about 1.0%, which is well above the 0.2% median spread since 1982. 4. REITs can and do grow their earnings and dividends modestly, vs. the fixed interest payments on bonds. Hence, the total return potential of REITs (dividend yield + earnings growth = total return) has exceeded that of a fixed-income strategy. Of course, there is more risk to investing in any common stock versus a Treasury or corporate bond.
Equity REIT Returns During Two Periods of Rising Rates
2/94 - 4/95 Fed Funds 10 Year Treasury NAREIT Index Return
Source: Clarion CRA Securities.
7/99 - 6/00 +175 bp +22 bp 1.2%
+300 bp +137 bp 3.0%
History of REIT Dividend Yield vs. 10 Year Treasury Yield.
REITs offer STEADY and PREDICTABLE yield, not overly affected by interest rate fluctuations. When bond yields were extremely high from 1978 - 1986, REIT dividend yields remained steady around 7% - 9% range. Today, when the bond yield is well below the highs of 1978-1986, the REIT yield is steady at around 7%.
CHART III
A Portfolio Approach is the Best Route to REIT Investing
Because the shares of equity REITs carry both general market and company specific risks, Clarion CRA definitely favors a portfolio approach to investing in this sector. That means that most investors are best served by buying a package of REITs, diversified by both property type and geographic area of real estate holdings. Such a portfolio thus diversifies, or minimizes, the risks that may affect one company or property sector. Seasoned fixed-income investors, used to worrying more about credit and interest rate risks, will find the portfolio approach particularly helpful in dealing with equity market risks. For this reason many investors choose to invest in REITs via a specialized openend mutual fund. Of course, investors should review their holdings periodically to make sure their portfolio is achieving their objectives.
Equity REIT Dividend Yield vs. 10 Year Treasury Yield
Percent 40 30 20 10 0 -10 -20 -30 '81 '82 '83 '84 '85 '86 '87 '88 '89 '90 '91 '92 '93 '94 '95 '96 '97 '98 '99 '00 '01
Source: National Association of Real Estate Investment Trusts (NAREIT).
Income
Price
Modern Policies Provide Ample Dividend Coverage.
Dividend policy has matured with the growth of the REIT industry. During the 1970s and 1980s, equity REIT shares were mainly priced on the dividend yield. Payout ratios and dividends were increased to unsustainable high percentages of available cash, defined for REITs as Funds From Operations (FFO). From the early 1970s to late 1980s, average payout rose from about 70% of FFO to 96% of FFO. This provided virtually no margin of safety and left little cash to make capital expenditures on properties. During the 1990s, more modern and strategic dividend policies emerged to reduce this payout to about 70% of FFO currently. As a result, equity REITs of the 1990s typically retain significant internal cash flow for reinvestment in growth while maintaining ample dividend coverage. All this bespeaks both an industry and its investor base moving toward maturity in pricing and dividend policy.
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Summary REIT yields and prices are little affected historically by the rise and fall of interest rates, therefore, providing an element of stable income and principal protection. In addition, REITs and real estate securities continue to be a strong source for portfolio diversification through their low correlation to other asset classes including bonds. REITs offer attractive risk/reward characteristics through moderate capital appreciation that matches earnings growth. By paying attractive and modestly growing dividends, REITs historically provide a strong total return to income oriented investors.
Clarion CRA Securities (CRA) is an active equity investment advisor specializing in real estate securities portfolios for institutional and individual investors. CRA is an affiliate of Clarion Partners, a national direct property investment advisor and a subsidiary of ING Group of The Netherlands. CRA currently manages $2.0 billion in assets including separate account management and mutual fund management for the CRA Realty Shares Portfolio and the ING Global Real Estate Fund.