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 eco-
Benefits of Real Estate
Securities Compared to Bonds
nomic data pointing to growing
signs of an economic recovery
has made bonds look less
attractive given their low yields The special appeal of REITs to income-oriented investors.
REITs (Real Estate Investment Trusts) are corporations that own real estate and
and principal risk if interest 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
rates increase. In a strengthen-
creates a class of securities that historically has provided investors with signifi-
ing economy, real estate securi- cantly above-average yield. Since REIT's taxable income is net of heavy deprecia-
tion charges (a non-cash charge), their distributions generally are amply covered
ties offer a source of consistent, by total cash flow. Presently, we estimate that the average REIT dividend repre-
above average income and sents only a 70% of payout of its cash earnings.
potentially better performance
Diversifying into REITs can lower overall risk.
in a rising interest rate environ- REITs and real estate securities have displayed portfolio-enhancing characteristics
in a variety of market environments. As evidenced by the recent Ibbotson
ment.
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 non-
correlated 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.
A sharp rise in interest rates may slightly impact the earnings growth of a few
CHART I more highly leveraged REITs because of the increased short-term (variable rate)
Return Correlation Coefficients cost of borrowing money. However, most REITs are modestly leveraged at about
Equity REITs vs. Select Asset Classes 45% - 50% debt to total capital. Moreover, most debt is fixed rate and only a
S&P Small Cap Bonds small percentage (about 10% - 15%) of debt is variable rate, thus muting the
500 Stocks NASDAQ Govt./Corp.
impact of short-term rate fluctuations on REIT earnings.
3 Years 0.10 0.22 (0.05) (0.09)
5 Years 0.27 0.41 0.11 0.02 Typically, REITs have done well when interest rates rise because an expanding
10 Years 0.26 0.41 0.14 0.11 economy (often the reason for an increase in rates) has a favorable impact on
20 Years 0.56 0.60 0.47 0.12 real estate cash flows as improved demand increases occupancies and rents.
Source: Clarion CRA Securities as of 12/31/01. 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
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CLARION CRA Securities
the Fed increased the Fed Funds Rate by 300 basis points Benefits of investing in REITs versus Bonds.
over 15 months. The second occurred beginning in July There are 4 main benefits of investing in real estate securi-
1999 when the Fed Funds rate increased rates 175 basis ties compared to bonds.
points over 12 months. Chart II below shows that in both 1. History has shown that the REIT dividend market yield is
periods long-term rates rose much less and REIT returns little impacted by the rise and fall of interest rates com
were positive (albeit modest). pared to bond yield.
2. All current signs point to a recovering economy, which is
CHART II
Equity REIT Returns During inherently good for REIT earnings growth.
Two Periods of Rising Rates 3. The current spread of REIT dividend yield versus the 10
year Treasury yield is about 1.0%, which is well above
2/94 - 4/95 7/99 - 6/00
the 0.2% median spread since 1982.
Fed Funds +300 bp +175 bp 4. REITs can and do grow their earnings and dividends
10 Year Treasury +137 bp +22 bp modestly, vs. the fixed interest payments on bonds.
NAREIT Index Return 3.0% 1.2% Hence, the total return potential of REITs (dividend
yield + earnings growth = total return) has exceeded
Source: Clarion CRA Securities.
that of a fixed-income strategy.
Of course, there is more risk to investing in any common
History of REIT Dividend Yield vs. 10 Year Treasury Yield.
stock versus a Treasury or corporate bond.
REITs offer STEADY and PREDICTABLE yield, not overly
affected by interest rate fluctuations. When bond yields A Portfolio Approach is the Best Route to REIT Investing
were extremely high from 1978 - 1986, REIT dividend yields Because the shares of equity REITs carry both general mar-
remained steady around 7% - 9% range. Today, when the ket and company specific risks, Clarion CRA definitely
bond yield is well below the highs of 1978-1986, the REIT favors a portfolio approach to investing in this sector. That
yield is steady at around 7%. means that most investors are best served by buying a pack-
age of REITs, diversified by both property type and geo-
CHART III graphic area of real estate holdings. Such a portfolio thus
Equity REIT Dividend Yield vs. 10 Year Treasury Yield
diversifies, or minimizes, the risks that may affect one com-
Percent pany or property sector. Seasoned fixed-income investors,
40
used to worrying more about credit and interest rate risks,
will find the portfolio approach particularly helpful in deal-
30
ing with equity market risks. For this reason many
20 investors choose to invest in REITs via a specialized open-
10 end mutual fund. Of course, investors should review their
0 holdings periodically to make sure their portfolio is achiev-
-10 ing their objectives.
-20 Income Price
Summary
-30 REIT yields and prices are little affected historically by
'81 '82 '83 '84 '85 '86 '87 '88 '89 '90 '91 '92 '93 '94 '95 '96 '97 '98 '99 '00 '01 the rise and fall of interest rates, therefore, providing an
Source: National Association of Real Estate Investment Trusts (NAREIT). 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
Modern Policies Provide Ample Dividend Coverage. low correlation to other asset classes including bonds.
Dividend policy has matured with the growth of the REIT
industry. During the 1970s and 1980s, equity REIT shares REITs offer attractive risk/reward characteristics through
were mainly priced on the dividend yield. Payout ratios moderate capital appreciation that matches earnings
and dividends were increased to unsustainable high per- growth. By paying attractive and modestly growing divi-
centages of available cash, defined for REITs as Funds From dends, REITs historically provide a strong total return to
Operations (FFO). From the early 1970s to late 1980s, aver- income oriented investors.
age 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 Clarion CRA Securities (CRA) is an active equity investment advisor specializing in
emerged to reduce this payout to about 70% of FFO current- real estate securities portfolios for institutional and individual investors. CRA is an
ly. As a result, equity REITs of the 1990s typically retain affiliate of Clarion Partners, a national direct property investment advisor and a sub-
significant internal cash flow for reinvestment in growth sidiary of ING Group of The Netherlands. CRA currently manages $2.0 billion in
while maintaining ample dividend coverage. All this
assets including separate account management and mutual fund management for
bespeaks both an industry and its investor base moving
the CRA Realty Shares Portfolio and the ING Global Real Estate Fund.
toward maturity in pricing and dividend policy.
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