Cheap Real Estate

By Daniel Kadlec

What's wrong with real estate? Not much, as far as homeowners and commercial landlords are concerned. In much of the country, houses are going for their asking price and office rents are rising faster than inflation. Last year demand for new office space exceeded supply by 35%. Barring a weak economy, fundamentals are likely to remain strong.

So what's wrong with real estate? Plenty. Anyone who sunk money into publicly traded Real Estate Investment Trusts, or REITs, has been scorched badly. Last year the average REIT stock sank 17% while the Standard & Poor's 500 soared 27%, and REITs' dismal showing has extended into early 1999. Never have REITs lagged the market by such a wide margin. They're more out of favor than a home with peeling paint and shag carpets.

The recent woeful results stand a couple of basic premises on their ear: namely, that high dividend yields (around 7.5%) make REITs an anchor in choppy markets; and that the mere existence of dozens of publicly traded real estate companies will somehow smooth the industry's masochistic boom-bust cycle--making REITs less volatile. Wrong.

REITs are investment companies that finance, own or operate commercial properties, including offices, malls, apartments and hotels. By law, they must pay out 95% of their rental and other income as dividends in exchange for certain tax advantages. REITs have flourished in the '90s as developers have sold shares into the bull market to raise capital instead of using banks and pension funds. Investors viewed these publicly traded stocks as a quick way in and out of the real estate game.

But a surprising backlash has developed. For starters, sporting a big dividend yield on turn-of-the-millennium Wall Street is like going to school with a KICK ME sign stuck to your back. You'll probably get pummeled. Investors want growth and capital gain. Period. That's apparent in today's fury to own money-losing, dividendless Internet and other tech stocks. Meanwhile, there is some question whether the rash of REITs will smooth the real estate cycle as advertised. The theory goes like this: with many real estate companies dependent on stock sales to fund projects, Wall Street becomes a long-sought governor over the industry. Just when there is a danger of overbuilding, REIT shares should fall and limit the industry's ability to raise money and build to damaging excess.

The irony is that taming the real estate cycle appears to be transferring volatility from the value of the properties to the value of the REITs' shares. Take last summer. Fears of overbuilding began to creep into the news, and REITs were trashed like a wormy apple. The quick, severe reaction had the desired effect. Hotel starts fell 21% in October, 48% in November and 42% in December. The slowdown jolted supply and demand into balance, keeping projected vacancies down, rents and earnings up.

I expect that REIT shares will remain under pressure until the market sees more evidence that public ownership of real estate companies really does put a leash on the boom-bust mentality. The good news is that such evidence is building, as last fall's pullback suggests, and that REIT shares are so depressed--many trade below their breakup values--that they represent a real buy. If you're looking for a way to hedge your com bets, consider quality names like Boston Properties and Equity Office, or a REIT index fund, including Vanguard's.

See time.com/personal for more on REITs. E-mail Dan at kadlec@time.com And see him Tuesdays on CNNfn at 12:45 p.m. E.T.