The Long View: Reits no longer look that attractive, unless you are a Goldilocks

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Available at last to UK investors: Real Estate Investment Trusts. The long-awaited step has already seen most of the biggest names in UK property announce that they will be converting to Reits. It continues the development of property as an asset class and puts it within reach of small investors.

In the long-term, Reits will be a valuable new option for investors in the UK. Things also look good in the very short-term. The surge of capital into the sector triggered by the launch of Reits makes some up-tick in price a good bet.

But in the awkward period between the very short-term and the very long-term, things look more complicated. The valuations at which property is trading across the world are worrying. They suggest that the fledgling investment vehicles might have to live through the bad publicity of a severe tumble in the US before they establish themselves in the portfolios of European retail investors.

The tax advantages of a Reit are clear. With shares that can be bought and sold like those of any public company, and with large portfolios of property, Reits also directly deal with the two biggest drawbacks to commercial property for small investors – the high risk that comes with lack of diversification and the high minimum investments needed.

The requirement to pay rental income in distributions to shareholders is another point in their favour. With interest rates historically low, the regular income stream that can be generated by large buildings begins to look very attractive.

Even when other investments are looking better, property tends to follow a different cycle from other markets, as might be expected as it takes longer for supply (the construction of new buildings) to adjust to fresh demand. This means that it has low correlation with other asset classes. Thus it can be an effective means to reduce risk in your portfolio.

Reits are certainly a success in the US. At private investor conferences, crowds swarm around Reits’ stalls. Institutions have found income as hard to come by as anyone else in recent years and have also started piling into property – both through Reits and through direct investments.

All this money has ensured capital growth to go with the income. Last year, the FTSE Nareit index, which covers all the Reits listed on the three main New York exchanges, gained 30 per cent at one point, comfortably beating all other US asset classes. Its return was roughly double that of the S&P 500.

The phenomenon was not restricted to the US. FTSE real estate indexes – not restricted to Reits – show that global property stocks have outperformed the US since 2000.

That was also when real estate began its great run. Since the end of the last great bull market for stocks, the Nareit index has more than doubled. The S&P 500 is still slightly down from the high it set that year.

This is not coincidental. With the collapse of the first wave of internet stocks came a new aversion to risk. A key reason why people like property is that it seems less risky than other asset classes. As its name implies, real estate is of course based on very real and very tangible assets. This is not like investing in internet start-ups. Further, the requirement to distribute income arguably places a few handcuffs on management’s freedom of action, which in turn reduces risk (as well as opportunity).

At a more basic psychological level, people believe it is very hard to lose money on property.

But like any other asset, real estate can be overpriced. If you buy something for more than it is worth, you have an extremely good chance of losing money.

In the US at any rate, real estate looks mightily overvalued. Remember a chief attraction is the income generated from rents. Yet the dividend yield on the FTSE Reit index is now only 4.4 per cent. This is still far superior to the income from common stocks (the yield on the S&P 500 is 1.8 per cent). But it is less than the income from a government bond. Ten-year Treasuries currently yield about 4.6 per cent. For a retail investor wanting income, Reits no longer look that attractive. And for a developer looking to finance the sector, yields so low probably fail to match the cost of capital.

The decision of several big property investors to sell their Reits to private equity funds, who have recently appeared to have more money than sense, adds to the impression that US real estate valuations are unsustainably high.

There is, however, a beguiling counter-argument. It comes from Dirk Molenaar, who runs the property portfolio for Foreign & Colonial Investments of the UK. F&C is overweight in global property this year. He points out that property is vulnerable to a recession, which could cause vacancy rates to rise, but also to speedy growth. When the economy is moving well, other sectors look less risky and carry more growth prospects. If interest rates rise to slow the economy, this also increases the yield on alternative investments, damaging the prospects for property.

But if growth is slow and unexciting – the so-called “Goldilocks economy” – real estate is ideally positioned to benefit. Its income streams stand out and there are no big investment opportunities elsewhere to attract the money away.

If you are comfortable with the Goldilocks scenario, Reits make sense. Otherwise, such heady valuations suggest it would be better to wait a while before stepping in.

john.authers@ft.com

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