Money & Real Estate

REIT shares: Are they growth or income stocks? Because real estate investment trusts (REITs) have assumed such prominent roles in commercial property markets during the 1990s, a key issue is: Should investors view REITs primarily as growth stocks or as income stocks?

Traditionally, growth stocks have experienced recent increases in total earnings of 15% per year or higher. Those earnings increases justified fast increases in the market prices of their shares. So investors came to expect returns from such stocks primarily as price appreciation rather than dividends. These stocks also have high price-earnings ratios, since investors anticipated sharp future price appreciation.

Income stocks are stocks that have not experienced rapid earnings growth, but rather paid substantial dividends year after year. These stocks are valued primarily for their production of steady income. Hence they maintain low price-earnings ratios but high dividend payout rates.

The stock market has always treated REITs more as income stocks than growth stocks. The average ratio of share price divided by adjusted funds-from-operations per share for REITs in December 1997 (based on estimated 1998 earnings) was 11.7, and only five of 97 REITs had ratios exceeding 15. This compares with an average price-earnings ratio of between 15 and 17 for all Standard and Poor (S&P) 500 stocks (depending upon exactly how measured), and much higher such ratios for those stocks considered in the "fast growth" category.

Yet some REITs have characteristics of both types of stocks. Since REITs are required to distribute 95% of their income to their shareholders, they pay sizable dividends. As a result, they can retain at most only around 40% of cashflow earnings to plow back into expanding their property portfolios. Therefore, they can grow only by increasing the productivity of the properties in their existing portfolios or by raising external capital to acquire more properties.

REIT format requires growth But REITs are also under tremendous pressures to expand their property portfolios. The main reason is that larger size creates greater liquidity by generating a larger average number of shares traded each day. This is particularly important to large institutional investors like pension funds. They want to buy or sell big blocks of stock without affecting the stock's prices. The bigger a REIT, the more likely it is to attract the attention -- and funds -- of these large investors. The greater the institutional holdings of a REIT's stock, the easier it is for that REIT to float additional stock offerings. Therefore, larger REITs can often raise capital both at lower cost and faster than small ones.

In addition, REITs seek to grow because larger size permits them to buy larger asset portfolios, and to attain economies of scale in purchasing and operations. And fast growth attracts higher-quality personnel because of greater advancement opportunities. Fast growth also causes investors to give them higher ratios of price to funds-from-operations, which in turn enable them to consolidate more easily with REITs that have lower such ratios.

REITs generate high profit In the recent past, shares of some REITs have behaved like growth stocks. One reason is that they have generated high profits because of rapid rent increases in the current-most-favorable portion of the real estate cycle plus major consolidations. In addition, stock prices across the entire market have risen so fast that almost all stocks have had growth-stock attributes. But these causes of fast recent share-price appreciation surely cannot last long enough to be considered permanent.

Moreover, the "natural" growth rate of earnings from an existing real estate property portfolio is far below 15% per year. If general inflation is 2% to 3% per year, and real margins rise 3% per year because of greater management efficiencies or a slight imbalance in the market toward excess demand, then rents in current prices can be expected to rise no more than about 6% per year, on the average -- well below the increase required by growth stocks. Therefore, a REIT can attain growth-stock status in the long run only by achieving acquisition gains per share of around 9% per year or more.

The U.S. economy has been growing about 2% to 3% per year in real terms, so the need for new real property rises at about that rate, on the average. In addition, another 2% of the existing inventory becomes obsolete each year, so the total need for new expansion and new replacement properties might be from 4% to 5% of the existing inventory per year. If a REIT is to grow its portfolio by at least 9% per year, it must be increasing its share of the total market for the type of properties it contains. If REITs as a class are to achieve this, they must increase their overall marketshare of the ownership of all commercial properties by 5% per year. It is doubtful that REITs as a class can maintain this growth in marketshare for long.

REITs increase overall marketshare In the past few years, REITs have undoubtedly succeeded in increasing their overall marketshare of all commercial properties significantly. Their total capitalization value has risen at a much faster rate than the total value of all commercial properties, even though such properties are now in a rising-value part of their cycle. Moreover, because REITs still control a relatively small share of all commercial properties, it will be possible for at least some of them to expand the share of such properties that they control for as long as they can raise financial capital more easily than alternative sources.

Thus, the ability of individual REITs to achieve growth-stock status will depend upon their maintaining a capital-raising advantage in financial markets. Recently, they have enjoyed such an advantage because the stock market as a whole has risen so rapidly. If the stock market levels off or declines in the future, as it is bound to do, the capital-raising advantage of REITs over traditional property owners may be reduced.

Another factor relevant to particular REITs is the increasing difficulty of expanding a portfolio by a given percentage each year as its absolute size becomes larger. Although a few really fast-growing large REITs may have some advantages in price-earnings ratios that enable them to consolidate with smaller REITs more easily, it is generally harder to acquire $400 million of additional property in any given year than $100 million. Therefore, a REIT with a total capitalized value (including debt) of $4.44 billion should find it harder to grow by 9% than one with a value of $1.11 billion.

This will be especially true after the largest remaining property portfolios held by non-REITs are converted into REITs. Moreover, there are diseconomies of scale in management as well as economies -- especially the likelihood of developing bureaucratic rigidities.

In conclusion, it should be possible for a few of the best-managed REITs to achieve growth-stock attributes in the future -- as long as the stock market remains relatively buoyant. But in the longer run, most REITs will exhibit an income-stock status, especially if changed stock market conditions make it harder for them to raise additional capital. But in that case, REITs will have the advantage over many other types of stock of being able to continue to pay notable dividends even in recessions. They will also be better able to maintain their earnings and pay-outs than traditional developers, since REITs are much less heavily leveraged, and therefore less likely to become bankrupt in an economic downturn. So they will not only perform as income stocks, but as relatively reliable ones also -- unlike utilities -- relatively free from government regulation. These traits should give them a share-price advantage in down stock markets over firms with much more volatile earnings or more regulatory interference.

* The stock market treats REITs more as income stocks than growth stocks. * The average ratio of share price divided by adjusted funds-from-operations per share for REITs in December 1997 was 11.7. * A REIT can attain growth-stock status in the long run only by achieving acquisition gains per share of around 9% or more per year. * The ability of individual REITs to achieve growth-stock status will depend upon their maintaining a capital-raising advantage in financial markets.

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