Fall 2000
	Cover Story Doing the REIT Thing Western Properties’ Brad Blake and Bradley’s Tom D’Arcy put their shareholders first. Now they’re looking for work. Company Spotlight Failure to Communicate The "REIT Story" is a good one. Unfortunately, many companies haven’t done as good a job as they should have in telling it. Sector Spotlight Critical Conditions Opportunities among the healthcare REITs, but be careful out there. The New Economy Plugged In Making Money in the Internet Age Tracking The Market Bye, Bye Bear Market Blues After two of the worst years in their 40-year history, REITs have staged a strong comeback. By The Numbers Much Better, Thank You Real estate fund managers may never live down the 1998-99 bear market, but at least these days they can go out in public. Washington Wire Legislative Relief No legislation in the roughly 40-year history of REITs had the potential to alter the landscape more dramatically than the recently enacted REIT Modernization Act. Investment Basics Just How Safe Are REIT Dividends, REALLY? Yield-conscious investors drawn to REITs by their "rich" yields need to look beyond what’s printed in the stock tables of their daily newspapers. Investment Insight Opposites Attract It didn’t come as a surprise to portfolio managers at LaSalle Investment Management that REITs soared when tech stocks hit the wall this past spring. Investment Fundamentals NAV Growth: A Meaningful Performance Yardstick Growing FFO and enhancing shareholder value are not always one and the same. Focusing on NAV growth is a better, though not perfect, alternative suggests Green Street’s Mike Kirby and Jon Fosheim. Editor's Note The Journey Continues ... Parting Shot Wrestling With Net Asset Value The Penobscot Group’s Frederick S. Carr Jr. questions whether the market is telling investors that NAV is irrelevant. Newsline Urban To Be Acquired By Rodamco For $3.4 Billion Investor's Guide Questions Back Issues Feedback

by Barry Vinocur
Illustration by Chris McAllister

Even after the strong run-up in REIT prices this year, the stocks still offer dividend yields often hundreds of basis points higher than other favorites of yield-conscious investors, such as utilities. As we were going to press, the average yield for the roughly 120 companies that make up the Morgan Stanley REIT Index (see page 84) was 7.1 percent. Moreover, REITs typically raise their dividends in the fourth quarter, and with a number of companies bumping up against their minimum payout ratios, those yields are likely to increase. Which brings us to the big question, "How safe are REIT dividends, really?"

Eric Hemel, who oversees the REIT research effort at Merrill Lynch & Co., and his colleagues published a report in late 1998 titled, "Are REIT Dividends Secure? We Say the Answer is Yes!" Since it has been quite a while since Hemel and his colleagues published their report, we dusted it off and updated it.

Roughly two years after the Merrill analysts published their report, the dividend-related questions uppermost in the minds of individual investors and financial advisors remain: "Why are REIT dividend yields so high? Do the high dividend yields mean that there’s something wrong with the companies?"

The answer to the first question is less straightforward than the answer to the second, though it’s likely that dot-com mania had a lot to do with why many sectors of the market, including REITs, were mired in bear markets until the Nasdaq bubble burst this past spring. The answer to the second question is there are some REITs that are "healthier" than others, as is the case in any sector of the market. But generally speaking, there’s nothing wrong with the companies per se.

Surveying the Landscape
Though there’s some difference of opinion, most analysts and investors agree that REITs are currently at "fair value." As we note elsewhere in this issue (see "Bye, Bye Bear Market Blues" on page 36) Lee Schalop and his colleagues at CS First Boston believe the Morgan Stanley REIT Index could tack on another 9 percent this year.

There’s no single answer to the question: "Are REITs cheap?" The most often cited metric is premium/ discount to net asset value. After rebounding this summer and approaching parity, Green Street Advisors, a Newport Beach, California-based buy-side research boutique noted recently that at the end of August the stocks were once again changing hands at a material discount to NAV (see graph on page 81). As we went to press, the companies in our Side-by-Side table (see pages 72-77) were changing hands at an average discount to NAV of 10 percent.

If you look at a relative multiple analysis (that is, the Standard & Poor’s 500-Stock Index vs. REIT adjusted funds from operations multiples), the sector is trading well above its historic average (1994-2000) on both a bottom-up and top-down basis (see table on page 79), according to the Merrill analysts. As of September 14, Hemel and his colleagues reported that the S&P 500/REIT AFFO multiple was 2.63 (top down) and 2.42 (bottom up). The historic average (1994-2000) was 1.96 (top down) and 1.71 (bottom up).

If you look at the yield on 10-year Treasurys or the S&P 500 vs. REIT dividend yields, the differences are significant. In December 1998, when Hemel and his colleagues published their study, the 10-year Treasury had a yield of 4.6 percent and the S&P 500 had a yield a bit under 1.5 percent. The average REIT dividend yield, according to the Merrill analysts, was 7.5 percent in mid-December 1998. As of mid-September, the yield on the 10-year Treasury was 5.8 percent; and the yield on the S&P 500 was roughly 1.1 percent. The average REIT dividend yield, according to the Merrill analysts, was 7 percent.

Analyzing DCRs
There are a number of things to keep in mind when looking at REIT dividends. At the top of the list is the question: Is the dividend sustainable? Using the same general methodology as Hemel and his colleagues, we analyzed the dividend coverage ratio (DCR) of the dividend-paying REITs in our Side-by-Side table. The Merrill analysts defined DCR as a REIT’s cash available for distribution divided by its current dividend. (For our analysis, we used the 2001 consensus AFFO estimates from Realty Stock Review, this magazine’s sister publication. We believe that number is equivalent to the Merrill analysts’ CAD.) As Hemel and his colleagues pointed out in their December 1998 study, "The higher a company’s DCR, the more sustainable its current dividend."

The average DCR for the 113 dividend-paying REITs in Realty Stock Review’s coverage universe (see table on page 58) was 142.3 percent. (When Hemel and his colleagues did their study in December 1998, they reported an average DCR for the companies in their coverage universe of 136 percent.) Put another way, there’s roughly $1.42 of cash flow standing behind every $1.00 of dividends (on average). The range of DCR-by sector-is rather large, from 182.7 percent for the self-storage REITs (demonstrating what might be termed the Public Storage factor) to 123.1 percent for the healthcare REITs (see "Critical Condition" on page 26).

Don’t Forget Leverage
As Hemel and his colleagues underscored in their December 1998 study, when looking at DCRs, investors need to factor leverage into the equation. "Given that the average REIT is approximately one-third leveraged implies that the preleveraged cash flow figure (that is, the net operating income) would need to decline by 15 percent to 20 percent for the average dividend coverage ratio to reach 100 percent," the Merrill analysts noted. Hemel and his colleagues added that they viewed the likelihood of a 15 percent to 20 percent decline in NOI over the coming 12 months as unlikely. (Their assessment proved correct.)

On average, REITs are somewhat more highly levered today than they were in late 1998. That said, the likelihood of an across-the-board decrease in NOI-sufficient to jeopardize dividends-seems extremely unlikely over the coming year. That doesn’t mean that there won’t be some horror stories. How-ever, using the tables provided (see pages 59-61), you should be able to steer clear of all but the unforeseeable calamity.

As Hemel and his colleagues noted in their 1998 report, the sector you’ll need to keep an especially close eye on is lodging. Given the short-term nature of hotel leases (guests check in and out every night) and hotels’ high degree of operating leverage, lodging companies are a higher risk proposition on this score than, say, regional malls.

Using the Data
Dividend coverage ratios are but one metric. For instance, a highly levered company’s DCR is less sustainable than a company with the same DCR that has low leverage. Though there a variety of ways to gauge leverage, Realty Stock Review relies on several metrics, most important are interest coverage and fixed-charge coverage ratios.

For instance, if you compare Developers Diversified and Kimco Realty, you’ll find that Developers Diversi-fied’s dividend is roughly 400 basis points higher than Kimco’s. Further, DDR’s dividend coverage ratio is higher than Kimco’s, 149.3 percent vs. 147.8 percent. However, Developers Diversified is substantially more levered than Kimco. (According to a recent analysis by Green Street Advisors, Developers Diversified’s leverage ratio was 68.1 percent vs. 48 percent for Kimco. Green Street defines that ratio as debt as a percentage of the fair market value of the company’s assets.) Put simply, when gauging dividend sustainability, DCR by itself isn’t enough!

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