Commercial real estate has had a pretty good run this year, as strengthening demand — particularly in multifamily housing — has boosted both rents and investors’ returns. New signs suggest the good times could keep rolling into 2013: The National Association of Realtors (NAR) on Monday forecast declining vacancies across all commercial real estate sectors over the next four quarters.
NAR says apartment vacancy rates are only 4% nationwide and will inch down to 3.9% by this time next year. Anything under 5% is considered a “landlord’s market,” so it’s no surprise rents will rise 4.1% this year and another 4.6% in 2013.
Income investors have long viewed real estate as a building block for a well-diversified portfolio. But how many of us yearn for the landlord’s life of 2 a.m. plumbing calls and furnaces that go cold on Christmas Eve?
Thankfully, Wall Street has provided for folks who want to play this hot market without getting burned: Real estate investment trusts (REITs). Lower vacancies and higher rents mean more income for REITs, which are required to pay out 90% of their annual earnings to investors. That makes them particularly attractive. REIT cash flow is more stable than in some other investments because of steady rent payments.
And it gets better: REITs are exempt from corporate taxes, so dividends are taxed as ordinary income. That’s good news because the special dividend tax rate could zoom from the current 15% to 43.8% if we fall off the fiscal cliff.
Investor have several different ways to play this opportunity: multifamily residential equity REITs, which invest in apartments; mortgage REITs (mREITs), which invest in residential mortgages; and exchange-traded funds (ETFs) that hold shares in multiple REITs and trade over an exchange like stocks.
Your best choice depends on your risk tolerance and desire for diversification. That said, here are two individual REITs and two REIT ETFs that can put you into the rising commercial real estate market.
Multifamily housing REIT: AvalonBay Communities (NYSE:AVB). Multifamily rental markets on the East and West Coasts tend to be tighter than the U.S. average (New York City and Portland, Ore, vacancy rates are around only 2%), so AVB’s regional focus on the Northeast, Mid-Atlantic, Pacific Northwest and California is a sweet spot.
AvalonBay also stands to benefit mightily from the 66 Archstone apartment complexes it acquired from Lehman Brothers Holdings this week. That $6.5 billion deal, split between AVB and peer Equity Residential (NYSE:EQR), boosts the size of AVB’s portfolio by 37%.
Although Lehman scrapped plans for an Archstone IPO because of a four-month slide in apartment stocks, I think the laws of supply and demand will prevail and lift the rental market in 2013. AvalonBay shares were up nearly 3% Tuesday afternoon on the news. AVB has a current dividend yield of 2.9% and a one-year return of 15%.
Residential mREIT: MFA Financial (NYSE:MFA). If you’re looking for eye-popping returns, it’s hard not to be star-struck by mREITs right now. MFA, with a nearly $3 billion market cap, has a blinding one-year return of 46%, a current dividend yield of 10% and a five-year dividend growth rate of more than 23%.
MFA has a mix of hybrid and adjustable rate mortgage-backed securities (MBS). While its price-to-earnings growth ratio (PEG) of 2.2 suggests it’s overvalued, the forward P/E of 10 isn’t too bad. Like its peers, MFA uses leverage to invest in residential MBS, profiting from the spread between lower borrowing costs and the higher interest rates that MBS are paying.
But beware the ballast beneath this balloon: The juicy dividends aren’t necessarily reliable, as InvestorPlace Editor Jeff Reeves points out. But if you’re willing to roll with a risk level on par with other highly leveraged financial stocks like insurance companies, mREITs could make it worth your while.
Diversified sector REIT ETF: Vanguard REIT ETF (NYSE:VNQ). REIT ETFs are a good play for investors because they offer exposure to the real estate sector, diversification among multiple REITs and the classic ETF benefits of trading over an exchange like stocks and sporting lower expenses than mutual funds.
AvalonBay and Equity Residential are among VNQ’s top holdings at 4% and 3%, respectively, so you get the multifamily boost. But VNQ also offers broader exposure. Retail-oriented Simon Property Group (NYSE:SPG) is nearly 11% of its holdings. Healthcare-focused HCP (NYSE:HCP) and office REIT Boston Properties (NYSE: BXP) also are among VNQ’s top holdings, as is Public Storage (NYSE:PSA).
VNQ has a year-to-date return of 13.7%, a current dividend yield of 3.4% and a puny expense ratio of just 0.10%.
Residential housing REIT ETF: iShares FTSE NAREIT Residential Plus Capped Index Fund (NYSE:REZ). If you’d prefer to gain a little more exposure to residential rental REITs, REZ might be right up your alley.
Top holdings include multifamily REITs like AVB, EQR, Camden Property Trust (NYSE:CPT) and Essex Property Trust (NYSE:ESS). REZ does stray outside the apartment niche, however. The ETF’s top three holdings (a combined 29%) are in healthcare-focused HCP and Ventas (NYSE:VTR), as well as Public Storage.
REZ boasts a one-year return of 23%, a current dividend yield of 3.1% and an average expense ratio of 0.48%.
As of this writing, Susan J. Aluise did not hold a position in any of the aforementioned investments.