Well, here’s a pleasant surprise!
As you know, I’ve been worried—still am—about the lofty valuations of most U.S. stocks. Tuesday’s skin-of-the-teeth record close by the Dow and 13-year high for NASDAQ don’t exactly lay those concerns to rest. Yet, in the midst of this bubbly market, I’m finding one sector that still offers respectable value for conservative long-term investors like you and me.
I’m talking about commercial real estate. During the first five months of 2013 (until late May), real estate investment trusts (REITs) were skyrocketing with the rest of Wall Street.
Then Ben Bernanke and several other Federal Reserve officials started making noises about “tapering” the central bank’s massive purchases of bonds and mortgages. Bond prices tanked, of course, but so did certain sectors of the stock market—those thought to be most sensitive to interest-rate fluctuations.
REITS were among the victims. From its May 21 peak to the August 19 low, the MSCI U.S. REIT Index (RMZ) plunged 18.7% on a closing basis.
I’m not going to try to tell you that a sharp rise in borrowing costs wouldn’t hurt the real estate business. Obviously, it would. However, I strongly suspect that Wall Street, in its inimitable way, has vastly overreacted to any rate increase we’re likely to see in the next 12 months.
Furthermore, history—I mean the “ancient history” that old-timers like me recall from the 1970s—shows that REITs can adapt rather well, over time, to a rising-rate environment. For one thing, rising interest rates usually accompany stronger economic growth, which allows landlords to raise rents. Higher rents help offset the higher cost of borrowing.
As we speak, the REIT group has rallied modestly off its August lows, but not nearly as much as the broader market indexes over the same period. As a result, Vanguard REIT Index ETF (VNQ), a fund that embraces the entire REIT industry, continues to throw off a generous 3.9% yield, based on the four most recent quarterly distributions.
For an even higher yield, look to REIT Rayonier (RYN).
As one of the nation’s largest timberland owners, RYN harvests standing timber for production into lumber and pulp. The company’s important performance-fibers segment (about 80% of operating income) manufactures cellulose fibers and absorbent fluff pulp, which are used in an amazing variety of applications, from textiles to pharmaceuticals and even food. Land sales, mainly for real estate development, also contribute to cash flow.
All of these are cyclical businesses, affected by the ebb and flow of the economy. Nonetheless, RYN, in a little less than 10 years under the REIT form of organization, has managed to double its dividend, without cutting the payout once—even during the severe economic downturn of 2007-09. According to the key metric of return on invested capital, RYN has outpaced its timber peers by a wide margin over the past decade.
At today’s mid-day price, RYN yields a cushy 4.4%. Better yet, RYN’s dividends carry a tax advantage: Every year so far (since Rayonier converted to REIT status), all of the company’s dividends have qualified as either a capital gains distribution or a tax-free return of capital.
Under current federal tax law, capital gains distributions are taxed at the same rate as dividends. However, many states (such as my home state of New Hampshire) tax dividends but not capital gains. Thus, depending on where you live, you may be able to avoid state income tax on the capital-gains portion of RYN’s dividend, typically the bulk of the payout.
P.S. Best wishes to you and yours for a safe and happy Turkey Day, full of great memories!