If you watch any TV, you've probably seen the infomercial about making a million in real estate. Google "real estate millionaire," and you'll get more than 7 million hits. And over the past five years, the value of residential property in developed countries has more than doubled, according to The Economist. You know you want a piece of that action.
Unfortunately, real estate is historically no better a sector for investment than any other, and it might be due for a swoon. That means you need to be very careful these days when you're picking real estate investment trusts (REITs) for your portfolio. Many of the current valuations are overblown.
A fantastic run
For the most part, REITs are up significantly since the beginning of 2005. The Vanguard REIT Index Vipers is up 25%, Equity Residential (NYSE:EQR) is up 36%, Archstone-Smith Trust (NYSE:ASN) is up 35%, and Camden Property Trust (NYSE:CPT) is up 37%. These gains represent more strong performance in a five-year boom that has left the average REIT yield around 5%. Equity, Archstone, and Camden now yield 3.9%, 3.6%, and 3.8%, respectively, and trade for 17 to 20 times earnings -- just north of the market's average of 17. That's not optimal, given the volatility of the current environment.
Moreover, approximately 20% of purchasers in the current market are speculators or multiple-home buyers. These folks are inflating demand, particularly in San Diego, San Francisco, New York City, and Washington, D.C., and making the operating environment more expensive and more difficult for the REITs you know and love.
Recently excluded from the current boom are mortgage REITs, which have been squeezed by rising interest rates and a flattening yield curve. New Century Financial (NYSE:NEW) is down nearly 25% since 2005, and Friedman Billings Ramsey (NYSE:FBR) is down 40%. These drops followed strong performance from 2001 to 2004. Are they canaries in the REIT coal mine?
Tread carefully
I don't think the real estate sector is on the verge of collapse, and I continue to hold shares of two REITs: Thornburg Mortgage and American Financial Realty (NYSE:AFR), a Motley Fool Income Investor recommendation. But I do think investors need to be wary of where they put their money. Stay away from REITs that do most of their business in the aforementioned "hot" areas. Archstone-Smith Trust, for example, operates mainly in D.C., California, Seattle, and New York City. Then there's Post Properties (NYSE:PPS), an apartment developer with properties in Atlanta, Dallas, Tampa, and yes, Washington, D.C. It's up 32% since 2005 but now yields only 4.1%.
That's not the best deal. Investors can do better by focusing on companies that control small niches across the country, or do business in places where the premium on real estate is lower .
Foolish final thoughts
Fool dividend guru Mathew Emmert recently identified two small-cap REITs that meet those criteria and offer yields greater than 6%. These select opportunities take a little bit of digging to discover. If you'd like to know where you can get an above-average yield for a below-average price, click here to be our guest at Income Investor free for 30 days.
Real estate exposure is vital to a balanced portfolio. But remember: The best investors never overpay.
This article was originally published on Dec. 15, 2005. It has been updated.
Tim Hanson owns shares of Thornburg Mortgage and American Financial Realty. No Fool is too cool for disclosure ... and Tim's pretty darn cool.
