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The facts simply do not add up and the old excuses no longer apply. Advisors should begin using real estate investment trust mutual funds in their clients’ asset allocation portfolios. During the first week in October, Standard & Poor’s announced that it would be including real estate investment trusts (REITs) in the the S&P 500 index. “REITs were not eligible for the [S&P] indices for several years. The old policy reflects REITs’ role as passive investment vehicles during the late 1970s through the mid 1990s,” S&P says. But now, “REITs have become operating companies subject to the same economic factors as other publicly traded U.S. companies.”

No one knows quite the effect that this announcement will have on the performance of the industry or on the use of REITs by advisors. David Blitzer, chairman of the S&P index committee, says that following the addition of America Online to the index in 1998, the Internet sector came to be viewed with an additional measure of respectability. “I remember that a reporter told me during a phone interview at the time that we had blessed the Internet,” Blitzer says. “That wasn’t our intention. We just meant to show that that sector of American industry had come to play a sufficiently significant part in the overall scheme of things.” The implication for REITs? Now S&P regards REITs in a similar fashion–as major business concerns.

Such recognition may surprise many advisors unfamiliar with the evolution of REITs since they were first allowed by Congress in 1960. Indeed, during much of the first three decades of their existence, REITs functioned mostly as investment products rather than as going concerns. Robert Steers, who manages the nation’s largest REIT mutual fund along with partner Martin Cohen at Cohen & Steers Realty Shares, tells of how a third-party real estate advisory firm would put together a number of properties and then form a shell corporation. Shares in the shell would be underwritten by large wirehouses and sold to clients. “It wasn’t a company,” says Steers. “The real estate advisory firm and wirehouse would get a big commission up front and there was no incentive to manage the properties correctly. They would have no stake in whether or not the property succeeded.”

Typically, the properties would be low in quality so as to bolster the potential annual returns, and make the product more marketable to wirehouse clients. Strip malls were the big fad in this environment, says Steers, with their high rental margin throwing off 9% to 11% in annual rental returns. “Every drop of cash flow was sent back to the investor and, in many cases, the REIT would eventually be liquidated. It wasn’t a real company with a real staff.”

A lot has taken place since then. Suffice it to say that REITs are now actual operating companies, just as S&P acknowledges. They have real, full-time staffs that often number into the hundreds of employees that deal with financing, acquisition of new properties, development, and the management of existing properties. As Peter Haas Calfee of Calfee Financial Planners in Cleveland, says, “It was hard in the past to get a handle on what REITs were actually doing. You now know that they are running it in the best manner that they know how.” Indeed, go to the Web site of any REIT and look at the detailed description of floor plans, properties, and rents. These are real companies with real assets.

Despite this, however, REIT funds are still largely unused. AMG Data, which tracks mutual fund flows, estimates a net of just over $270 million has gone into REIT mutual funds since the beginning of the year. Comparatively, the entire REIT mutual fund universe has a total of $11 billion under management. One might argue that this amount is comparatively large, considering the redemptions being recorded by traditional stock-oriented funds. Yet, while most of the equity mutual fund categories have suffered losses over the past 18 months, real estate is up. The National Association of Real Estate Investment Trusts Composite Index, which tracks the performance of all publicly-traded REITs, was up 26% last year, and has risen another 14.35% this year through October 9. In a year when investors are seeking a respite from investments in traditional large-cap stocks, REIT mutual funds, despite their stellar performance, have gone largely neglected.

This is doubly hard to understand when you consider that these recent results are only indicative of a larger trend. Over the course of the last 10 years–the period that is considered the modern REIT era–REITs have been up an average of 11.49% annually. However, they were down significantly in 1997 and 1998.

Also, REITs sport a very low correlation to other market indices. No more evidence of this is needed than their performance this year in relation to the Dow Industrials and Nasdaq, but the oft-noted correlation coefficients are equally indicative of this fact. The Wilshire REIT Index, a broad indication of performance of the entire industry, has only a 0.2 coefficient with the S&P 500 and a 0.06 coefficient to the Nasdaq, according to the diversified real estate company Lend Lease Corp.

Then take a look at the efficient portfolio frontier that will be produced when allocating even a small percentage of a client’s assets to real estate. Using historical returns, with 75% stocks (S&P 500), 25% bonds (Lehman Brothers Bond Index), and no REIT investment, a portfolio should be able to achieve around a 16.6% annual return with a 9.7% standard deviation, according to Lend Lease. Allocate 15% to REITs and you lower the standard deviation to 8.7%, while only losing a percentage point in annual return.

But what of the argument that a client already has significant assets tied up in real estate in the form of their home? Calfee admits that this doesn’t really hold water since advisors shouldn’t be including the value of a home in the allocation model in the first place. “When working with liquid assets, you’re trying to preserve the client’s standard of living until the client and his or her spouse pass away. If they’re going to be living in their home until the end of their life, they are not going to be liquidating that asset to maintain their standard of living,” he says. “It shouldn’t be counted.”

Then there is the topic of yield. REITs are averaging around a 7% yield, according to data from Cohen & Steers, when the S&P 500 only has a 1.3% dividend. And REIT dividend growth has been 5.1% over the last year while the S&P has declined by 2.5%. How safe are these REIT yields? Cohen & Steers estimates that REITs are only paying out 63% of their cash flow as dividends. This may not make sense when one thinks of the rule that REITs must pay out 90% of their earnings in the form of dividends. But net taxable earnings are taken after depreciation, which is significant with real estate. Therefore cash flow is often much higher than net taxable earnings. “REIT earnings would have to decline some 40% for dividends to be in jeopardy,” says Martin Cohen.

So with their diversifying qualities, dividends, dividend growth, and recent recognition by S&P, why in the world aren’t advisors making more use of REIT mutual funds? “I don’t know why I don’t use them,” says advisor Linda Barlow, a Santa Ana, California-based advisor with $38 million under management. “Considering the arguments in their favor, I think I should be taking a closer look.”

Calfee agrees. “I think when it comes to real estate that advisors are largely in uncharted territory that they don’t feel comfortable with,” he says. “Most of what they know focuses on stocks and bonds.” As for Martin Cohen, he simply wonders at their lack of use: “I just don’t understand it,” he says. “The facts are so clearly in their favor.”