Utilities, REITs lose their luster

Your Money

June 24, 2007|By Gail MarksJarvis | Gail MarksJarvis,Tribune Media Services

As you examine your investment records, you may find that your dearest, reliable lower-risk stock investments of the past few years have suddenly taken a turn in the opposite direction.

Real estate investment trusts and utilities - two investments that conservative investors typically buy for dividend income and modest growth - have been uncommonly strong for five years. But amid an inflation and interest-rate scare the past few weeks, they slumped more than other categories of stocks. And analysts have been warning investors not to continue to count on them to be the stalwarts they have been.

"We would minimize any holdings in those two sectors, especially REITs," Mark Salzinger said in a recent issue of The No-Load Fund Investor, a publication that advises individuals on mutual fund investing.

Mercer Investment Consulting, which advises pension funds, said in a report to clients that while the fundamentals driving real estate values remain strong, "We do not believe performance levels are sustainable."

The concern comes down to interest rates and the popularity of REITs and utilities. When investors soured on technology stocks and the stock market in general amid the nearly 50 percent decline in 2000-2003, risk-averse investors and speculators alike poured money into real estate.

And retirees - seeking income - shunned U.S. Treasuries and certificates of deposit as yields sank below 4 percent. Instead, they bought both utilities and REIT mutual funds, hoping for more income and a chance to make money on stock prices climbing, too.

They got what they were after. The average utility fund has averaged a 16.9 percent return a year for the past five years, and the average REIT fund has climbed 20.3 percent, according to Lipper Inc. Both provided returns well above the 8.6 percent average in the benchmark Standard & Poor's 500 during the same period.

But since investors flooded them with cash, utilities and REITs aren't the good deals they were years ago, many analysts said, and could be vulnerable to a fall because investors have expectations that might not fit a changing interest-rate environment.

Yields on 10-year Treasuries recently climbed above 5 percent, and economists are debating whether strong growth and inflation could push them above 6 percent.

The direction of interest rates is difficult for even the brightest of economists to predict, but stock investors have recognized potential warning signs. When yields climb above 5 percent, the trend can become a drag on REIT and utility stocks and mutual funds because investors who shunned Treasuries and CDs yielding 4 percent might be willing to partake in the safer bonds once their rates climb over the 5 percent threshold.

"Given the recent relatively benign inflation measures, we would be surprised if yields rose much higher," Salzinger said. "If they do, however, interest-rate sensitive stocks, especially REITs and utilities, are likely to suffer - especially since their valuations are already stretched."

Likewise, BCA Research suggested that investors cut back on utilities. "Utility stocks are as overvalued relative to the broad market as at any time in the past two decades," it said in a note to clients.

Investors have been heeding the warnings. After pouring $2.1 billion into REITs in 2006, investors pulled $1.9 billion out of them in May, according to AMG Data.

"It was the largest outflow of any month since 1992," said AMG Data President Robert Adler, and investors continued withdrawing money this month.

After pouring $775 million into utility mutual funds in 2006, investors have pulled $143 million out during the past three weeks, Adler said.

During the past four weeks, investors in the average utility fund tracked by Lipper have lost 2.5 percent, and those in real estate funds are down about 1.5 percent.

While analysts are trying to help investors realize that a changing interest-rate environment could be detrimental to individuals who are betting too heavily on REITs and utilities, they are not suggesting that investors simply drop everything.

Utilities in general are hurt by rising interest rates in two ways, said Justin McCann, a Standard & Poor's utility analyst.

Aside from the competition with bonds among investors, "almost all utilities have huge capital costs" as they build and repair facilities and buy power, McCann said.

But investors should examine whether a company has large financing costs ahead or whether it has already issued the necessary bonds - making it less vulnerable to rising costs of making improvements.

Goldman Sachs utility analyst Michael Lapides also notes that some utilities are more vulnerable than others.

In a report titled "Baby and Bath Water," Lapides said that while regulated utilities, diversified utilities and independent power producers all dropped about 10 percent over the three weeks leading up to June 8, not all are purchased based on the dividends they pay.

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