By Art Gering

As a leading equity source for income, REITs try to find their rightful place in dividend-focused funds

Income-oriented investing seems to have acquired new stature with individual investors, a development evident in the recent emergence of dividend-focused funds—closed-end or mutual funds that invest primarily in dividend-paying equities. And, despite a reduction in the dividend tax rate that impacted only roughly a third of all REIT dividends, real estate equities seem to be gaining favor with closed-end fund portfolio managers while also making modest inroads in the much larger mutual fund universe.

		Slashing Taxes The Jobs and Growth Tax Relief Reconciliation Act of 2003 is the formal name for the dividend tax reduction legislation signed into law last May.

Nonetheless, obstacles still seem to stand in the way of REITs becoming a greater component of dividend-focused mutual fund portfolios. REITs represent a small portion of assets held by equity income, income and balanced funds that, by definition, invest in income-generating securities. Given the strength of REIT dividends compared to other publicly traded equities, these fashionable income-oriented funds appear to be a way for REIT stocks to increase their mass appeal.

Some of these obstacles are identified and discussed later in this article. First, however, some of the dividend-focused closed-end and mutual funds that came to market in 2003 are separately examined to gain a sense of how REITs fit into the fund manager's investment strategy. REIT-dedicated open-end mutual funds will not be considered.

Closed-End Boom

Many reasons may be cited for the surge of investor interest in dividend-paying stocks, but one reason stands out. Corporate accounting shenanigans over the past several quarters buckled investor confidence in the financial results firms were releasing, thereby enhancing the appeal and safety of dividends and the companies that pay them. As Paul Herbert, a fund analyst with Morningstar Inc., explains, "A dividend can't be faked. It has to be paid with real cash."

Closed-end funds have long favored current-income investing objectives. Not all closed-end funds invest in dividend-paying equities, but roughly 75 percent of closed-end funds are income-oriented, according to Don Cassidy, a senior research analyst with Lipper Inc.

According to Lipper, 12 dividend-focused closed-end funds began trading in 2003 (see table on next page). Lipper and the fund companies report the funds collectively raised more than $7.7 billion. Shares of the 2003 crop of funds appear to be finding their way into the portfolios of individual investors in a significant way due to underwriting syndicates that typically included retail brokerage networks such as Merrill Lynch & Co., Inc. and A.G. Edwards & Sons, Inc.

Many of the funds introduced in 2003 contain REIT holdings.
Nuveen Investment's Diversified Dividend & Income Fund (NYSE: JDD), for example, came to market in September. Four asset classes are represented in JDD's portfolio: emerging market debt, floating-rate corporate debt, equities and REIT common shares. On Dec. 31, JDD had 26.7 percent of its total assets in REITs.

Bill Adams, Nuveen's executive vice president, says that the firm devised its mix of debt and equities to diversify risk exposure. Regarding the equity component, Adams says, "by investing half the equity portfolio in REITs and half in other stocks, we have two markets that are somewhat uncorrelated. This mix provides diversification and is less volatile than an equity portfolio of, for example, all REITs or all other equities.

"We're always looking for opportunities to provide investors with investment choices to add income and provide a manageable amount of investment risk," Adams adds.

In August, First Trust Portfolios' Value Line Dividend Fund began trading on the American Stock Exchange under the symbol FVD. The 178 issues it held in early February 2004 consisted of the safest stocks as defined by Value Line Inc., a stock and fund analysis firm. The company invested in 18 REITs (approximately 10 percent of its portfolio) including Archstone-Smith (NYSE: ASN), New Plan (NYSE: NXL) and United Dominion Realty Trust (NYSE: UDR). According to First Trust Portfolios' SEC filing, the Value Line safety ranking is derived from measurement of a stock's price stability and the financial strength of the firm.

The issues in the FVD investment universe also have dividend yields higher than the Standard & Poor's 500, which was running about 1.6 percent in February.

"REITs are very attractive from a long-term perspective," maintains Robert Carey, chief investment officer for First Trust Portfolios. "Even taking into account the higher taxes, they're still attractive compared to bonds and other stocks."

In September, Eaton Vance launched its Tax-Advantaged Dividend Income Fund (NYSE: EVT). According to the firm, the fund invests primarily in "tax-advantaged" dividend-paying common and preferred shares. EVT had a 2.7 percent allocation to REITs, and Vornado Realty Trust (NYSE: VNO) and ProLogis (NYSE: PLD) ranked among the fund's top 10 holdings.

In June, Cohen & Steers Capital Management Inc., long-time investors in the REIT industry, rolled out its REIT & Preferred Income Fund (NYSE: RNP). The offering, distributed through a syndicate of 20 underwriters, raised more than $1 billion. The firm has remained active in early 2004, launching its REIT & Utility Income Fund (NYSE: RTU), which combines investments in REIT and utilities equities.

2003 Dividend or Income-Focused Closed-End Funds Select Debuts
Fund	Ticker Symbol	REIT Allocation
BlackRock Dividend Achievers Trust	BDV	NA
Cohen & Steers REIT & Preferred Income	RNP	100%1
Eaton Vance Tax-Advantaged Dividend	EVT	2.7%
First Trust Value Line Dividend	FVD	10.4%
Gabelli Dividend & Income Trust	GDV	0%
ING Clarion Real Estate Income Fund	IIA	100%2
Neuberger Berman Income Opportunity	NOX	50%2
Neuberger Berman Real Estate Securities	NRO	70–80%3
Neuberger Berman Realty Income	NRI	100%
Nuveen Diversified Dividend & Income	JDD	26.7%
Preferred Income Strategy Fund	PSY	20.5%4
Scudder RREEF Real Estate II	SRO	100%
Sources: Lipper, SEC's EDGAR Web site, company reports, Strategic Insight's FundFiling.com Notes: 1 56% in REIT common shares, 44% in corporate preferred and debt. 2 Mix of REIT common and preferred shares. 3 70–80% in REIT common equity. 20–30% in preferred securities issued by REITs and other real estate companies. 4 REIT preferred.

Speaking on RTU, Cohen & Steers' Executive Vice President and Director of Marketing John McCombe says, "the first thing we wanted to do was deliver high current income to investors, regardless of the tax implications. Secondly, we wanted to focus the portfolio on utilities and REITs, the two highest yielding sectors of the equity market."

Closed-end offerings targeting income-oriented investors from ING Clarion and Neuberger Berman are dedicated REIT sector funds. While other closed-end funds mentioned here have REIT exposure, those funds diversify their holdings across several industries. Information from the fund firms reveals that the greatest industry concentrations appear to lie in the energy sector and financial services.

Mutual Funds Lag

Dividend-focused mutual funds do not comprise their own category of funds but, rather, fall into different segments within the Lipper taxonomy. Open-end funds with dividend-focused strategies might be categorized as either equity income, balanced or income funds. In early February, REIT shares accounted for 2.5 percent of assets in equity income mutual funds, 1.4 percent in balanced funds and 3.2 percent of assets in income funds. Many of these funds display much greater portfolio concentrations of firms in the financial services and energy sector, according to Lipper.

It's difficult to determine the number of new mutual funds registered during any time period. The few organizations that attempt to track this data come up with widely varying estimates. For example, an article in the November 2003 issue of Time states that 19 new dividend-focused funds were initiated during 2003 and cites Morningstar as the source of the information. However, Paul Herbert of Morningstar conceded that more funds were probably launched.

A search of Strategic Insight's FundFiling.com database, however, found registrations for seven funds in 2003 with "dividend" or "equity income" in their name. Five opened for business during the year.

Eaton Vance's Tax-Managed Dividend Income Fund, which appeared in May, has a sizeable REIT component. REITs comprised 15 percent of the fund's $141 million in assets as of Dec. 31, according to the firm.

Fidelity Investment's Strategic Dividend & Income Fund rolled out in late December. The fund seeks a 15 percent allocation to REITs. And the Excelsior Equity Income Fund also targets REIT investments, according to the fund's prospectus.

Whether REITs can achieve a higher level of representation in the portfolios of mutual funds with current income or yield-oriented objectives such as the categories mentioned is a point worth pondering. Such consideration should attempt to identify the obstacles blocking wider acceptance of REITs.

Overcoming Obstacles

Fund industry sources suggest a large-cap bias in mutual funds prevents REITs from occupying a greater portion of fund portfolios. Also, the newness of the REIT industry and debate on REIT valuations may preclude wider acceptance of REIT shares, based upon an understanding gathered from several prospectuses on how mutual fund portfolio managers select stocks.

Large-Cap Bias: Excluding the six firms in the Standard & Poor's 500, REITs are predominantly included in mid and small-cap categories. This doesn't appear to affect the investment strategies of REIT sector funds, which have a multi-cap orientation, and probably a host of other funds that also invest in large, mid and small-cap issues. However, there is a distinction between the way closed-end fund managers and their mutual fund counterparts view capitalization and it may help to explain why REITs have a strong following in the closed-end fund universe, according to representatives from the fund firms.

"If it's an open-end fund and it rakes in gobs of money every month, there might be a slight bias toward large caps just to get the money working," says Lipper's Cassidy. "You can buy large blocks without affecting the market much. But there is probably not a large-cap bias in closed-end funds."

Because closed-end funds do not have daily share redemptions and the consequent need to unwind equity positions that mutual funds do, closed-end managers can build a multi-cap portfolio to achieve their objectives. "We can take advantage of investments that might be a little less liquid," Adams says.

Carey agrees. "The closed-end structure allows the fund to execute its strategy of pursuing above-average dividend-yielding stocks regardless of market capitalization," he states.

Newness of Industry: The modern REIT era got under way in the early 1990s and many of today's better-known companies didn't go public until later in the decade. Equity Office Properties Trust (NYSE: EOP), AMB Property Corporation (NYSE: AMB) and Boston Properties, Inc. (NYSE: BXP), for example, did not go public until 1997.

This is worth mentioning because some managers of dividend-focused mutual funds select stocks based upon their dividend-paying history. The Franklin Rising Dividends Fund for instance, invests in "companies that have consistently increased dividends in at least eight of the past 10 years and have not decreased dividends during that time," among other factors, according to the fund's prospectus. This strategy automatically disqualified from consideration the REITs named above and many others due to their limited public track record.

Valuation Calls: Many mutual fund managers use some type of valuation metric, such as price-to-earnings ratio, to filter stocks. Stocks deemed too expensive on the basis of these metrics are dropped from additional consideration. Depending on the metric, some REITs may not measure favorably.

Presently, within the REIT universe, there is some well-reasoned debate on where stock valuations are after a lengthy run up. On one hand, Stephanie Krewson, senior vice president and senior REIT analyst with BB&T Capital Markets, estimates a 28 percent return for REITs in 2004 due to continued strong demand for income investments.

2004 Dividend or Income-Focused Closed-End Funds Select Filings

BlackRock Strategic Dividend Achievers

Cohen & Steers Select Utility Income Fund

Evergreen Utilities & High Income Fund

Macquarie First Trust Global Infrastructure/Utility Dividend & Income

Neuberger Berman Dividend Plus Fund

RMR Healthcare & Real Estate Fund

RMR Hospitality & Real Estate Fund

RMR Real Estate Fund

RMR Real Estate Securities Fund

TS&W Claymore Tax-Advantaged Balanced Fund

Source: SEC's EDGAR Web site. Note: Many of these funds have yet to launch and information on ticker symbol and portfolio allocation were unavailable.

"The market is valuing REITs for what they represent: hybrid investments that combine income streams similar to bonds with upside potential or downside risk of equity investments," Krewson explains.

The analyst uses a new metric—going concern NAV (gcNAV)—that values REITs as operating companies and not merely a collection of assets (see "Developments" on p. 11). Krewson finds that the REITs in her coverage universe trade at an average 6 percent discount to gcNAV.

Following Krewson's lead, a mutual fund portfolio manager would probably look favorably upon REITs. Sharing a different view from Krewson is Gregory Whyte, head of the real estate and REIT research team at Morgan Stanley.

Whyte suggests that some portfolio managers of yield- oriented funds would evaluate REITs relative to U.S. Treasurys or a corporate bond index. "On those measures, REITs were trading at spreads (in the first quarter of 2004) that suggested fair value, maybe slightly expensive, depending on the time period over which the analysis is done," according to Whyte. However, "REITs would not appear as expensive on a yield analysis as they currently appear on either a multiple or relative multiple basis," he adds.

Very few analysts were claiming REITs were overvalued in 1999 or 2000, but opinions on recent valuations were diverging. Mutual fund managers that heed the well-reasoned calls of analysts claiming shares are overvalued may decide not to put their money in REIT shares. And in fact, REIT share prices did decline in early April as Portfolio went to press.

Some of these factors may be disputed. However, they can't obscure that REITs probably remain an under-represented asset class in mutual fund portfolios.

The Next Step

There is not much that can be done about the size of the firms in the industry or their age. But the industry should continue to spread the word to fund managers about the benefits of REIT investing, especially its low correlation with other asset classes.

As an example, First Trust Portfolios had previously sponsored REIT-specific unit investment trusts. But the management of the FVD fund debated whether to include REITs in their holdings and submitted for testing a model portfolio that included REITs.

"We saw in our back testing that they improve the downside of the fund," Carey relates.

From 1993 to 2002, FVD's strategy yielded average annual total returns of 10.3 percent, Carey explains. The average annual return of the S&P 500 during the same span was 9.2 percent. Also, the standard deviation of total returns for the First Trust fund was about two-thirds that of the S&P.

Since inception, the fund has produced a raw beta of 0.58, Carey reports. "Our NAV has steadily gone up without a whole lot of market movements," he adds.

Back testing of Cohen & Steers' RNP, which combines REIT shares and preferred equities, yielded a similar result. "Our back testing showed that there had been only one year in the last 13 where both of those assets were down in the same year," McCombe says. "That lent itself to being a good, balanced product."

In short, a compelling case could be made for the inclusion of REITs in the portfolios of dividend-focused mutual funds. "Any computer with any power will tell you that REITs have done well in the last few years," Cassidy quips.