Allocation for Income: Electric Utilities v. REITs

This may insight or ignorance, but I'd think that the leverage inherent to the properties REITs own provide the potential for higher growth. Of course, utilities have the advantage of a guaranteed (mostly) customer base, but limited ability for increasing their revenue. Keep in mind, REITs have already enjoyed a nice run up the past few years, so further upside may slow. JOE

so.

and keep in mind that as the cap rates on commercial properties drop from their current lofty heights, REIT share prices may very well decline.

"joetaxpayer" wrote

What you say seems a good start.

Not sure if you are also implying government regulation tends to take a toll more on electric utilities than REITs. This is something that occurred to me but I have not investigated it thorougly.

For sure. I think them currently overvalued, and so would wait until company fundamentals indicated they were reasonably priced. Which of course could be years. One rolls the dice a bit with my Graham-based strategy.

Gil, REITs come in so many flavors that I hesitate to generalize as you did about them. Certain categories of REITs will be hit hard if and when interest rates rise again, for one, AFAIC. I have avoided mortgage-based REITs in particular.

Thanks for the input, Joe and Gil.

what about the likes of CBG as a favorable stock in the commercial real estate biz ?

"P.Schuman" wrote

P.Schuman, I guess you know CBG is not a REIT. Thus, for my purposes, my only possible, current interest in it would be as a "value stock with a record of increasing dividends." But it has never had a dividend.

WYU, on taxation of (typically much of) REIT dividends as "non-qualified": Good reminder. It's generally not a concern for my situation, but every year it is becoming more of one. Others definitely need to be aware of it.

well, I was just giving food for thought, not a well thought out plan for you. Look at historical cap rates for the sector(s) a particular REIT is in, look at current cap rates, and ponder that as part of your planning process.

Elle, my two cents. Skip sorry for a long post.

First you said individual securities and if it's been enough time my first suggestion is to copmare the returns you've gotten vs. buying the basket. Compare your REITs to say ticker:IYR or Vanguard's REIT fund purchased the same day. That's the first question...should you have bothered with individual issues? Sometimes the answer is surprising (in either direction).

If you're going to buy REITs individually you might consider finding one that has a DRIP that allows you to reinvest dividends and purchase shares at a discount. This is an way to increase returns, and it's not available to a lot of money that is invested in REITs (insitutional investors like me don't custody through DRIP custodians). You said you need the income so it may require a mental-accounts adjustment. Say you have $20k in REITs and desire $1200/yr in income from that piece. You might have some of that in REIT DRIPs with all those dividends reinvested, to get that discount, and the balance in a REIT mutual fund (also reinvested). But the mutual fund is set up for >6% periodic redemptions, of whatever sum you need. Eventually you would access the DRIP REIT through a partial sale, which should be at no cost if it's in a DRIP. At the end of the day you would have enhanced your yield...all else equal (which it may not be...you do have the issue of taking on company-specific risk for each REIT you buy in a DRIP, if the alternative is buying the asset class via a REIT index fund).

REIT vs. utility...going all REIT changes your risk because those two sectors are affected by different factors. REITs are near all-time highs by many measures, whether stock price, low yields, premium to asset value, etc. With electric utilities you at least have diversification into a different type of business.

But "utilities" are no longer a homogeneous category of investment and there are a lot of company specific risks. It used to be largely a matter of nuke liability vs. no nuke liability. Now I think it's more complicated. There's deregulation and big variations in what "electric utility" means. Some conduct trading operations (a la Enron), with the ancillary risks. Some operate in deregulated markets and handle only generation (others handle only distribution). Some have overseas investments or revenue sources. And there has been some merger activity so there can be that possibility for enhancing returns. It's impossible to generalize really and your utility may be a steady-freddy or a time bomb!

One quirky category you might look into is master limited partnerships, in energy-related fields. These are publicly traded on the exchanges (though thinly). The way these work is that you're paid dividends periodically that are treated as return of capital, so you don't pay tax then. Your basis adjusts downwards instead, at least until you run out of basis. When/if you sell the gains are ordinary income. These aren't usually appropriate for IRAs because they generate something called UBTI. Income is reported on a K-1 which adds a little complexity to your tax return. But they're out there as an income alternative with yields above the typical REIT. Some are in the very boring business of energy distribution monopolies, with stable customer bases.

-Tad

"Tad Borek" wrote

Tad, this was answered years ago when I began shifting from funds to individual stocks. The funds you name yielded and still yield quite a bit less than my stable of REITs. I could have increased the yield more, but that would demand taking on more risk via younger, smaller REITs, for one. I also certainly could have banked on principal appreciation in the short term, maybe going with funds as you suggest. But aren't you exhibiting a bit of 20/20 hindsight here? Isn't that a gambler's game /in the short term/? I absolutely did not expect the REIT boom to continue. Instead, as I selected my REITs a few years ago, I reminded myself that I must be braced for a downturn, both in share price and dividends. I am not filthy rich assets-wise. I can't take the risk you seem to be proposing.

Things turned out as planned, insofar as income is concerned. Plus the appreciation is quite satisfactory. I'd say "stunning" except IMO anyone who suggests they possess deep expertise on the horns of a rather bullish market lately is a silly goose. I certainly regret some of my less informed non-REIT stock picks, but I am very pleased with all the REITs I have owned. Of course, AFAIC, it was just luck that they did /this/ well.

I understand the (popular) strategy you're proposing--cashing in principal sort of as needed and otherwise reinvesting using, potentially, discounted stock prices via DRIPs. But as I suggest above, I am conceited enough to think my situation is a little unusual. In my view, I currently cannot diversify, maintain income, and sleep at night the way someone not in retirement can.

I am not sure "electric utilities" is really as broad as you suggest. Some stock screeners might conflate, say, an overwhelmingly mostly energy trading or management services company with a bona fide company that has electric generators, a gas distribution pipeline system, etc. But I for one go digging further so as to obtain only the latter.

I certainly agree about the effects on short term risk of holding only REITs vs. a mix of REITS and electric utilities. But it's the longer term in which I am interested. I think this distinction is important. Hence my original query.

Don't master limited partnerships involve more risk to give that higher yield? If so, they fail my "be able to sleep at night" criterion. I'll google on the subject, anyway.

Even if one needs to spend some money from a portfolio, the focus should be on total return and risk, rather than income, especially now that transaction costs are so low. There is no economic difference between annually selling 3% of an investment expected to appreciate at

8% a year and spending a 3% dividend on an investment with the same expected total return and risk.

If one does want a high yield portfolio, the question should not be electric utilities OR REITS but rather what allocation to give to bonds and ALL stock sectors with substantial dividends, which would include industries other than electric utilities, such as banks and energy.

wrote

I think this tends to disregard the first rule of investing: If one needs some money from one's portfolio (in whatever form) in the short run, then one needs to invest it in lower (short-term, implied) risk assets.

The key word is "expected." If expectations are not met, there is an enormous economic difference. My strategy is more along the lines of some of the IIRC aptly-labeled "consumption smoothing" ones mentioned here in the last year or so: Like many retirees, my dividends and interest cover my basic annual expenses. When times are good, as they are now, I either spend more, or I take some of the gains and invest them with an eye towards more diversity, to increase gains and reduce risk for the long run.

Elle, I think you have it backwards...as with any individual-security selection, picking a few REITs based on higher yield, or perceived superiority of some kind, is the riskier approach. It's less diversified, by definition, and if you focus on higher-yield REITs you could end up with a riskier subset (REITs that might cut dividends, or might not have the FFO to support dividends paid). I'm suggesting that you validate your picks against the returns of the asset class, just as any stock-picker would. Vanguard's fund and IYR are both index funds, so are decent proxies for the US equity REIT asset class (incidentally IYR is at an all-time high).

It's still a hindsight analysis and of limited value, but not in the way you suggest...rather, it's of limited value for validating your picks. Theory says the REITs are all priced for their relative risks and there shouldn't be any free rides within the asset class. In effect you're the "manager" and the question is, did active management help things? Perhaps you'd find that IYR outperformed on a total-return basis.

The general answer to that question is always "yes"! Though MLPs do have that partnership structure, which might partially explain yield differences. They pass through all income, pay no entity-level tax, and by nature of the markets they typically are working in (eg gas distribution through an existing infrastructure), have very limited prospects for growth.

-Tad

"Tad Borek" wrote

Tad, a few randomly chosen REITS may indeed be riskier to principal and dividends than holding a REIT mutual fund. But I propose that foregoing the potential for, say, greater principal appreciation in certain REIT mutual funds in favor of holding hand-picked, strictly older, larger, non-mortgage-based REITs, most likely with less room for principal growth, can reduce this risk. It's like you have it backwards: I should buy strictly CDs (in lieu of REITs) because CDs are really low risk.

Bear in mind that REITs denote a tiny fraction of my portfolio. I'd elaborate more, but it's way off the point of my original query. You're already trying to get me to defend something unrelated on which I am already settled, and misreading or considering my investing goals, to boot.

Tad, excuse me, but did you not read that I said the above in my previous post?

Any stock-picker with experience would not make a judgement over such a short timeframe. Or are you saying that if the S&P 500 dives today, while some obscure single stock pick holds its ground, then the person holding the obscure single stock pick has good justification to continue picking stocks? Seems to me this is highly debatable.

Also, what you are saying is like telling someone who chooses 80% investment grade bonds at age 78 to validate her choice against an allocation of 80% stocks. I am not saving for retirement. I am /in/ retirement.

The question is not simply whether my principal's returns keep up with a mutual fund's principal's returns. The question is whether my portolio is meeting my income and principal requirements, at a perceived risk level. Yup, my portfolio is.

On MLPs: Interesting asset category, and something to keep in mind for one's investing arsenal. Some of the problems with MLPs for my current situation are:

-- They are overwhelmingly young. I'd say something like 90% of them are under eight years old, from a quick check of the few dozen listed at

. So I can't get much of a feel for how they do against, say, the S&P 500, as far as principal growth is concerned. Not having that history denotes risk, to me.-- They are not terribly liquid. Their trading volume is typically a tenth or less of a blue chip stock.-- Dividends do not necessarily keep up with inflation, though with some notable exceptions, like TPP.-- MLPs evidently were vulnerable to scandal in the 1980s. I'm sure you agree anyone buying individual MLPs today should study that period and make sure they understand the problems that existed in the 1980s do not exist today. Still, like hybrid stocks (preferreds, ETDS's, etc.), MLPs are something to keep in mind for when I am much older.

I think I'm starting to understand your strategy here. You're saying that the volatility of dividend increases is less than that of the price change of the underlying security, right? And so if you're set up to live off the dividends, then you can pay less attention to the price of the underlying securities. A quick check of Shiller's data shows that this is indeed the case for the S&P 500 (defining volatility as annual standard deviation). I wonder if it is also true for REIT's and utilities? Interesting. Or did I miss your point entirely?

-Will

See but by owning REITs you take on the asset-class risks, whether you perceive them or not...plus company-specific risks (the ones you could diversify away by owning more REITs). So your approach doesn't honestly assess the investment selections you've made. If you buy bonds, you compare your picks to a comparable bond index, stocks to a stock index, REITs to a REIT index (or index fund). If you did better or worse, you assess why that was and whether you think your picking will continue to pay off (or if it hasn't, whether the underperformance is temporary).

Let's say you've held your REITs for 3 years. REITs, as an asset class, had a 3-year annualized return of about 27% through the end of October

1. That's 27% per year, not total, and it was easy to own the asset class at low cost through one of several index funds. Did you get at least the asset-class return?

Why is it relevant here? You asked for comments about selling utilities to buy more REIT stocks. A logical question is "have you been successful at picking REITs?" If they put in say 15% annually it may look good, but that was actually well below average for the asset class overall.

-Tad

Stock prices change because of (1) new information about future earnings and dividends (2) rational changes in discount rates (3) noise

It is not easy to determine the relative importance of these factors, but the extreme assumption that stock returns convey NO information about future dividends is a "head-in-the-sand" approach that could lead someone to overspend. Dividends are set by management and respond much more slowly to company fundamentals than stock prices do.

"Will Trice" wrote

Yessir, you nailed it. I sure did not want to set up a portfolio where the dividend yield would be lower such that I would have to regularly withdraw from principal /at this point/. This would have been the case had I chosen mutual fund categories similar to my various stock categories.

It's too early in my "retirement," and too risky for the long run in my estimation, to draw down right now.

I hadn't previously checked the standard deviations of the Shiller data, but from anecdotal study I am sure you are right. I chose stocks (REITs, utilities, and other categories) with long records of dividend achievement (increases). If history continues, by my calculations not only will the dividend income stream keep up with inflation, but its increases will trump by a lot an alternative dividend income stream from the S&P 500. In sound bite form, this of course is because the S&P 500 is not all "value stocks."

Without question, though, if history continues, the tradeoff will be less growth of principal. But I am not giving up, say, my GE position, whose principal has only gained about

10% while the S&P 500 has gained about 20%, starting from the same dates. Not when GE's dividend historically has increased at about 33% a year over the last ten years, while the S&P 500's dividend has increased at about 5%.

I still welcome commentary on whether it's true that electric utilities generally cannot keep up with REITs when it comes to stock principal appreciation, and why.

"TB" wrote

I do not know what parts of "the time period is too short to ascertain with precision my success in meeting my long-term goals" and "my goals are not simply principal appreciation" you do not understand. Fact one: If I were only interested in principal appreciation, I would not have chosen the stocks I did. Fact two: If I had chosen REIT mutual funds and other funds, I would have had to draw down on principal, and possibly when the market was down. It did not go down, but that's only using hindsight, Tad. This early, I do not want to touch principal. See my post to Will for more, though obviously this has become repetitive.

I really thought you might have something to say about long term principal appreciation of electric utilities vs. REITs, either confirming the trend I think I see or not, and explaining why. See Joetaxpayer's "best guess" on this, for example.

This seems like a rather forced attempt to correlate dividend changes with stock price changes From my (admittedly anecdotal but nonetheless pretty extensive) study, dividend changes do not particularly affect stock prices, except for a short-term burp when a drastic cut is made. See CAG, SLE, PSD, TCR (now CLP), for example. All had drastic cuts in the last five years. The price of all recovered within two years. For stocks where increases are steady, e.g. General Electric's, stock prices can be all over the map. I have a bunch of other companies showing the same.

Dividends derive from earnings, and earnings certainly affect stock prices, of course.

Dividends respond much more rationally to fundamentals, too. So in fact I can ignore periods of irrationality by stock investors that cause share prices to change ridiculously /in the short term/, and find solace in my steadily increasing dividends instead. I agree with Will.

Seeming critics of this approach might note the recent popularity of mutual funds and ETFs explicitly focused on "dividend achievement." Vanguard in the last year interested one or a few; same for PowerShares; same for Wisdom Tree (Jeremy Siegel, senior advisor). I am in fact watching some of these ETFs, but for now, I am quite pleased with my individual picks. Of course I hope I could say the same, by virtue of the steadiness of the dividends, were the market not so generous of late.