A Tale of Two Yields
Is it better to get dividends from shiny condos or rusty industries? (Trick question.)
By Stephen Gandel

(MONEY Magazine) – If you want assets that pay generous dividends, you face a clear and simple choice today. You can place your money in a sector that is one of the stock market's best performers over the past five years, a sector that still averages a dividend yield of 4.7% and that almost guarantees you'll draw an admiring crowd if you let slip at a cocktail party that, ahem, yes, you do happen to own a few thousand shares. That sector would be real estate investment trusts, or REITs, which invest in apartment towers, office parks, malls and other gleaming monuments to the real estate boom. Or you can instead make your picks from among the lumbering giants of industry and finance in Standard & Poor's 500-stock index. These companies generally impress no one with their growth rates, and they traditionally pay dividends somewhere between modest and desperate. The average REIT is up 30% since the beginning of 2004, nearly triple the gain of the S&P 500.

So it's obvious which sector you should go with, isn't it? Why, the grimy old S&P, of course.

Okay, maybe it's not obvious. But investing smart is always a matter of looking ahead, not back, and when you do that today, you get a very different read on the two sectors. After three years in the doghouse, the high-dividend stocks of the S&P 500 are trading below their historical averages. By contrast, a year and a half of thumping the market has left REITs at prices well above normal compared with the cash their properties throw off.

In fact, the REIT sector has gotten so far ahead of itself that at least one mutual fund is checking out. Westwood Management recently converted its strongly performing REIT fund--up 27% in 2004--into the Westwood Dynamic Income Fund, pulling most of the portfolio's assets out of REITs and reinvesting into blue-chip stocks, among other things. "We are concerned about the valuation of REITs," says Westwood's chief investment officer, David Spika.

As Spika knows, when you buy stocks for income, you need to be concerned about three things: the size of the dividend you get for your dollar (the yield); the odds that the dividend will increase; and whether the stock will rise or fall. On all counts, the outlook today favors high-dividend stocks over REITs.


The most irresistible thing about REITs over the years has been their extraordinarily generous dividend yields. But those now stand at their lowest in more than 30 years, an average of 4.7%, down from 9% as recently as 1999.

That puts REITs in roughly the same ballpark as the highest-paying industrials and financials. The 50 highest yielders in the S&P 500 (excluding REITs) pay a dividend equal to 4.4% of their stock price. That means REITs still have the edge--until you consider taxes. Because the tax code treats REITs differently from other corporations, REIT dividends are taxed at regular income rates, which can run as high as 35%. Dividends from regular stocks get tapped for just 15%.

That can make S&P yields quite competitive. Of those 50 generous S&P stocks, 47 have better after-tax yields than the average REIT, according to Merrill Lynch analyst Steve Sakwa, another REIT specialist who is souring on the sector. (Among the most appealing of these S&P income stocks are Bristol-Myers Squibb, Citigroup and Verizon, discussed on page 66.) "REITs are not as attractive as they once were," says Sakwa.


Stock yields, unlike those from REITs, have room to grow. The average S&P 500 company pays out 32% of its earnings to shareholders in the form of dividends. That's well below the historical average, 54% according to Standard & Poor's. With more and more retiring baby boomers clamoring for income, Howard Silverblatt at S&P expects blue chips to continue to boost payout ratios. If that happens, their dividends could get a double boost--from expanding payout ratios on top of growing earnings. REITs, on the other hand, are required by law to pay 95% of their income to shareholders. So REIT dividends can't grow faster than earnings.

And because REIT earnings depend on the rental market, they're likely to grow slowly, if at all. The rush to own a home has held down apartment rents. Corporations have been slow to increase the work force, reducing the need for office space and keeping rents cheap. And retail industry megamergers such as that between K Mart and Sears have reduced the number of stores available to fill malls, lowering rents there. As a result, Merrill's Sakwa expects REIT earnings growth to slow to 6% next year, from an estimated 6.4% this year. "The growth rates implied by REIT prices are too high," says Sam Leiber, manager of the Alpine U.S. Realty fund. "I think REITs will disappoint."


The average REIT share trades at 15 times FFO (funds from operations, the preferred method for measuring REIT earnings) vs. a historical average of 12. Stocks in the S&P 500 trade at 19 times the past 12 months of earnings. But that's below the price-to-earnings ratio of 22 that stocks in the S&P 500 have averaged for the past 20 years. (Let alone the 27 they've averaged over the past ten.)

That means you take a much bigger chance if you pick REITs over blue chips. Suppose REIT earnings grow 5% a year over the next half a decade, as analysts are predicting, and by the end of that period they settle back to their historical average price in relation to FFO. That would work out to a 5% loss in share price. Add in dividends, and an investment in REITs will be worth 22% more in 2010 than today. Now take S&P 500 stocks, expected to grow 6% annually during the next five years. If by 2010 they trade at their historical P/E ratio of 22, price appreciation plus dividends will create a total return of 47%.

Mind you, this is not a prediction. No law says that stocks or REITs have to return to their average valuation in the near (or not so near) future. But it does strongly suggest which market sector is on the right side of the law of probabilities. And it's not REITs.

Blue Chips for Yield and Value

All three sport higher after-tax yields than typical REITs. They're also undervalued compared with their five-year average P/Es.

NOTE: Data as of Sept 1. SOURCE: Thomson/Baseline.