Morgan Stanley's notes linked to real estate ETF seen as good play on REITs for savvy investor

By Emma Trincal

New York, Jan. 23 - Morgan Stanley is prepping an issue of 0% buffered jump securities due January 2014 linked to the iShares Dow Jones U.S. Real Estate index fund. Sources said the notes could be a better alternative than a direct exposure to the underlying exchange-traded fund.

The structure, they noted, offers the potential of an enhanced return along with some downside protection. Both features give investors a reasonable chance to outperform the ETF despite the fact that investors do not earn dividends with the product as they do with the ETF.

Investors, however, need to understand the sector they're investing in, a financial adviser said. They also must tolerate the credit risk of Morgan Stanley, another noted.

If the final share price is greater than the initial share price, the payout at maturity will be par of $10 plus the upside payment, which is expected to be 25% to 29% and will be set at pricing, according to an FWP filing with the Securities and Exchange Commission.

Investors will receive par if the share price remains flat or declines by 10% or less and will lose 1% for every 1% that it declines beyond 10%.

The iShares Dow Jones U.S. Real Estate index fund tracks the performance of the real estate sector of the U.S. equity market as represented by the Dow Jones U.S. Real Estate index.

The ETF has been rallying since fall. It is up 23% since last October on the view that U.S. home sales are showing signs of recovery. Other real estate ETFs have also posted strong performances as investors continue to flock into real estate investment trusts for the high yields they offer.

Fair structure

Scott Cramer, president of Cramer & Rauchegger, Inc., said that as long as an investor is comfortable with the segment tracked by this particular ETF, the notes represent an opportunity to outperform the underlying fund due to an attractive structure.

"If you like this space, I think it's a good way to play it over the next two years. You have a better shot at outperforming what the REIT ETF is going to do over that two-year period," he said.

"On the downside, you can limit the risk. And if the fund is up, the share price doesn't have to be up a lot for you to outperform and to get your upside payment.

"It's a fair trade-off."

One difference between these notes and owning the ETF outright is the dividend.

Fund investors earn about 4% per year in dividends, or 8% for the two-year term. The noteholders, on the other hand, do not receive dividend payments.

REITs own income-producing properties and are required by law to pay at least 90% of their income to investors. This has made those securities an appealing source of income for equity investors.

Cramer, however, still believes that the notes offer an advantage over the fund.

"While you're not getting your dividend, you can still outperform the ETF," he said.

"If for instance the ETF is down 10%, I may not have my dividends, but at the end of the day, I still outperform the ETF by 2%."

That would be because the fund investor would lose 10% in price and earn 8% in dividends, generating a net loss of 2%. The investor in the notes would get his principal back and not lose anything.

Cramer said that the potential to do better than the fund is true on the upside as well.

"Even if you take into account the dividend yield you're not getting with the notes, I still think the structured product is a better bet because I don't think you're going to get a 25% to 29% [return] from the space," he said.

Know what you buy

Cramer said he likes the structure but is less comfortable with the underlying fund.

"The first thing I would tell a client is 'You need to understand the sector and feel comfortable with that space,'" he said.

"Please understand that it's not a pure real estate play. It's an equity play on a real estate sector. And you'd better look at the underlying companies."

Cramer pointed to the fund's first holding, Simon Property Group Inc., with an 8% weighting.

"They specialize in malls. This is not going to be my favorite part of the real estate sector. There are plenty of malls that have gone broke," he said.

"Looking at the other holdings, you can tell that this is a mixed-use REITs ETF. It's not a sector-specific REITs ETF. You have things such as retail, industrial, office buildings, specialty REITs, mortgage and hotels.

"While if I think some sectors of the real estate space will do very well, I'm not particularly bullish on mixed-use REITs.

"But if you understand what you're buying and if it's an area you want to make a bet on, then this structured note is a good place to be in," he said.

Good upside

Mike Kalscheur, financial adviser at Castle Wealth Advisors, said he likes the buffer that protects investors against the first 10% decline but is wary about the credit risk of the issuer.

"I like buffers a lot. You get at least some downside protection no matter what the index does. A 10% is good," he said.

"There's also something to be said from a client's perspective. For instance, if the index is down 30%, you're down 20%. My goal is to outperform the benchmark, and with this type of product, I can."

Kalscheur added that he is comfortable with the risk/reward profile of the security.

"The 10% buffer is right because you don't want to give away the upside potential for more buffer," he said.

"Say you have a 20% buffer with maybe a 15% upside potential. If the market is up 50% and you're up only 15%, you're significantly underperforming the index.

"I'd rather hedge my bet by having more upside potential than a real significant downside."

Objections

Kalscheur noted that the "2.25% fee is not terrible over a two-year period," adding that some REIT mutual funds charge that much. "It's expensive for an index, but this is a structured note," he said.

His main concern is that investors are subject to the credit risk of Morgan Stanley.

"We get nervous with a single-A negative credit watch, and that's probably why the terms here are so good," he said.

"They have higher spreads. They have more room to play around with the numbers and put together a better product.

"I love the product. I just wished it was backed by a bank with a better credit.

"If we did buy this note, we wouldn't take a big bite of it. We would want to limit our exposure to that type of credit risk. Currently, we don't have any exposure to Morgan Stanley, and that's been intentional."

The notes (Cusip: 61760T389) will price and settle in January.

Morgan Stanley & Co. LLC is the agent.

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