Morgan Stanley's notes linked to real estate ETF offer absolute value return, REIT exposure

By Emma Trincal

New York, May 10 - Morgan Stanley's 0% dual directional buffered Performance Leveraged Upside Securities due May 2014 linked to the iShares Dow Jones U.S. Real Estate index fund offer attractive terms to investors seeking exposure to the real estate sector of the U.S. equity markets, sources said.

However, they must forego the rich dividends available to investors in the high-yielding, real estate investment trust-dominated exchange-traded fund.

If the ETF finishes above its initial level, the payout at maturity will be par of $10 plus double the gain, up to a maximum return of 28% to 32%, according to an FWP filing with the Securities and Exchange Commission. The exact cap will be set at pricing.

If the ETF finishes below its initial level but at or above the trigger level, the payout will be par plus the absolute value of the return. The trigger level is 85% of the initial share price.

If the ETF finishes below the trigger level, investors will lose 1.1765% for each 1% that it declines beyond 15%.

Decent terms

"It seems like it has really decent terms: the absolute value return, a buffer, some leverage on the upside and 15% a year as a cap. That's not bad," said Steve Doucette, financial adviser at Proctor Financial.

One of the "negative" aspects of the structure, however, is the downside leverage factor of 1.1765%.

"I've seen 1.1 or 1.2. But 1.176 is the biggest multiple I've see so far," he said.

Kirk Chisholm, principal at NUA Advisors, said that the structure is appealing for this type of underlying.

"It's a reasonable investment for someone who wants to be exposed to real estate," he said.

"As long as the index stays within a plus or minus 15% range at the end of that two-year period, it's still good. You get the leverage on the upside up to 30% in two years. And on the downside, up to a 15% decline, you still make some money."

Despite the downside leverage factor, the investor benefits from a superior type of protection with the buffer than what he would obtain from a contingent buffer or barrier, he noted. That's because once breached, a barrier would expose investors to all of the negative performance of the underlying from its initial level.

"With this note, the incurred losses are still buffered," he said.

Ups and downs

A 40% decline of the ETF at maturity would generate a 29.41% loss for the holder of the Morgan Stanley notes. In comparison, the holder of a note offering a traditional one-for-one 15% buffer would lose 25%.

Given the recent evolution of the REIT sector, the buffered protection can be helpful, Chisholm said.

"The real estate sector is at a point in time when a full recovery is still uncertain, but there are signs of life and improvements," he said.

"Large banks continue to have problems with non-performing loans sitting on their books. But people in some places like Florida are buying properties that have been discounted in price because it makes sense now.

"That's not to say the sector is not volatile," he said, noting that the ETF fell by about 20% between July and October last year.

"It's close to what the S&P 500 did. It's not without volatility. You can't really predict that the fund's performance will be markedly different from the S&P because they have been somewhat correlated. But at least you have that 15% buffer."

To have or not to have

According to the prospectus, investors in the buffered PLUS must forgo the right to receive dividends.

For Doucette, not having dividends is a drawback given the very nature of REITs, which are vehicles that invest primarily in income-producing real estate.

"If you're stripping down the dividend yield, you're giving up on a major component of what is traditionally real estate," he said.

Chisholm said, "If your interest is to invest in REITs for the income, you would more than likely not invest in the notes. For the note investor, the drive is more the expectation of growth in the sector."

Doucette said that for a change, the notes' duration may be too short. Usually, two years is his maximum tenor, he said.

"If you're looking at it from a capital appreciation standpoint, I may want to go longer. I know that I usually prefer short durations, but for this one, I may want to extend the term," he said.

"Historically, the value of real estate comes from very long cycles between peaks and troughs. It got hit very, very hard in 2006, 2007 and 2008.

"We always hold some exposure to real estate. We would have to take a look and see if something like that makes sense. Maybe the same structure but with a different underlying may work. Or if it's with this one, we may really prefer an extended maturity."

Chisholm said that giving up the fund's dividends is not a real concern. This disadvantage is offset by the terms of the structure, he said.

The annualized yield of the underlying ETF is 3.54%, or 7% for the two-year term.

"With the notes, you're not getting the dividends, but you're getting compensated for the lack of yield because you're getting gains from the negative performance of the fund up to 15%. This absolute value feature is a good way to buffer against losses just as a yield would. You're losing 7% in dividends, but you're getting up to 15% in absolute value returns," he said.

The notes (Cusip: 61760T801) are expected to price and settle in May.

Morgan Stanley & Co. LLC is the agent, and Morgan Stanley Smith Barney LLC will handle distribution.

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