Tuesday, March 15, 2005

The Wrong Time for REITs?

Business Week

While overall 30%-plus returns may be gone, some subsectors, such as mall and office trusts, are likely to remain good buys

As interest rates continue to rise and strength in the stock market persists, the stellar 30%-plus returns that investors have been enjoying from real estate investment trusts (REITs) the past few years are starting to wither. Although the sector outlook has turned decidedly bearish, keen-eyed investors may still find some good buys that perform well.

Since the start of the decade, REITs had helped assuage investors' wounds from the devastation of the Internet bubble. While the sector didn't provide the dizzying returns of that the tech market did in the late '90s, the publicly traded stocks that are real estate holding companies returned 15% annually for five consecutive years. REITs turned in their best performances the past two years, with total returns for the Morgan Stanley REIT Index increasing 36% in 2003 and 32% in 2004.

That success was driven primarily by fund flow, experts say, as many investors who had been burned in tech stocks turned to real estate seeking income and appreciation. Yet those days likely are near an end. With the sector's strong correlation with interest rates, the Morgan Stanley REIT Index (RMS ) is already down more than 5% for the year. When rates spike, which they have lately, prices on bonds plummet -- as do the returns on REITs.

PRICEY COASTS. Analysts such as RBC Capital Markets' Jay Leupp sees total returns falling up to 10% in 2005, while Lehman Brothers' David Harris has an even more bearish prediction -- an 18% decline. "As yields increase in the stock market or in the bond market, the attractiveness of REIT dividend payouts decrease as their dividend yields look less attractive," says Michael Knott, an analyst at independent real estate research firm Green Street Advisors.

Analysts are especially negative on residential REITs, such as Archstone-Smith (ASN ), AvalonBay Communities (AVB ), and Essex Property Trust (ESS). Residential REITs generally are among the most expensive subsectors, but these particular ones are considered likely overvalued because they hold coastal properties, says Harris. At the same time, "single-family housing starts are up to all-time highs, and there's also some excess building around the condominium sector, especially in South Florida, Washington, D.C., and Southern California," he adds.

Despite the bearish outlook, REITs still make sense for anyone looking to diversify their portfolio with some income-generating real estate. Over the past few years, the stocks have proved to be a profitable defensive investment, with average dividends of 4% to 6% on top of stock-price appreciation. Most of their earnings are paid out in dividends from cash flow based mostly on long-term leases, making them less risky than other businesses, says Don Wood, CEO of retail shopping center REIT Federal Realty (FRT ).

RETAIL RESILIENCE. Despite his negative prediction for the sector this year, Leupp, like many other experts, believes REITs remain a strong investment class. "The fundamentals -- earnings growth and dividend growth -- are still positive," says Leupp. "High-quality, well-maintained, well-positioned real estate assets will provide investors with superb returns over the long term."

Analysts point out that the fundamentals found in certain sectors mean they'll likely hold their own in comparison with others in a Goldilocks economy -- one not too cold, not too hot. "Retail REITs have tended to remain strong, particularly in the mall area," says Lehman Brothers' Harris.

REITs specializing in buying and managing mall properties are a favorite of analysts and managers in 2005 because of their economies of scale and national tenant base. Some mall-subsector REITs such as Simon Property Group (SPG ) and General Growth Properties (GGP ) have seen a real improvement in fundamentals. They also have an advantage in this sector because it's difficult to add to capacity of existing malls or build new ones to compete, says Richard Cervone, portfolio manager of Putnam Investors Fund.

CHEAP ALTERNATIVES. Cervone and Harris like these two REITs, both of which have made significant improvements to the malls they own. Also General Growth Properties recently acquired Rouse Company and its portfolio of properties. Harris includes Macerich (MAC ) and Developers Diversified (DDF ) among his top picks as well.

Office REITs are also looking cheaper compared to most other sectors and have the greatest growth potential, says Green Street's Knott. He recommends Boston Properties (BXP ), whose properties are concentrated in top markets such as New York, Washington, D.C., and San Francisco.

Investors looking to make a killing in REITs have probably missed their chance this cycle. Returns of more than 30% in all likelihood won't be repeated anytime soon. But for careful long-term investors looking for diversity and to keep a portion of their portfolio in real estate, REITs can still do the job.

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