By all accounts, real estate investment trusts find themselves in the proverbial sweet spot. The moderate, albeit choppy, economic recovery has helped boost real estate fundamentals while simultaneously capping any rally for the broader equities market.

In fact, the REIT market has outperformed every broad market index since 2000. The only exception was 2003, when the Nasdaq Composite Index shifted into recovery mode, beating REITs, according to research firm SNL Financial. In 2003, the Nasdaq finished up over 50% on a price basis only. The total return for the Morgan Stanley REIT Index was nearly 27%.

So far this year, REITs remain hot. As of mid-October, the Morgan Stanley REIT Index had posted a total return of 17.8% year-to-date, while the S&P 500, Nasdaq Composite Index and Dow Jones Industrial Average were all in the red (see chart, p. 22).

So, it's little wonder that both institutional and individual investors continue to place their bets on REITs. With returns on other asset classes falling, investors have been pouring money into REITs and driving up prices.

Last year, a record $4.75 billion flowed into real estate mutual funds, according to AMG Data Services. Through September of this year, investors have plowed nearly $4 billion into real estate mutual funds. Real estate funds posted an average 12-month total return of 25% at the end of September and were ranked the fourth-best performing mutual fund category in The Wall Street Journal's third-quarter mutual fund report, based on trailing 12-month performance. Only Latin America funds, gold-oriented funds and natural-resources funds performed better.

Caution Ahead

But over the past several years, REITs have become much more expensive on a price-to-earnings basis. In 2001, REITs generally traded at a price-to-FFO (funds from operations) multiple of 10. Today, based on a broad index of REITs, the average stock is at a 13 multiple, SNL research shows. The question now is whether inflated share prices will hold or bust. “If REITs have historically traded at 8- to 10-times multiples, then share prices might have to come back down,” says Keven Lindemann, director of the real estate group at SNL Financial.

“REITs have had a very good run, and I'd almost say the run is over,” adds Timothy Pire, managing director of the real estate securities group at Heitman LLC in Chicago, where he oversees investments by pension funds and other institutions. “But if I'm a chief investment officer, I'd look at my alternatives and wonder, ‘where can I go?’”

Short-term investors should be cautious, advises Keith Pauley, an analyst with LaSalle Investment Management Securities. “The REIT market is pricing in the economic recovery and improving fundamentals, and if that doesn't come to pass there will be a re-evaluation.”

So, are investors heeding the analysts' warnings and dialing back their REIT allocations?

There has been “a bit of a pullback” by institutional investors, says Doug Poutasse, principal and chief investment strategist with Boston-based AEW Capital Management, but that's primarily because investors need to routinely rebalance their portfolios. Institutional investors today typically allocate about 25% of their total real estate holdings to REITs, explains Poutasse. With the annual return of REITs since March 2000 climbing well into the double digits, the value of those holdings has soared relative to the real estate portfolio as a whole.

“The ones who are pulling back aren't doing so because they think the market is overvalued, they're pulling back because they've exceeded their targeted amounts due to REITs' strong performance,” says Poutasse, whose firm is plugged into the investment community. AEW manages $5 billion of real estate securities for institutional and individual investors.

Some institutional players who are having a difficult time investing in the private real estate market at their desired pace — perhaps due to the intense competition for product — are plowing even more money into the REIT market, explains Poutasse. That can result in investors exceeding their 25% target allocation for REIT stocks, which forces them to do one of two things: either rebalance the portfolio or increase the target allocation.

The growth of REITs as part of institutional investors' real estate portfolios has been nothing short of dramatic. Five years ago, less than half of investors plowed money into REITs, Poutasse recalls, and when they did it was typically only 5% to 10% of their total real estate allocation. Three years ago, the transition had begun with allocations rising to 10% to 15%, but even then the number of participants was far fewer than today. “The average person at a pension fund knows something about these REIT companies today, whereas five or six years ago they didn't know anything about them.” The inclusion of Equity Office Properties in S&P's 500-stock index in 2001 undoubtedly helped REITs enter the mainstream.

A Brief Retreat in Performance

During the current run, REITs already have dodged one bullet: rising interest rates. After 14 consecutive months of positive total returns, REIT stocks retreated early this spring on speculation that the Federal Reserve would start raising rates in response to an improving U.S. economy. The specter of higher rates shaved 15% off REITs, on a total return basis, in April.

“There is a general nervousness about REITs. They've done really well in a low interest rate environment,” says Kelly Rush, director and portfolio manager for Principal Investors Real Estate Securities Fund (PRRAX). Many investors worry that REITs will not perform well when interest rates rise.

While the Federal Reserve has increased short-term rates three times this year, the 10-year Treasury note — a benchmark for all long-term interest rates — registered nearly 4% in mid-October down from 4.85% in June. Some industry observers believe that the drop in the 10-year yield is due to concern over a slowing economic recovery.

Of course, trying to figure out what will happen to the economy is best left to economists, but even their projections can be wrong.

Jon Fosheim is CEO of Oak Hill REIT Management LLC, a new private-equity investment firm sponsored by Texas billionaire Robert M. Bass that is focusing on REITs. Fosheim attended a REIT conference in June when short-term interest rates had started rising and the 10-year Treasury note registered 4.85%. The consensus among several major economists who participated in a panel discussion was that the 10-year Treasury note would end the year at 5.5%. “They all got it wrong,” Fosheim says. Although rates could rise after the presidential election, a spike that high is now generally considered unlikely by experts.

REIT stocks have rebounded as long-term rates have fallen. From April to October, REIT shares have returned to near historic highs and are now up 12% for the year. The key driver is rate of return. With high-quality corporate bonds yielding less than 4% and the dividend yield on the S&P 500 at less than 2%, REITs offer a relatively attractive current income opportunity. “Even with the high share prices, [REITs] have been paying out healthy dividends. The average dividend yield is 5.5% or close to 6%. Where are you going to get that these days?” Lindemann asks.

While the interest-rate bomb has stopped ticking, it has not been defused. “With recent acquisitions trading at yields below 6% and borrowing costs in the low 5% area, interest rates do not have to move much before the spread is gone,” wrote Citigroup Smith Barney analyst Jonathan Litt in a September report in which he downgraded all REIT issues and advised investors to underweight the sector. Litt also is concerned about the collapse of a commercial real estate bubble.

Litt's worst-case scenario is based on a faltering recovery. But if the economy muddles along, he says, REITs will still look attractive as net asset values (NAVs) gradually rise and cap rates fall.

A Matter of Interpretation

One common metric used for valuing REITs, net asset value (NAV) — basically the underlying value of the real estate in a company's portfolio — shows how expensive REITs may be getting. SNL tracks 130 public REITs, and Lindemann studies the NAV estimates that Wall Street analysts are calculating for those stocks. He then matches the share prices of the stock to the NAV estimates. His conclusion: Investors on average are paying a premium of 11% over the NAV numbers for REIT stocks.

In early October, the stock of major mall REIT General Growth Properties, which announced its $12.6 billion purchase of The Rouse Co. in August, was trading around $32.50, compared with an NAV estimate of $23.30, estimates Citigroup Smith Barney. That's a 39% premium and a price that sets off alarms among some investors.

Such data has many concerned that REITs are overvalued. In response to analysts' comments regarding the Rouse deal, General Growth is quick to point out that it is paying what the private market dictates.

“Part of the reason REITs look expensive on an NAV estimate is that analysts' estimates of NAV are very conservative in relation to where transactions are happening on the private market,” says Pauley of LaSalle Investment Management Securities.

Rating the Property Types

Litt isn't the only Wall Street analyst to express concerns about REIT valuations. Every fund manager interviewed by NREI for this story agreed that REITs are getting expensive. But they also expressed their devotion to the sector, mostly because of REIT stocks' ability to post solid, long-term historical returns.

And, notes Pire of Heitman, one-half to two-thirds of REITs' total returns come from the “income return” of dividends — or that portion of the total return of a REIT that goes back to the investor as income — which are generally stable.

Performance, of course, varies by property type. So, which sectors are the best performing? Retail gets the nod from many managers. “It's been the one place where one can invest with confidence in recent years, and it continues to exhibit strong fundamentals,” says Rush of PRRAX. Retail REITs are up 20% year-to-date as of Sept. 30 (see chart, p. 22).

“Retail continues to be the solid part of the foundation of a portfolio today,” says Michael Torres, CEO of Berkeley, Calif.-based Adelante Capital Management LLC, formerly Lend Lease Rosen Real Estate Securities LLC. Adelante Capital invests in REITs on behalf of institutions and pension funds. Although Torres admits mall stocks are getting pricey, he is high on the sector because he believes that development of new malls will be constrained, and existing owners will benefit.

However, the retail sector does pose some risks next year, especially if there is a dramatic pullback in consumer spending. That would be precipitated by a stronger-than-forecasted rise in interest rates, which would hurt mortgage refinancings, the method by which many consumers are getting their excess cash, says Hans Nordby, a research strategist with Property & Portfolio Research.

“If retail sales get hurt by the end of cash-out refis faster than they benefit from increased hiring [in the overall job market], then retail sales will take a hit,” Nordby says. “All of that will be exacerbated by increases in interest rates higher than what we expect.”

Many expect the office sector to show improving fundamentals in 2005 with Gross Domestic Product (GDP) growth accelerating and productivity waning, which will force employers to hire more people, boosting the need for additional office space. “Everybody knows the office market will rebound,” Fosheim says. “The tougher part is to answer the question of whether it is factored into the share price.”

If interest rates rise, the apartment sector will perform better, fund managers say, since homeownership becomes less affordable than renting. A rise in interest rates due to an improving economy means more jobs and more renters.

Ultimately, an improving economy also means healthier profits for corporate tenants in commercial properties owned by REITs, which translates into improving real estate fundamentals. Says Torres: “It's hard not to have confidence.”

Analysts and industry experts alike agree that smart investors should consider a diversified strategy. “For low-to-moderate risk investors, we believe diversified portfolios provide the best risk-adjusted returns,” says Poutasse of AEW Capital. “Higher-risk investors may need to execute much more concentrated strategies without diversification.”

Meanwhile, the debate over valuations will continue, predicts Torres of Adelante Capital, but that hasn't yet curbed his clients' appetite for REITs. “But the flip side is what is my investment horizon? My investors look out three to five years.”

Fund managers generally agree that REITs will remain a winning strategy over the long haul. “We think with regard to REIT stocks, it's really impossible to see the future,” Rush says. “If you have a long-term focus [of 7 to 10 years], over that period of time, you'll get a good return” in the high single-digits to low double-digits range.

Nicholas Yulico is an Oakland, Calif.-based writer. Editor Matt Valley contributed to this report.

REIT RETURNS -VS- INVESTMENT ALTERNATIVES

Domestic price-index returns are listed in annual percentage changes.

2004 YTD* 2003 2002 2001
Morgan Stanley REIT Index ** 17.8% 36.74% 3.64% 12.83%
S&P 500 -0.78% 26.38% -23.37% -13.04%
NASDAQ -5.01% 50.01% -31.53% -21.05%
Dow Jones Industrial Average -5.35% 25.32% -16.76% -7.10%
* As of Oct. 14, 2004
**Percentage change in total returns, defined as the aggregate value realized by a common shareholder during the year, including price increases and dividends paid. The dividends are reinvested into additional shares of common stock.
Source: SNL Financial


EQUITY REIT RETURNS BY PROPERTY SECTOR

Percentage Change In Total Returns
2004 YTD* 2003 2002
Retail 20% 48% 21%
Regional Malls 24% 54% 25%
Shopping Centers 17% 42% 16%
Multifamily 14% 26% -6%
Industrial 12% 33% 17%
Hotel 11% 30% -1%
Office 9% 33% -4%
*YTD as of Sept. 30, 2004
Source: SNL Financial