After back-to-back years with 30 percent gains, REIT stocks finally appear to be showing signs of flagging. While retail REITs are still performing better than their peers, they too are well behind their torrid pace of the past two years.

Has the long-awaited pullback from REITs begun? Observers say no. But what is true is that the market is experiencing much greater volatility than before, which is puzzling to analysts who point to continued strong fundamentals.

“I don't think there's been a shift in underlying properties,” says Merrie Frankel, vice president and senior credit officer at Moody's Investors Service. “Retail REITs seem to be able to get tenants, to renovate and to do what they have to do.”

Retail REIT balance sheets are clean. And even with a healthy pace of development and some acquisition still occurring, REITs aren't stretching themselves.

“From a debt side, we've had a positive outlook for the sector,” says Matt Gallino a director and REIT analyst at Fitch Ratings. “Over the past three to four months, we've had several upgrades, but no downgrades. … There is low exposure to floating rate debt and most have long-dated debt on their books.”

With third-quarter earning season kicking into gear, early reports were encouraging. But investors haven't responded. They seem spooked by interest rate concerns and the possible impacts on property values and stock prices. In early August, the Morgan Stanley REIT index hit its high for the year — up 11.1 percent over the 2004 close. Since then it's pulled back to nearly flat as the third-quarter earning reporting season began in earnest in late October.

With REIT stocks down in August and flat in September and down in October, REITs are experiencing their first prolonged struggle since the REIT rally began in earnest in 2001. The year as a whole has seen much more fluctuation in REIT stock prices than in the past. There have been several pullbacks and recoveries in the Morgan Stanley REIT index. But an ominous sign is that the REIT rallies following the most recent pullbacks have both been weak.

Pricing instability

The story has been true across the board. In retail, shopping center REITs had posted a total return of 7.1 percent through Sept. 30 while regional mall REITs were at 14.4 percent, according to Morgan Stanley. Both are healthy figures and ahead of other property types, but well behind last year's gains of 36.3 percent for shopping centers and 45 percent for regional malls. Some analysts say the recent trading results are indicative of a new stage for REIT stocks in which there will be greater volatility in pricing than the past.

“It's like kids growing up. As you change, one group of issues replaces another,” says Barry Vinocur, editor of Realty Stock Review. “It used to be that nobody paid attention,” so trading volumes were low and prices were stable. “Today there are more indices, more trading activity.”

In a study of the Morgan Stanley Index, Vinocur found that over a period of 403 trading days between April 2004 and October 2005, the index rose or fell by more than 1 percent 130 times — or 32.4 percent of the time. Over the same time frame in 2002 and 2003, it did that 25.3 percent of the time. In a more comprehensive study, Morgan Stanley Capital International found that REITs have had a greater volatility than other indices in the past two years, but had the lowest volatility looking back over five- and 10-year spans.

Analysts say that recent fluctuations are due to heavier trading in REIT stocks than has been historically the case. In the past, REIT stockholders have been long-term holders in the sector. But REITs today have a higher profile and are drawing in a more diverse crop of investors, some of whom are cycling money in and out, leading to higher volatility.