Retail REITs that attracted attention last year for outperforming other property types have fallen out of favor in recent months.

Mutual fund managers are placing comparatively smaller stakes in strip center, regional mall and outlet center REITs, and have opted to put much bigger investments in office, industrial and apartment REITs.

For example, the Davis Real Estate Funds portfolio comprises 33 REIT stocks, only two of which are from the retail sector, says Andrew Davis, portfolio manager for the Santa Fe, N.M.-based firm.

The fund's holdings include General Growth Properties Inc. (GGP) and JDN Realty Corp. (JDN). "We like those two companies. We're not enamored with the rest of them," Davis says of the retail REITs. (GGP and JDN represent the stock ticker symbols).

"We share the view that the retail REITs are being viewed negatively," says Mark Zeisloft, a vice president and retail analyst with RREEF Securities in Chicago.

Vital signs Low retail REIT stock prices have created opportunities for bargain hunters. Some retail REITs feature low prices and good dividend yields, Zeisloft says. But many investors are still hesitant. They are waiting to see if those retail REIT stock prices will drop even lower, he notes.

Although retail sales have enjoyed strong growth, real estate mutual fund managers are wary of investing in shopping center REITs partly because of their lackluster performance compared with other property types.

According to NAREIT statistics, retail REITs have posted a year-to-date return of -5.14% as of Sept. 14, which is much lower than the 0.48% return in industrial; 3.9% in office; and the whopping 9.34% in apartment REITs.

Retail REIT prices have been influenced in part by Wall Street's fears relating to rising Internet sales, as well as concerns about an economic downturn, even though no such decline appears imminent.

Mutual fund managers also have their own reasons for avoiding retail REITs. There are several solid property owners and managers among the retail REITs, yet it remains difficult to make money in their stocks, says Skip Aylesworth, a fund manager for FBR Realty Growth Fund, part of the Friedman Billings Ramsey family of funds based in New York.

"Weingarten Realty is one that has been a terrific company, but it has been tough to make money at simply because it's so expensive," Aylesworth says. Weingarten Realty Investors (WRI) is one of the higher priced retail REITs, trading at about $40 to $46 per share.

The FBR Fund portfolio is about 7% retail REITs. "We want to maintain some retail allocation for diversification purposes," Aylesworth says. "We're not wrinkling our nose at retail. Part of it is the numbers, pricing, etc."

Aylesworth also admits to being wary of some of the dynamics of the retail environment, such as the Internet, an active development cycle and a decline in mall population. "It's a tough industry in our eyes to be able to push rents up," he says.

"Retail is harder to figure out," agrees John Kramer, co-portfolio manager of the Fremont Real Estate Securities Fund, a fund launched by Fremont Investment Advisors Inc. in San Francisco.

There are more trends that affect (retail) than pure supply and demand. "It's not just e-commerce," explains Kramer. "It's Gap and Old Navy, and the move from malls to the Main Street arcade."

About 17% of the Fremont Fund is invested in retail REITs. Currently, the fund has 2% in regional malls, 9% in strip centers, and the balance in diversified REITs.

"We're neutral to cautious on retail stocks in general," says Paul Gray, co-portfolio manager of the Fremont Real Estate Securities Fund. Part of that caution is due to supply issues. Development has been ambitious across the board, and one concern is that some retail markets will end up being over-stored, Gray says.

Negative indicators Ironically, the strong run in consumer spending has helped to push REIT stock prices down. "People are asking, 'How much better can it get?'" Zeisloft says.

The conventional wisdom on Wall Street is that the retail industry is at its peak - with nowhere to go but down, explains Zeisloft. That translates to scaled-back expansion plans among retailers, and ultimately lower earnings growth for REITs, he adds.

A consumer spending binge and aggressive retailer expansion have helped boost occupancies among REIT portfolios. The regional mall category is reporting close to 95% occupancies. "That's at the upper end of the range where it becomes a lot more difficult to realize further gains," Zeisloft says.

As a result, shopping center REITs are facing slower internal growth. If the economy takes a downward turn, and consumer spending drops further than what people expect, those occupancy numbers could take a prolonged nose dive. "The market is saying that there is more risk in occupancies and earnings growth going down over the next six to 18 months than there is for it to go up," Zeisloft says.

E-commerce effect Another uncertainty is how e-commerce is going to impact bricks-and- mortar retail stores. "The question with retail REITs - at least the popular question - has been, 'What is the impact of the web?'" Davis says. "I'm in the camp of believers that malls will not get destroyed by the Internet."

Some retail property owners will suffer a negative impact from the Internet, but others are discovering new ways to use the Internet to their advantage. General Growth is using the Internet to electronically distribute mall coupons.

Davis is attracted to retail REITs like General Growth not only for their performance but also for their innovation in leveraging the Internet in marketing strategies. Nevertheless, Wall Street's concerns about the effect of the Internet are likely to drive down the return potential on retail stocks in the short term.

"There has been a lot of talk about Internet sales leakage - and, yes, Internet sales are growing fairly rapidly," says Joe Rodriguez, portfolio fund manager for the Houston-based AIM Advisor Real Estate Fund.

However, retailers that offer both physical stores and an online presence are likely to be the retailers of choice in the future, Rodriguez explains. During that transition period, there is likely to be some shakeout among both retailers and some of the weaker malls that are more susceptible to Internet competition, he adds.

"Our concern is that we can't quantify the transition between physical store sales and the Internet," states Rodriguez.

Investors are worried about REITs that have a strong power center component. "In general, we don't like power centers right now. We believe that centers which compete mainly on price will suffer the most from Internet sales leakage," Rodriguez says.

Neighborhood centers are considered to have the lowest exposure to Internet fallout. "We're comfortable with grocery-anchored centers. We also like the idea of these neighborhood (center) REITs that have very low debt and are in this segment of the market," he says.

Looking for an edge Several fund managers are using retail REIT investments as a means to add stability and diversity to portfolios. "Our retail exposure is between 10% and 15%," Rodriguez says. "We primarily view the retail segment of the REIT universe as being fairly defensive, so we don't expect a lot of growth out of these stocks."

The AIM Fund currently owns stock in three regional mall REITs and three strip center REITs. A primary draw for the strip center REITs is the very low debt ratio, he notes.

Features the AIM Fund looks for in mall REIT investments include strong and improving sales per square foot and proven development or redevelopment capabilities. As of June 30, the three mall REITs the AIM Fund owned stock in were General Growth, Simon Property Group (SPG) and CBL & Associates Properties Inc. (CBL).

"We're looking for good management teams and good franchisees," Rodriguez says. "In this case, CBL and General Growth have the added dimension of a development pipeline to significantly enhance their earnings."

The Fremont Real Estate Securities Fund holds a stake in Malan Realty Investors (MAL) as one of its few retail investments. Malan is attractive because it's trading at a 15% discount and its yield is above 11%, Gray says.

Another more risky buy for the Fremont Fund is Developers Diversified Realty (DDR), which has a yield between 9% and 9.5%, Gray says. "We believe that to be undervalued."

According to SCW's monthly stock scoreboard, DDR closed at $14.75 per share on Sept. 7, down from its 52-week high of $19.63 per share.

Investment strategy The FBR Realty Growth Fund uses three different strategies to identify potential investments.

One method is to focus on high-quality, blue-chip real estate companies. These firms are liquid and well regarded in the investment community. "The only negative to that group is that they're generally expensive," Aylesworth says.

Currently, the FBR Fund has no retail stocks among its blue-chip holdings. In the past year, the FBR Fund has owned stock in firms such as Kimco Realty Corp. (KIM) and Bradley Real Estate Inc. (BTR).

However, the FBR Fund sold its positions due to stock movement, or what Aylesworth likes to refer to as the "Warren Buffet rally." Warren Buffett, chief executive of the investment conglomerate Berkshire Hathaway Inc., bought 5% stakes in two retail REITs, Tanger Factory Outlet Centers Inc. (SKT) and Town & Country Trust (TCT). Buffet's REIT purchase this spring helped boost some prices within the REIT sector.

A second FBR Fund strategy focuses on "value plays" - investments perceived to be good companies but are out of favor. Value buys include Acadia Realty Trust (AKR) and Malan Realty.

The fund's third strategy focuses on "opportunistic plays" - distressed companies that may be extremely out of favor due to a change in management or potential merger or acquisition.

First Union Real Estate Investment (FUR) is one buy on the opportunistic side of the ledger. The REIT is in the process of selling its regional mall holdings, and First Union's stock has dipped from $15 to $4 per share.

Many mutual fund managers are basing investment decisions on stock fundamentals vs. property type. Davis Real Estate Funds, for example, concentrates on finding appropriately valued companies with growth potential.

"I'm not avoiding retail for any specific reason," Davis says. "We really don't look at it by group. We look at it by company."