After a decidedly up and down 2007, executives with many of the nation’s real estate investment trusts (REITs) may breathe a sigh of relief when 2008 draws to a close, according to a report by Steve Sakwa, research analyst with Merrill Lynch in New York.

Sakwa and his analytic team are forecasting high single-digit returns for REIT stocks when December 2008 rolls around, quite a turnaround from the dismal 21.6% drop in returns just registered for 2007 by the Dow Jones U.S. Real Estate Investment Trusts Index.

But that good news comes only after a challenging first six months. Sakwa is cautioning REIT investors to hold their money on the sidelines through the first half of the year, which he predicts will be rocky. “We expect to see cap rates move higher over the next six months, and real estate values to decline on the order of 10% to 15%,” he notes.

In the apartment sector, the growing risk of a recession, coupled with increased competition from the high volume of renters in single-family households, has Sakwa generally “cautious” on the group. His top stock picks include Aimco (AIV), Home Properties (HME), and American Campus Communities (ACC), while pans include Avalon Bay (AVB), BRE Properties (BRE) and Camden Property Trust (CPT).

In the closely watched retail sector, while mainstream investors are busy checking out holiday sales figures, Sakwa believes a better barometer of retail’s health is found in the pace of store closings and new store openings in early 2008. The reasoning is that store closings have an immediate impact on retail real estate, while slower revenue growth does not lead to immediate earnings reductions for retail landlords.

“We expect companies with lower quality assets – CBL & Associates Properties, Glimcher Realty Trust, Pennsylvania Real Estate Investment Trust, Cedar Shopping Centers – to be impacted to a greater degree than upscale retail owners,” says Sakwa. That explains why his top retail REIT picks include Federal Realty Trust (FRT) and Regency Centers (REG) in the shopping center sector, and Simon Property Group (SPG) and Taubman Centers (TCO) in the mall sector. Sakwa believes their strong balance sheets can best weather the financial storm and deliver consistent earnings growth.

When it comes to the office market, the nation’s largest office center, New York City, will be a closely watched barometer. Sakwa believes Big Apple office rents will decline by 10% this year, but rents could soften further if Wall Street job losses mount in the coming weeks.

Office space absorption nationwide is expected to slow to 50 million sq. ft., versus an estimated 59 million sq. ft. in 2007. And while the investment sales market has come to a screeching halt, foreign investors continue to aggressively source deals, particularly in New York.

“We expect well-capitalized investors to selectively pick off deals, while foreign capital could provide a floor to pricing across trophy markets such as New York City, Boston, Los Angeles and San Francisco,” says Sakwa.

His top stock picks are SL Green Realty Corp. (SLG) and Vornado Realty Trust (VNO), while pans include “suburban operators” HRPT Properties Trust (HRP), Mack-Cali Realty Corp. (CLI) and Brandywine Realty Trust (BDN) due to their concentrations in high-vacancy, low-job-growth, non-supply-constrained markets.

Industrial REITs were a shining star in 2007, returning 2.3% on a total return basis, more than 1,900 basis points higher than the broader REIT universe. But given the slowing U.S. economy, projected slowing in shipping volumes, and already high stock valuations, Sakwa is cautious on the entire sector.

So what company is Merrill’s shining star among top stock picks for 2008? Guess again, it’s Digital Realty Trust (DLR) which owns data centers and internet gateways in the U.S. and in Europe. Sakwa expects DLR to grow its funds from operations by 19% in 2008 on top of 25% growth in 2007.

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