After Two-Year Slide, REITs Showing Signs of Recovering
After taking a beating for the past two years, real estate investment trusts are regaining popularity with investors looking for bargains and a way to capitalize on an industry rebound.
More commonly known by their acronym, REITs are funds that provide investors with a broad range of investment opportunities while delivering substantial tax breaks to the corporations that set up the vehicles.
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Wildly popular in the earlier part of the decade during the real estate boom, REITs nosedived in 2006 and 2007 as the market fell correspondingly.
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But recent developments over the past several weeks have sharp-eyed investors again examining REITs as a way to profit from a looming rebound in the industry.
And contrary to the growing trend of investors to eschew the traditional buy-and-hold stocks strategy, REITs are being looked at as long-term plays that will stand up against expected economic trends.
"It's not a play I'm looking to go into for a month or two. Over the next several years there will be opportunity in REITs," says Joe Heider, president of Dawson Wealth Management in Cleveland, which manages more than $400 million in assets.
"The market did oversell, and if you look at the replacement costs, the net asset value of these individual REITs, and roll them up into a portfolio, that is where the opportunity is."
But it's been a tough ride getting here.
REITs have fallen precipitously over the past two years. In 2007, the FTSE National Association of Real Estate Investment Trusts All REIT Index fell 17.83 percent, then dropped 37.34 percent in 2007. While the index is down more than 10 percent in 2009 after negative months in January and February, March posted a 4.41 percent gain and April saw a rise of just under 28 percent.
Industry experts trace the rebound in REITs to several factors.
Over just the past several weeks publicly traded REITs have gone to the marketplace and raised more than $10 billion in equity, according to Real Capital Analytics, a New York firm that follows real estate trends. While that can be dilutive to share prices, the ability to raise cash in a market that has struggled for liquidity has been a show of strength from some of the less debt-laded companies.
There also has been an important economic trend that has fed into enthusiasm for REITs: Growing optimism that the economy is improving--so much so that inflation could be the next significant problem. Real estate is generally seen as an effective hedge against inflation as property values increase.
And there's also value: REITs have tumbled in some cases more than 60 percent in the past two years, worse than even the woeful stock market performance and coming in as one of the biggest investment losers. Despite continued fears that the worst may be yet to come for commercial real estate, the performance of REITs could change soon.
Experts see industrial REITs as being particularly strong, followed by office, residential and retail.
"You're buying the prospect of recovery--stability first, then recovery," says Peter Slatin, editorial director at Real Capital. "These companies, for the most part if they're well managed and have a strong balance sheet and can manage upcoming debt securities, they are poised to weather the storm."
A Bevy of Choices
In evaluating companies, investors are looking at a variety of factors, with sound management and debt load considered paramount.
While commercial REITs naturally hold lower debt because of tougher loan-to-value ratios banks require for developments, some companies are better positioned than others.
Some investors prefer diversity, such as Heider's choice of Russell Real Estate Securities (OTC Funds: RRSCX), which employs multiple managers and invests across an array of residential, commercial, retail and other offerings.
Many investors are familiar with the bigger REITs such as Vornado Realty Trust (NYSE: VNO) and Simon Property Group (NYSE: SPG). But various smaller companies provide value as well.
Among some of Slatin's recommendations are Mack-Cali Realty (NYSE: CLI), Digital Realty Trust (NYSE: DLR), SL Green Realty (NYSE: SLG) and First Potomac Realty Trust (NYSE: FPO).
"Is this a buying opportunity? Yes, but one has to be very selective with REITs," Slatin says. "Most of the companies that have issued equity in the last year are good companies on the up and up and have long-term solid growth prospects."
Some with a more cautious view are buying convertible REIT shares just in case the economy remains unstable.
Convertibles provide yield while also offering protection if share prices get hit.
Average yield for REITs now runs above 7 percent.
"REITs have cut dividends to preserve capital," says David Grenier, president of Cutler Capital Management in Worcester, Mass. "We find by being in the convertibile securities we're less likely to lose that income stream. So we've become more defensive."
Among the companies Grenier finds compelling include Essex Property Trust (NYSE: ESS), Health Care REIT (NYSE: HCN) and Lexington Realty Trust (NYSE: LXP).
"If you make the call that the whole economy roars back quickly, you're still in the game becaue your convertible security will increase in value," he says.
Another variable in REIT investing is how the industry weathers the consolidation likely to occur, just as it has in financials and others hurt during the credit crisis.
As a fresh round of debt comes due on commercial real estate holdings, portfolio managers are watching closely to see which companies will have the most staying power.
"Good companies, or perceived good companies, will have access to the capital markets. But companies that don't have sustainable cash flows ... are going to be looked at differently," Grenier says. "It's that grouping here that will really struggle and then roll over into another phase, which will be a merger and acquisition phase."
A larger-than-expected surge in loan defaults could cause further turmoil in the real estate market and create a more challening investing environment.
"It's very hard to underwrite what the future will be right now. The biggest component is it's so hard to source debt," says Jonathan Schultz, managing principal of Onyx Equities, a Woodbridge, N.J.-based high-end commercial investor. "I just think everybody's still in a little bit of denial of what real estate is really worth."
Optimists, though, think most of the bad news is already priced in to the market, making solid REITs and real estate as a whole a bargain.
"What you would call opportunistic buyers are considerably more active than even just two months ago," says Ross Moore, director of marketing research at Colliers International, a Boston-based real estate investor. "There's a perception that we may have hit bottom and now is the time to start looking."
Despite what he calls "a tough slog ahead" Moore also sees REITs, particularly those that focus on industrial properties, as solid value over the long term.
"It's what's baked into the price that really matters. Obviously real estate is a tough sell bearing in mind what's going on in the residential world," he says. "The flip side is a lot of the bad news is known so prices have come off. If you're getting into REITs now, over the next five years you're probably going to do very well."For more stories from CNBC, go to cnbc.com.