How long will the REIT rally last?

Contrary to all the doom and gloom coming out of the housing industry these days, the commercial real estate market is alive and well, and real estate investment trusts are enjoying a historic rally.

The broad category of REITs, as measured by the FTSE Nareit All Equity REITs Index, gained 204.7% from the March 6, 2009 market bottom through March 31 of this year. That compares with a 112.8% gain by the Dow Jones U.S. Total Stock Market Index over the same period.

MORE ROOM TO RUN

Despite the solid run, the REIT index is still 18% below its February 2007 peak, which has some market analysts suggesting there is plenty of upside in the current bull market cycle.

“A normal real estate cycle is about 18 years, and we just went through a two-year downturn followed by two years of recovery, so that means there’s about 14 years of recovery left,” said Brad Case, a real estate economist at the National Association of Real Estate Investment Trusts.

REITs, which are traditionally only about 50% correlated to the equity markets, experienced a rare near-perfect correlation to stocks two years ago when both asset classes bottomed at the same time.

The subsequent recovery, while certainly impressive on the equity side in general, has been particularly powerful for REITs.

The initial advantage coming out of the downturn had a lot to do with the REIT structure, which en-ables them to raise capital quickly through secondary stock offerings and new debt issuance.

Last year, according to Nareit, the $430 billion industry raised $24 billion through secondary equity offerings and issued $10 billion worth of debt.

“When the recovery really started to take hold, REITs dominated the real estate purchases because they had better and faster access to capital,” said Peter Muoio, senior principal at Maximus Advisors, a research and consulting firm.

While private-equity funds and other large real estate investors were scrambling to refinance or off-load properties, REITs, as publicly traded companies, were able to buy properties and build up their portfolios at bargain prices.

“REITs came into the recession low on cash and they had to refinance their debt, but they proved they could recapitalize and deleverage,” said Jason Ren, an equity analyst at Morningstar Inc.

“There’s still a lot of debt coming due [inside many of the private real estate funds],” he added. “The big theme that could continue to add value to REITs is how much property they’re able to acquire cheaply.”

CHEAP PROPERTY

Just as the market recognized in early 2007 that the unfolding subprime mortgage crisis would bring down the overall real estate sector, investors have also identified the advantages REITs have by being able to load up on cheap real estate.

“When the REITs went down dramatically, starting in February 2007, it was mostly due to the liquidity crisis,” Mr. Case said. “But in March of 2009, when REITs started raising money through secondary offerings, it said to the market that REITs were not going to default on their loans.”

It also helps that REITs have stood out as income-producing investments at a time when other income strategies such as bonds have been generating historically low yields.

Until recently, REITs, which are required to distribute 90% of their taxable income in the form of dividends, had been averaging annual dividend yields of more than 4%.

Mr. Ren said the REIT market rally has to be considered in context of the extreme downturn the market suffered from the February 2007 peak to the March 2009 bottom.

The REIT index fell by 73% over that period, which compares with a 53% drop by the S&P.

Some of that volatility can be attributed to the leverage component of REITs, which averages around 40% and can be crushing in a down market cycle but beneficial in a market rally.

“Part of the strength of the REIT recovery is that they fell so far,” said Mr. Ren, who thinks investors should proceed with caution after such a strong rally.

“There are lots of good tail winds, but much of the attractiveness of the REIT operations is fairly baked into the prices,” he added.

The FTSE Nareit All Equity REIT Index gained 25% for the 12-month period ended March 31, compared with a 16% gain for the S&P 500.

In the first quarter, the REIT index was up 7.5%, while the S&P gained 5.92%.

By sector during the first quarter, timber REITs dominated with a 24.6% gain, followed by industrial REITs (11.7%) and self-storage (11%).

SHORTER LAG FACTORS

But the strongest sectors coming off the bottom — and the sectors seen best-positioned to continue to outperform — are apartment and hotel REITs.

“When it comes to apartments and hotels, there are shorter lag factors that allow them to adjust prices more quickly when the economy is stronger,” Mr. Muoio said.

“If you think about it, those categories are re-leasing daily or yearly,” he added. “They will feel it faster in the downturn, but they also participate faster on the upturn.”

The apartment REIT sector was up 43.3% for the most recent 12- month period and was up 30.4% in 2009. Hotel REITs gained 16.4% in the past year, and were up 67.2% in 2009.

“Apartments are benefiting from people moving out of their homes, and the special circumstance of the children of baby boomers now starting to rent,” said Mr. Muoio.

On the hotel side, he added, the strength of the category is directly linked to the economic recovery.

“There is no better correlation than the correlation between hotel revenues and GDP,” he said.

In REIT parlance, apartments, offices, retail and industrial often are described as the “four main food groups” because they are such strong indicators of the health of the overall industry.

Office REITs gained 17.1% in the past 12 months and were up 35.5% in 2009. Industrial REITs gained 27.8% in the past year and 12.2% in 2009.

Both office and industrial REITs continue to be held back by the “unemployment overhang” that is keeping vacancy levels higher, Mr. Ren said.

Retail REITs, including shopping centers, malls and free-standing stores, gained 24.9% in the past 12 months and 27.2% in 2009.

Health care REITs, which with retail have been considered the “performance laggards,” gained 19.8% in the past year and 24.6% in 2009.

“Over the past year, performance has been strong for every category,” said Mr. Case. “The health care and retail-shopping markets have been weak but still not terrible.”

The retail category initially was affected by a reduction in consumer spending, which turned out to be less severe than most economists anticipated. However, according to Mr. Case, the retail category is still operating under the shadow of a potential consumer spending pullback.

Health care is unique in that it provides investors a steadier ride.

“In addition to dependable revenue streams from government programs, the health care group will also benefit from “favorable demographics,” according to John Sheehan, an analyst with Edward Jones.

A large part of the appeal of commercial real estate in a portfolio is as a diversifier, according to Chip McKinley, global portfolio manager at Cohen & Steers, a $36 billion asset management firm.

While Mr. McKinley described apartments and hotels as seeing the strongest demand, he pointed out that many of the more defensive categories also have done well.

“Health care facilities tend not to be cyclical and not as economically sensitive,” he said.

“ACCESS POINTS’

Genworth Financial Asset Management Inc. chief market strategist Christian Hviid considers “multiple access points” for investing in REITs.

Considering factors ranging from income yields and rising occupancy rates to valuations and diversification benefits, he said, Genworth, which has $17 billion under management, has maintained a stable allocation to REITs.

While rising interest rates could lead some income investors toward higher yields beyond the REIT market, many of the fundamentals of the REIT story remain in place.

One particular advantage, according to Mr. Case, is the industry’s ability to continue to bolster portfolios by buying up properties.

“REITs only control about 10% to 15% of the commercial real estate in this country, which represents a huge opportunity for them to continue to buy up weak operators,” he said.

“You don’t see that same kind of opportunity in other industries, where public companies ussually own most of the market, and that’s why REITs are in a position to take advantage of so many other players,” he said.

E-mail Jeff Benjamin at [email protected].