REITs getting ready to make a move

They aren’t cheap, but publicly traded real estate investment trusts could be just the right property for yield-thirsty investors.

Even with a languid economic recovery and sluggish real estate markets, REIT yields, which average about 4% overall, are safe, analysts said. What’s more, their dividends are poised to rise with any kind of turnaround.

“No building [of new properties] is going on, and with any demand growth, you’re going to see [REIT] earnings grow,” said Paul Puryear, managing director of real estate at Raymond James & Associates Inc.

Higher earnings will cause REIT dividends to climb back up after being severely cut in the financial crisis of 2008 and 2009, analysts said. Back then, real estate managers sought to conserve cash and pay down debt.

REIT operators are still following that strategy. Many REITs are now “paying the bare [minimum payout] they can,” Mr. Puryear said. The percentage of profits being paid out is “pretty well at historic lows.”

Under Internal Revenue Service rules, REITs must distribute 90% of taxable income to shareholders. If profits increase, dividend payouts will have to rise.

“We could see a lot [of REITs] raise dividends,” said Bill Acheson, a senior REIT analyst at The Benchmark Co. LLC.

While investors wait for those higher payouts, existing dividends should be safe, analysts said. That’s because REIT operators have cut costs and are well-positioned for tough times. “These guys really cut to the bone in many cases,” Mr. Acheson said.

And make no mistake — the commercial real estate market could remain challenging for a while. Observers are worried that the economy is too sluggish to spark a meaningful turnaround in real estate fundamentals.

Economic growth “is the overall demand driver” for higher REIT profits, Mr. Puryear said, noting that “there’s no pricing power anywhere” in the real estate market at the current time.

REITs will have to increase net operating income to justify higher stock prices, Mr. Acheson said.

Occupancy and lease rates have stabilized somewhat, especially for apartments and hotels, analysts said. But weakness still abounds.

“I don’t think we’ll see a profound [economic] recovery until we get more job growth,” said Jason Ren, an equity analyst at Morningstar Inc. who covers apartment, health care, hotel and self-storage REITs.

“We’re seeing a small recovery, but in the apartment or storage spaces, improvement is going to be difficult without more job growth,” Mr. Ren said.

REITs seem to be fairly valued right now, according to analysts, so advisers should be careful about taking positions.

On a net-asset-value basis — assessing REITs on the appraised value of the underlying properties — the stocks are trading at “very close to fair value,” Mr. Acheson said.

Most of the stocks currently are right near their NAVs or at slight premiums, according to Mr. Acheson’s analysis.

According to Raymond James research, REIT share prices tend to trade within a band of plus or minus 20% of the estimated value of the REIT’s net asset value.

Since the huge sell-off in early March, REIT share prices have recovered to the point where they’re now about 13% above still-depressed NAVs.

“At the bottom of the commercial real estate cycle, history tells us that REITs trade at about 20% above NAV because the market anticipates a recovery,” Mr. Puryear said.

REITs currently are “not cheap but certainly not expensive, especially now that they’ve pulled back in price,” he added.

Likewise, Todd Lukasik, an equity research analyst at Morningstar who covers office and industrial REITs, said his sectors are “pretty fairly valued,” based on their estimated cash flows.

Price-earnings ratios on REITs, though, look high relative to stocks. The average P/E ratio for REITs, based on expected 12-month forward earnings, is 19.2, compared with the historical average of 15.5. The P/E for the S&P 500, by contrast, is currently 11.6, compared with a historical average of 16.8.

REITs seem overpriced compared with stocks because REIT earnings “remain mired in a deep trough,” Mike Kirby, head of research at Green Street Advisors Inc., wrote in a report last month.

Corporate profits at operating companies in the S&P 500, on the other hand, have exploded, making the index appear relatively cheap, Mr. Kirby said.

Green Street recommends that investors maintain a normal portfolio weightings in REITs, rather than be scared off by what seem to be high multiples. Others agree, but they caution not to overpay.

“If you think there is going to be … inflation in the future, you definitely want to be in real property,” Mr. Ren said.

Publicly traded REITs are run by “probably the best real estate operators in the U.S.,” Mr. Puryear said. “So you’re tapping into management ability, not just a collection of assets.”

E-mail Dan Jamieson at [email protected].