REITs pay off for investors

The nation's housing market still may be struggling, but don't rule out investment opportunities in real estate. Last year, real estate investment trusts, as measured by the FTSE Nareit All REIT Index, gained 7.3%, more than three times the 2.11% return of the S&P 500. For many REIT investors, the primary appeal is income, which represented nearly two-thirds of the broad REIT index's total return last year.

GOOD OPPORTUNITIES

Even though 2011 paled by comparison with the previous two years, when the REIT index gained more than 27% annually, REITs offer solid arguments for investing. “Unlike a bond that has a fixed coupon, REIT dividends have the potential to grow with increased cash flow,” said Ritson Ferguson, co-portfolio manager of the $3 billion ING Global Real Estate Fund (IGLAX). “Real estate's natural appeal is even more obvious in a [sluggish economic] environment like this,” he said. “If you can buy a 4% dividend where the income is expected to grow by 7%, why wouldn't you do it?” Several trends favor the broader REIT market and help it appear attractive on a relative basis, but it is the underlying subcategories that truly illustrate how and where real estate is attractive. The self-storage subcategory, which gained 35.2% in 2011, stood out as the most logical winner among REITs. “The strength of self-storage REITs shows the defensive demand characteristics,” said Rick Romano, manager of the $800 million Prudential Global Real Estate Fund (PURAX). Self-storage facilities, he said, are directly benefiting from the “dislocation” in the housing market as more borrowers walk away from their mortgages, or are forced to move because of foreclosure, and have to put at least a portion of their possessions in storage. Along the same lines, apartment REITs also have benefited from the steady realignment in homeownership across the country. The apartment REITs category gained 15.1% last year as vacancy rates continued to fall and property owners enjoyed some renewed pricing power. And according to the National Association of Real Estate Investment Trusts, that trend is still headed in a positive direction.

DECLINING VACANCY RATES

Nareit calculated vacancy rates for multifamily-housing properties at 9.8% at the end of the third quarter, down from 11.1% at the end of 2009, though still above the historical average vacancy rate of 8%. “We have seen the realized demand as people have moved into rental properties, but the pent-up demand will lead to a strong increase in multifamily-housing construction starts,” said Calvin Schnure, vice president of research and industry information at the association. “A lot of things slow down in a recession, but one thing that doesn't slow down is population growth,” he said. The normal development resulting from demographic events such as marriage, divorce and young people's moving out of their parents' homes historically has led to an annual increase in housing formations of 1.3%. But through the economic downturn of the past four years, new-housing formations have grown by less than 0.5% annually. These kind of data add up to significant pent-up demand for housing, Mr. Schnure said. “We're going to see about 3 million new households unfold over the next two or three years,” he said. “That means rising occupancy rates for REITs.” Homeownership in the United States, which peaked at 69% in 2006, has since fallen to 65%, which is in line with historical averages. But in the context of a gloomy economic outlook, there is a very real possibility that homeownership levels will continue to fall. “We could certainly go below that [65% ownership] level, because there are really no catalysts in place to turn it around,” Mr. Romano said. Even if he isn't entirely optimistic, the macroeconomic data for REITs are positive, Mr. Romano said. For example, construction starts of multifamily-housing units are equal to 0.5% of existing supply, which is a quarter of the historical average of 2%, he said. “It's difficult to have any real conviction about where demand will come from, but the apartment demand drivers are in place,” Mr. Romano said. “The [collapse of the] single-family-housing market has definitely contributed to the success of the rental space.”

SHOPPING MANIA

One of the REIT categories that has been an unexpected surprise for market watchers is regional malls, a subcategory of retail, which is dominated by public REITs. Its 22% gain last year was a testament to the resolve of consumers, according to Brad Case, Nareit's economist. “At this point, there is no reason to think there will be a pullback in consumer spending,” he said. Some of the other strong- performing categories last year were health care REITs, up 13.6%, and manufactured homes as a subcategory of residential housing, up 20.4%. Of the 13 categories of equity REITs, nine finished the year up. The biggest laggard last year was the lodging/resort category, which declined by 14.3%. “Hotels are extremely sensitive to the overall economy, and people are still really concerned about the global economy,” Mr. Case said. Unlike most REITs, which can lock in longer-term leases to help weather economic volatility, hotels often are forced to lower room rates in stride with the economy. That also makes them stronger performers during economic upturns. Mortgage REITs are unique from equity REITs in that they don't own property but essentially are finance businesses that buy mortgages and sell debt. Although mortgage REIT dividends are producing impressive yields of beyond 14%, the category is seen as vulnerable to macro forces such as the European financial crisis and the potential for rising interest rates, which is why the category declined by 2.4% last year. “The risk related to mortgage REITs is [that] they come with quite a bit of leverage,” said Christian Hviid, managing principal at Point Guard Capital LLC. Mr. Hviid takes a contrarian view of several equity REIT categories. “I believe job demand will pick up in 2012, so I think office space REITs will give you the most bang for your buck,” he said of the category, which declined by 0.8% last year. Ultimately, against the backdrop of a muted run for equities and a forecast for sluggish economic growth, the market is embracing REITs. Through November, REITs raised a record $37.3 billion through equity offerings, which beats the previous record of $32.7 billion raised during all of 1997. The new money helped to push the leverage for equity REITs down to historical average levels of 41%. That leaves the industry well-positioned to manage many of the five-year loans established during better times and that are coming due in 2012. jbenjamin@investmentnews.com