Lower returns seen for REITs

Real estate investment trusts are positioned to build on an improving fundamentals picture, with vastly reduced leverage, healthy balance sheets and — thanks to a historic period of capital raising in the debt and equity markets — robust war chests for new acquisitions.

But many analysts and investors fret that this robust picture already has been fully reflected in share prices for most REITs, putting them at a disadvantage relative to other sectors of the stock market.

“REITs have had a terrific run in the last two years, and we are now seeing the improving fundamentals that investors have been looking for. But it looks like most of the good news has already been reflected in current valuations,” said portfolio manager Tom Bohjalian, who runs two REIT funds at Cohen & Steers Inc. “I think U.S. REITs will be underperforming this year.”

REITs are trading at an estimated 16.8 multiple of their projected 2011 price-to-funds-from operations ratio (a widely accepted measure of REIT profitability) compared with a 13.1 projected multiple for the S&P 500.

As stock market investment allocations go, REITs are what Wall Street calls “chicken cyclicals.”

These are “cyclical stock market plays with a lot of defensive characteristics,” said Nick Colas, chief market strategist at BNY ConvergEx Group LLC. “They offer some exposure to an upturn in the economy, while protecting against downturns.”

Indeed, REITs have been the beneficiary of the hunger for income, due to the high level of fear and uncertainty about the economy's tepid recovery in the past year. But as fears of a double-dip recession fade and a rising chorus of Wall Street economists lift their 2011 GDP forecasts north of 3%, the allure of sinking money into a conservative strategy is on the wane.

“We have a real estate allocation of 3% in our client portfolios, and we're currently underweight, because of REITs' hefty premium to net asset values and [the fact that] yields are well below historical norms,” said John Workman, chief investment strategist at Convergent Wealth Advisors.

Fundamentals are continuing to improve, Mr. Workman believes, as will dividend yields. But with valuations running high, only the most bullish analysts are expecting REITs to hit 10% returns this year, with most forecasters calling for a gain in the 6% to 8% range.

While that pales in comparison with the 27.45% gain in 2009 and last year's year-to-date advance of 27.22% through Dec. 28, it does place the two previous years' horrendous losses — returns of -17.83% in 2007 and -37.34% in "08 — firmly in the rearview mirror.

REITs owed much of their outperformance in 2010 to growth in funds from operations, which was much stronger than anticipated due to improving macro fundamentals. Now the Wall Street consensus forecast is for 16% FFO growth year-over-year for 2011, and Nino Jimenez, senior vice president at Brinson Patrick Securities Corp, is among the REIT analysts who worry about that being too optimistic.

“We may or may not get there,” he said of the growth forecasts. “And with valuations quite toppy now, I'm not expecting much of a return for 2011 — something in the low to mid- single digits.”

With the yield curve steepening, the average REIT dividend of 3.65% has begun looking a lot less appetizing to yield-hungry investors. As recently as November, REITs were maintaining a reasonably healthy 100-basis-point yield spread over benchmark 10-year Treasuries, but REITs fell behind as yields on the 10-year note rose to 3.5% over the last two months of 2010.

The 10-year note had eased to a 3.39% yield as of Dec.24, leaving REIT dividend yields only about 80 basis points higher than the 10-year, significantly below the average spread of 128 basis points over the last 10 years, according to Keefe Bruyette & Woods Inc.

“If interest rates stay in their current range, it doesn't affect REITs, but it's throwing a real wrench in the works if the 10-year yield continues to climb toward 4%,” said Paul Puryear, a REIT analyst at Raymond James & Associates Inc.

The spartan dividends most REITs paid during the financial crisis in order to preserve dwindling cash reserves have exaggerated the impact of the rate backup. FFO payout ratios were cut to around 60% over the last four years, down from historic norms in the 75% to 80% range.

With many REITs still paying out only the bare-bones minimum required by law — REITs must pay at least 90% of net income in the form of dividends to shareholders — analysts see a lot of room to push the dividend yield back up toward the 6.16% long-term average, going back to 1995.

Mr. Puryear, who is forecasting a 9% to 10% return for REITs, expects them to shed that fiscal conservatism in earnest this year, pointing to recent moves by Simon Properties, Alexandria Real Estate Equities LP and Kimco Realty Corp., among others, in announcing hefty raises — 33%, 20% and 12.5%, respectively — in their quarterly dividend payouts.

“Dividend growth should average about 10% this year,” said KBW REIT analyst Sheila McGrath, who is counting on ramped-up dividend yields, plus solid if not spectacular growth prospects, to help REITs keep pace with the S&P 500.

“REITs certainly are trading at a premium, but not compared to historical multiples, when they are in asset acquisition growth mode and FFO is recovering,” pegging a return of 9% to 11% for the asset class as a whole, she said.

WARY OF HEALTH CARE

Within the REIT class, fund managers are particularly wary of the health care sector and longer-term net-lease property types such as office, retail and industrial that have lower growth prospects. They see the most compelling values in the multifamily, hotel and self-storage sectors.

“In multifamily, shares are trading below NAV, and their short lease durations and ability to pass through inflation increases directly to rents should mean double-digit returns in that sector,” said Mr. Bohjalian, who targets hotel REITs for many of the same reasons.

Ms. McGrath likes Alexandria Realty, which specializes in life sciences offices. “They've been an underperformer this year (16.3% gain as of Dec. 28), and they've a lot going on that will positively impact results,” she said, citing as the prime factors same-store growth of 2% to 4%, exposure to global real estate markets with China properties and a lot of development coming online.

Mr. Puryear's top picks also include less expensive turnaround stories such as Campus Crest Communities Inc. (CCG), Apartment Investment & Management Co. (AIV) and Digital Realty Trust Inc. (DLR), which specializes in data centers.