Those investing in apartments, offices likely to keep struggling

The rising stars in the real estate investment trust sector will likely be in the retail segment, investment professionals say, while most apartment and office REITs are expected to continue to disappoint.

REITs are favored among income-oriented investors because they must distribute at least 90% of their taxable income to their shareholders every year.

Over the last five years, these dividends have remained relatively stable, averaging around 7%. Meanwhile, the average REIT share price has outpaced all broad-market indexes over the last decade.

But overall, investors are concerned that REITs may be nearing the end of a great ride.

For one thing, continued weak growth in employment hurts the sector because it dampens formation of households and commercial demand for space.

What’s more, as investors increasingly are betting on economic recovery, equities have become more appealing relative to REITs.

“Short term, I’m relatively more cautious” about REITs, says John Wenker, head of the real estate department for U.S. Bancorp Asset Management Inc. in Minneapolis and manager of the $165 million First American Real Estate Securities Fund.

But Kelly Rush, director of the real estate portfolio for Principal Financial Group Inc. in Des Moines, Iowa, says investors’ “thirst for yield” so far has proven stronger than he had anticipated, “causing REITs to move more in tandem with equities.”

tax implications

REITs aren’t favored under President Bush’s tax cut bill, because investors who own them won’t be entitled to the tax break on dividends that investors in other stocks will, analysts say.

But while REITs may lose some competitive advantage as a result, some say they remain attractive to income investors because they start out with such high yields.

That conclusion also is helping investors to refocus on distinguishing among REIT sectors as well as differentiating them from other investments.

REITs specializing in shopping malls and other retail properties head most experts’ lists of favorite investments in the sector.

Consumer spending held up relatively well through most of the economy’s three-year slump, and that strength is reflected in REITs that own store sites.

“Well-located malls with good demographics continue to have healthy occupancy levels,” Mr. Wenker says. “Their vacancies are relatively low from a historical standpoint, and they’re saying they can continue to push rents up. The only question is how long does consumer spending hold up, and do we slide through with it into a recovery?”

Some investors also believe that the tax refund portion of the Bush bill, by putting billions of dollars back into consumers’ pockets this summer, “will indeed stimulate the retail market further,” says Susan Breakefield Fulton, president of Fulton Breakefield Broenniman Inc., a Bethesda, Md., firm that manages $150 million, about 5% of which is invested in REITs.

She also predicts relatively good performance by industrial- warehousing REITs such as ProLogis in Aurora, Colo., which provides distribution facilities to Amazon.com Inc. and other growing companies.

REITs operating in other sectors of commercial real estate remain dicier.

Office property REITs have the advantage of low volatility because of the long-term leases – seven to 10 years – that prevail in the sector, but they have suffered as the economic slump has boosted metropolitan office-vacancy rates.

Hotel and resort REITs, of course, began suffering a couple of years ago as the economy softened, and then the terrorist attacks of Sept. 11, 2001, aggravated their troubles. Investment managers don’t expect dramatic improvement soon.

The most bearish prospects are reserved for apartment REITS, say some experts. The typical one-year leases of apartments make this arena highly volatile.

But more important is the strength of the market for buying single- family homes, thanks to record low interest rates.

The affordability of homeownership makes renting relatively less attractive. And those left in the rental market, Ms. Fulton notes, tend to have declining credit quality.