REITs Attract Yield-Hungry Investors

With yields above other asset classes, real estate investment trusts are popular again. Pros tell Businessweek.com how to spot the best REITs

By David Bogoslaw

The U.S. commercial real estate market has so far averted the catastrophe that many strategists were predicting last year. Even after sales of existing homes plummeted 27 percent to record lows in July, threatening further home-price declines, analysts see commercial real estate values stabilizing. Vacancies for apartment buildings, office complexes, retail mall, and self-storage facilities are no longer rising meaningfully, rents are no longer falling, and many Real Estate Investment Trusts, the main vehicle for individual investors to participate in the sector, continue to reduce their debt loads.

Equity investors are taking notice: FTSE NAREIT's All-REIT index, comprised of 148 publicly traded REITs, was up 11.7 percent year-to-date as of Aug. 26 while the Standard & Poor's 500-stock index was down 4.9 percent. Publicly traded REITs represent 15 percent of the total U.S. commercial real estate market. Equally striking is how much more confidence investors have put in U.S. mutual funds and exchange-traded funds that focus on real estate assets than they have in equity funds in general. Year-to-date through July, $1.42 billion flowed into U.S. real estate mutual funds, while $27.1 billion flowed out of U.S. equity funds, according to an Aug. 20 research note by Deutsche Bank Securities (DB).

This doesn't mean that there aren't plenty of commercial real estate loans in default. Fitch Ratings, in an Aug. 20 report, said that 43 percent of the 126 commercial mortgage-backed securities set to mature in September—representing $962 million in face value—are either delinquent or in foreclosure. (Commercial mortgage-backed securities are pools of loans that were bundled and sold to investors in tranches rated for their level of risk of default.)

Given that the value of many properties has fallen dramatically since commercial mortgages were taken out five years ago—the typical loan duration—and that most of these loans are interest-only, for which principal hasn't been paid down, most borrowers will be hard pressed to provide the additional equity required by banks in order to refinance them at considerably lower loan-to-value rates, says Jeremy Anagnos, co-portfolio manager of the American Beacon Global Real Estate Fund (ABEAX).

funds from operations Reported up

The REITs trading at the highest multiples are those with better-quality properties and stronger balance sheets. Investors must decide whether it's worth paying up for those stocks on a bet that they'll use their liquidity for growth, says Paul Adornato, an analyst at BMO Capital Markets. They may prefer to buy a cheaper REIT facing a high cost of capital on the belief that the value of their portfolios will appreciate as the broader economy recovers. If you're not expecting a quick recovery, you may prefer the higher-valued REITs, Adornato says.

Nearly all of the 15 REITs on Credit Sights' coverage list reported funds from operations (FFO) in the second quarter that exceeded analysts' consensus estimates. Roughly two-thirds of the companies increased their full-year FFO forecasts, according to an Aug. 16 report by the ratings provider.

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