The Rundown on REITs

Amid recent weakness in the group, some stocks are still good bets. S&P breaks down six key sectors and finds the best plays in each

by Sam Stovall From Standard & Poor's Equity Research

"What do you think about REITs?" That's a question I have been asked fairly frequently over the past few weeks. Rightfully so, since this asset class, which skyrocketed in the past few years, now appears to have fallen on hard times. Year to date through July 6, the Standard & Poor's Composite 1500 index gained 8.5%, while the majority of the six real estate investment trust indexes declined from approximately 3% to 6.5%. This erosion in performance has caused many to ask: "Is this the beginning of the correction in real estate stocks?"

Source: Standard & Poor's

There are 46 companies in the S&P 1500 that are assigned to six REIT subindustry indexes. S&P STARS (Stock Appreciation Ranking System) reflect our analysts' investment outlooks on individual securities (5 is highest and 1 is lowest), and offer an impression of each subindustry's investment prospects based on the market-weighted average of the 3 to 12 companies found in each group.

Our analysts also generate fundamental outlooks on each of the subindustry indexes found in the S&P 1500 based on economic, market, and legislative projections. Investment and fundamental outlooks could differ, however, depending on whether the share prices and valuations of the underlying issues properly reflect their fundamental outlooks. On the whole, based on both the average STARS and fundamental outlooks, S&P analysts are neutral to positive on both outlooks of each style of REIT.

Royal Shepard follows the Diversified, Office, and Residential REITS. Robert McMillan covers the Industrial and Retail REITs, while Jason Wiley covers the Specialized REITs. They reminded me that, in general, REITs have historically been economic laggards, depending in part on the timing of lease expirations. An expanding economy typically helps boost property revenue across the category.

In addition, many REITs aim to boost earnings via other means, such as merger and acquisition activity, refinancing debt and preferred issues, or by divesting non-core holdings to unlock potential capital gains. On the other hand, slower economic growth, due to higher interest rates and a drop in housing activity, could restrain demand for leased space.

In evaluating REIT securities, one should consider the dividend yield, long-term dividend growth rate, and payout ratio of funds from operations. Investors should also consider the anticipated direction of interest rates, fundamentals for the REIT's dominant property type, and net asset value (NAV) per share. One should also look at growth in same-store (those open at least a year) sales and net operating income, as well as rent growth and occupancy levels.

The following are the fundamental outlooks currently held by Roy, Bob and Jason, on the different classes of REITs found in the S&P 1500 index.