Commercial REITs: Investing in a Shaky Market

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BMO has a neutral rating on REITs overall. That's based on how the high valuations compare not only with the March lows, but with historic levels. Adornato expects REITs to perform only as well as the stock market as a whole.

One group he sees as fairly cheap, however, are industrial REITs that own and operate warehouses used by distributors. The need for U.S. companies to replenish drawn-down inventories of goods—and an expected pickup in international trade as the economy recovers—will drive demand for these warehouses, he says.

A BMO favorite: Duke Reality

Although Adornato isn't optimistic about factory-sector fundamentals, he believes that the industrial real estate market could turn around quickly. "Industrial space tends to be less overbuilt than other property types that are more generic in nature and relatively quick to construct, like malls or office buildings," he says,

Among Adornato's favorites is Duke Realty (DRE), which owns warehouses and suburban office parks. Demand for office space will probably remain soft, but Adornato likes Duke's management, mix of tenants from diversified industries, and market strategy. The shares trade at 14 times estimated adjusted funds from operations (AFFO) in 2010, a nearly 23% discount to the overall REIT average of 18.1 times 2010 AFFO. (AFFO, a measure of operating profitability for REITs, is equivalent to free cash flow.)

First Potomac Realty Trust (FPO) is a small-cap company specializing in industrial space and real estate that can be adapted for either industrial or office use. With 60% of its properties located in the greater Washington metropolitan area, First Potomac benefits from economic stability around the capital, which is bolstered by the growth of government programs, Adornato says. The stock trades at 11.6 times estimated 2010 AFFO, a 36% discount to the average REIT.

DCT Industrial Trust (DCT), which has traded publicly for less than five years, has been overlooked by a lot of investors, according to Adornato. The stock is trading at 15.4 times estimated 2010 AFFO, a 15% discount.

One of the top five holdings in Wenker's fund is Public Storage (PSA), which benefits from diversity in its large national portfolio of self-storage properties. In addition to considering the company well-run, Wenker likes that Public Storage has financed acquisitions by issuing preferred shares in lieu of debt. Although the preferred stock carries a higher coupon than secured debt, it need never be paid back because it's perpetual, he says.

will U.S. consumer spending recover?

Wenker concedes, however, that unlike in previous recessions, self-storage has proved to be less resistant to this downturn.

Adornato says he's reluctant to recommend REITs that focus on retail properties because he's not certain that discretionary spending by U.S. consumers will return to pre-financial-crisis levels.

While many retailers have been adept at managing inventories and cutting costs, he expects to see a further wave of bankruptcies among weaker merchants after the holidays. Another concern is whether the smaller mom-and-pop retail tenants in shopping malls—think nail salons and pizzerias—have nearly depleted their personal savings to keep their businesses going during the recession. With few reserves left, Adornato asks, might they have to shut down?

Instead of the wave of commercial property liquidations that some economists anticipate—as followed the savings & loan debacle in the early 1990s—Adornato thinks liquidations will "probably be much more limited both in terms of volume and discounts."

Of the $300 billion worth of commercial mortgages slated to mature in the next two years, he believes roughly $75 billion of them, or 25%, will end up being liquidated.

For now, investors who expect bargains to gleam among the rubble once that happens might want to consider buying well-capitalized REITs long before the recovery takes shape.

Bogoslaw is a reporter for Bloomberg BusinessWeek's Finance channel.

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