By Ray Mathis and Robert McMillan So far in 2005,
real estate investment trusts (REITs) -- entities that manage portfolios of real property -- have generally seen firming fundamentals in all property types, from office buildings and shopping malls to apartments and hotels. And those favorable conditions appear to have been noticed by investors: This year through May, the total return (capital appreciation plus dividends) of the S&P REIT index was 1.26%, vs. a loss of 0.95% for the S&P 500 index.
Indeed, REITs have outperformed the S&P 500 on a total-return basis over the past 1-, 3-, 5-, and 10-year periods. We at Standard & Poor's Equity Research Services attribute this outperformance to the fact that much of REITs' total return comes from dividend income, which can never be negative. That makes REITs less volatile than the broader market over the long-term, in our view.
Historically, the financial performance of REITs has tended to lag behind the economy by several quarters. We believe this lag in performance can be traced to the varying lengths of leases. Lodging REITs, which operate hotels, can re-price rooms on a daily basis, making them one of the most economically sensitive property types.
PROS AND CONS. At the other end of the spectrum, office REITs typically have significantly longer average lease terms, often 10 to 20 years. As a result, they tend to have more stable earnings in an economic downturn, but also take longer to exhibit growth as the economy recovers.
In addition, REIT share prices tend to reflect the market price of commercial real estate. In the late 1980s and early 1990s, a confluence of events -- including an overhaul of the U.S. tax code, the savings and loan crisis, recession, and war -- depressed commercial real estate values. As a result, the government set up the Resolution Trust Corp. to auction off foreclosed properties. Many of the largest-cap REITs were established during this period, and began building their portfolios by buying properties at depressed prices at the RTC auctions. Long-term investors in these REITs have seen their share prices appreciate considerably over the past decade as commercial real estate prices recovered.
REIT stocks were notably weak in early 2005, and we attribute this to portfolio rebalancing by investors and fear of rising interest rates, among other things. Because REITs outperformed the broader market in the past few years, investors wishing to allocate a certain percentage of their investment portfolio to REITs have had to sell REIT shares and reinvest in other sectors in order to maintain proper portfolio balance.
TOP PICKS. First-quarter operating earnings for REITs were slightly better than we expected. Several REITs that were unable to meet dividend payments with cash generated from operations boosted net income with capital gains from property sales.
What is S&P's view of the REIT group? Generally, we're positive on the lodging, retail, storage, and health-care categories. Here's a look at the key segments within the REIT sector -- and our top choices within those groups:
Hotel REITs: These outfits are enjoying a recovery in business travel and conferences, while tourism has remained strong, pushing overall occupancy higher than year-ago levels. We believe the declining value of the dollar since last summer should bolster foreign tourism while keeping domestic travelers from venturing abroad. Most of the hotel REITs in our coverage universe reported that they have regained pricing power, posting an increase in revenue per available room between 7% and 12% in each of the past few quarters.
We think an industry recovery continues and is gaining traction. We also think year-over-year comparisons will be relatively easy for the next several quarters. Overall, we think liquidity is improving, and many valuations are attractive, with most issues trading well below our estimates of
net asset value (NAV). S&P has a 5 STARS (strong buy) ranking on only one dividend-paying lodging REIT: LaSalle Hotel Properties (LHO
; recent price, $31).
We also have a 5-STARS ranking on one other non-dividend paying lodging company, La Quinta (LQI
; $9), whose stock trades as "paired shares" -- each unit consisting of one share of a REIT and one share of a "C" corporation operating company. Since divesting its non-lodging assets, the company has demonstrated industry leading revenue improvement due to its focus on updating its technology platform, expansion of its geographic footprint, and growth of its franchising program.
Retail REITs: First-quarter results for this group generally exceeded our expectations. Earnings gains were robust, supported by what we see as solid fundamentals in shopping center portfolios. On average, occupancy levels and same-property net operating income rose. Rental rates on new leases and renewals continued to improve.
We look for conditions to remain robust in 2005, buoyed by continued healthy consumer spending. We think retailer demand for more space, combined with limited new mall construction, should support additional rent increases. The retail REITs with 5 STARS recommendations from S&P are CBL & Associates (CBL
; $85), General Growth Properties (GGP
; $40), and Simon Property Group (SPG
Storage REITs: We believe an expanding U.S. economy should continue to stimulate increased demand for self-storage. As we see it, economic growth should lead to a pickup in hiring that will cause some people to relocate for new jobs, and these transitions often require the renting of storage space. None of the storage REITs we follow has a 5 STARS recommendation. Two are ranked 4 STARS (buy): Public Storage (PSA
; $61) and Sovran Self Storage (SSS
Health-Care REITs: The most recent quarterly results for these outfits, which operate hospitals and other health-care properties, were about what we expected. We think operating trends in the group will continue to improve slightly because of higher Medicare reimbursement rates. S&P has no strong buy recommendations on health-care REITs. Two are ranked buy: Health Care REIT (HCN
; $36) and Nationwide Health Properties (NHP
Besides directly buying REIT shares, there are other ways investors can play the group. There are a few exchange-traded funds that track the REIT industry, including iShares Cohen & Steers Realty Majors (ICF) and streetTracks Wilshire REIT ETF (RWR). Analysts Mathis and McMillan follow shares of real estate investment trusts for Standard & Poor's Equity Research Services