REITs on a roll, but what's next?

By Chris Taylor NEW YORK | Fri May 4, 2012 1:09pm EDT

(Reuters) - Talk to any American homeowner, and you'll probably encounter some symptoms of chronic anxiety. Underwater mortgages, tanking house values and rampant foreclosures have shaken our psyches regarding the wisdom of property ownership.


But when it comes to real estate investment trusts (REITs) that invest in commercial property, they've been doing quite nicely, thank you very much. In fact if you invested in Vanguard's REIT Index ETF during the lows of March 2009, you would have tripled your money since.


Of course REITs come in many flavors; they fill their portfolios with everything from office buildings to malls to hotels to mortgages. Looking at the sector's fundamentals - low interest rates for REITs that are borrowing to fund projects, paired with rising rents and a recovering economy - some analysts expect the happy days to continue for a while.


"I think investors will be surprised by the fundamental improvements going on in REIT portfolios," says Wilson Magee, director of global REITs for New York City-based investment managers Franklin Templeton Real Asset Advisors. "The simple fact is that virtually no construction has been going on, and no new supply is being added. That makes for a long-term trend of powerful earnings growth."


That's enough to make some investors, like Jacob Frydman, a New York City real-estate veteran, lick their chops. He recently formed United Realty Partners, a new real estate investment company, with fellow investor Eli Verschleiser. He cites a "perfect storm" of positive factors for REITs - low borrowing rates, slipping vacancy rates and climbing rents. In fact, office rents are projected to rise 1.9 percent this year, according to the Commercial Real Estate Market Survey of the National Association of Realtors.


"Buildings are now available significantly below their replacement cost, and at a substantial discount to three years ago," says Frydman. "Also a lot of debt that originated five years ago is now coming due, and won't be able to be refinanced. You're going to see some great opportunities to buy."

Of course, the rosy scenario is not without its risks. Mortgage REITs that invest in loans instead of property can be especially buffeted by the volatility in their underlying securities. And some commercial REITs are weighed down by portfolios of pricey properties acquired during the pre-bust years of 2006 or 2007. In fact, delinquencies for office and retail loans recently hit their highest-ever levels, according to Fitch Ratings.


That's why some financial planners are advising clients to tread carefully. "The current REIT market is still fraught with challenge," says Bruce Specter, a wealth manager with Universal Value Advisors in Reno, Nevada. "Though interest rates are low and it would appear buying opportunities abound, there's still plenty of downside."


Among the issues REITs face: State and local governments, strapped for cash, will likely be squeezing big property owners for taxes and fees in years to come. And when so much of REITs' income has to go out in dividends (over 90 percent by law), that can handcuff them when it comes to stockpiling cash for a rainy day. Warns Specter: "That's awfully thin financial ice to be out on."


But it seems like Mr. Market isn't too concerned about those drawbacks. So far this year, real estate mutual funds have rocketed up by an average of 13.69 percent, according to data from Lipper, a Thomson Reuters company. That's even better than the S&P 500's year-to-date gains of 10.65 percent.


Investors are taking notice, and continue to bet on the sector. So far this year they've chipped in $3.4 billion for real estate funds, already surpassing the $2.8 billion they contributed for all of 2011.


As a result of that investor interest and the gains of the last three years, the sector is starting to look a little pricey. One of the nation's largest REITs, Simon Property Group, is hovering near 52-week highs - hardly the profile of a beaten-down bargain sector.


That said, there are some buys to be had, according to sector analysts. Research firm S&P Capital IQ, for instance, has issued ‘Strong Buys' on Essex Property Trust and Home Properties Inc.. Franklin Templeton's Magee, for his part, likes Starwood Hotels and mall specialists Taubman Centers.


Part of the logic behind the REIT run: baby boomers and their insatiable appetite for dividends. The trusts are required by law to pay out 90 percent of their taxable income in yield. That's catnip to those entering their golden years, who aren't about to get that much income from T-bills or plain old bank accounts.


"REITs are currently yielding around 3.4 percent, which is significantly better than the S&P 500 and certainly better than Treasuries," says Magee. "That's been a factor in their positive performance, and why the market has started to price these stocks up. But that yield is actually much lower than we've seen historically, so we expect strong dividend growth for REITs going forward."