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Nicholas Yulico
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REIT Shares Ripe for Slowdown

Nicholas Yulico

11/02/05 - 07:19 AM EST

As the REIT industry gathers this week in Chicago for the annual National Association of Real Estate Investment Trusts convention, the mood will be more subdued than in past years.

Earnings misses, interest rate fears and concerns over expensive valuations have dragged down the sector in recent weeks, leaving investors to wonder if the magnificent bull run that REITs have enjoyed over the past five years is coming to an end.

Ever since the tech sector imploded in 2000, REITs have trounced the broader market. Individual investors flocked to the sector as commercial real estate was viewed as a safe investment that paid healthy dividends on their 401(k) and IRA dollars.

However, during this time, something interesting occurred. Huge bundles of money flowed into the sector, while earnings growth for equity REITs (those that don't primarily invest in mortgages) remained minimal.

In 2004, equity REITs as a group posted a 32% total return. However, the group's funds from operations -- a key profit measure for REITs -- rose by just 3.2% on a per-share basis, according to SNL Financial, a real estate research firm. In 2003, the industry posted a 37% total return while FFO grew 2.2%.

The concern nowadays is that investors will no longer pay substantial premiums for REITs' minimal earnings growth.

"Two years of 30% returns in a row are a huge anomaly," says Lou Taylor, a longtime REIT analyst with Deutsche Bank. "The group on a long-term basis is low-double-digit [annual total returns] with half of that in terms of yield."

Taylor says the biggest issue facing REITs is competition from the rising yield on the two-year Treasury note, a risk-free investment that is currently yielding 4.4%. The average current dividend yield for equity REITs is 4.7%, down from 7.6% in 2000, according to SNL. Some REITs, such as Simon Property Group (SPG Quote), have yields as low as 4%. As REIT yields drop and the two-year Treasury yield rises, money flows are being affected, Taylor says. "It's attracting money into the money market and bond funds."

REIT Total Return Performance
Index Total Return YTD* 2004 2003 2002 2001 2000 1999
Industrial 5% 31% 33% 17% 7% 33% 4%
Multi-Family 11% 35% 26% -6% 10% 35% 10%
Office 9% 22% 33% -4% 5% 36% 1%
Regional Mall 9% 46% 54% 25% 30% 19% -15%
Shopping Center 2% 36% 42% 16% 29% 20% -12%
Hotel 0% 33% 30% -1% -6% 43% -22%
All Equity REIT 7% 32% 37% 4% 14% 26% -5%
Russell 3000 1% 12% 31% -23% -13% -9% 19%
DJIA** -4% 3% 25% -17% -7% -6% 25%
S&P 500** -1% 9% 26% -23% -13% -10% 19%
NASDAQ** -4% 9% 50% -31% -21% -39% 86%
Source: SNL Financial
*Year to date as of Oct. 31
**Price change only

Taylor is advising his clients to wait it out on REITs until it's clear when the Federal Reserve will end its campaign of raising interest rates. "We're telling people it's going to be a choppy finish to the year," he says.

Last year, a record $6.9 billion flowed into real estate mutual funds and ETFs, according to mutual fund data provider AMG Data Services. That number doesn't look like it will be topped this year. As of Oct. 26, $2.73 billion has flowed into the sector. But during the last two months, real estate funds saw a total net outflow of $697 million, while money market funds are seeing their best inflows of the year.

As a result of the investor dollars that were sunk into REITs over the past few years, the group is now trading at about 14 times its projected FFO for 2005, which looks pricey based on historical multiples. In 2000, the first year of the great bull run for REITs, the multiple was 8. During the past five years, REITs have seen "multiple expansion without having the accompanying earnings growth that would, by historical measure, justify that," says Keven Lindemann, director of real estate with SNL Financial.

For REITs to trade at such lofty multiples yet only grow earnings by single-digit percentages each year "probably isn't tenable in the long run," Lindemann says.

This year, REITs as a group are expected to post their best earnings growth since 2000. However, on Tuesday a number of companies reported disappointing quarterly results that rattled the sector.

Shares of Equity Office Properties (EOP Quote), the nation's largest office owner, fell 5.8% Tuesday after the company's third-quarter FFO missed analysts' estimate. The company also opted to not give future earnings guidance, citing the uncertain effects of rising utility expenses, construction costs and interest rates.

Mills Corp (MLS Quote) plunged nearly 15% after the mall developer delayed its earnings release and said third-quarter results would come in "substantially below expectations."

Apartment REITs sagged after AIMCO (AIV Quote) reported lower-than-expected FFO and said higher heating costs could hurt its operations for the remainder of the year. AIMCO shares fell 3.6%. Equity Residential (EQR Quote), meanwhile, fell 3.4% after the apartment owner's third-quarter FFO per share missed Wall Street's forecast by a penny, partly due to hurricane costs.

Going forward, the best scenario for REITs may be for the broader equity markets to continue to disappoint. So far this year, the Dow Jones Industrial Average and the Nasdaq are each off 4%, and the S&P 500 is down 1%, as of Monday's close. Meanwhile, the index of all equity REITs is up 7% year to date, according to SNL.

"If you're worried that the economy is slowing down on the earnings side, then REITs should hold up better than the general economy," says Jeung Hyun, a principal with Adelante Capital Management, which runs the (LLUKX Quote) Adelante U.S. Real Estate Securities fund.

On the flipside, if general corporate earnings grow at a faster rate than REITs', then the sector could prove disappointing in the short term.

However, as a long-term investment, many say REITs are a good portfolio diversification tool. Over the long term, investors in REITs should expect dividend yields of about 6% with low single digit earnings growth, says Lindemann of SNL. "Over time, you should look for total returns in the neighborhood of 10% to 12%," he says.

Brokerage Partners