REITs' Rut May Be Exaggerated

After soaring 21% from late March through early August, the Dow Jones REIT Index got clobbered last week as 10-year Treasury yields rose dramatically. Following a bearish cover story about the sector in Barron's over the weekend, the index fell another 3% Monday and it seemed as if no one wanted to touch real estate investment trusts.

But the sector has made a bit of a comeback since, and industry observers say the same conditions that originally attracted investors toward high-yielding investments such as REITs remain in place. Notably, REITs rose while the rest of the market fell on Wednesday, and the Dow Jones REIT Index was recently up 1.7% Thursday, outperforming major averages.

"We believe that capital looking for property investment will prove to be quite sticky and will not disappear in a higher-yield environment," says Dave Harris, REIT analyst at Lehman Brothers.

With the Federal Reserve seemingly intent on continuing its tightening campaign, few -- Harris included -- deny there are risks associated with rate-sensitive stocks, including REITs. Undeniably, the same phenomenon that led to the residential housing boom -- historically low interest rates -- has led those searching for higher returns into high-yielding assets, such as REITs. The frenzy to own tangible assets such as real estate has also, by extension, boosted the price of REIT stocks.

But with short-term interest rates poised to continue rising, and with 10-year Treasury yields now seemingly following suit, the appeal of REITs should wane. Furthermore, the once generous dividend yields of 8.75% offered by the sector in 1999 have dwindled to roughly 4.5%.

A short-term correction may indeed be in the works, says Harris. "By historic standards, the stocks are not cheap. Even after last week's fall, they're still very expensive," he says.

But what happened last week was likely just "a pricking out of the exuberance" in the stocks rather than the end of the bull market, Harris says.

REIT stocks had been trading in a "detached manner" from the fundamentals that normally affect them, such as the direction of long bond yields, he says. Yields started rising in late June, but REITs kept on rising amid high expectations for second-quarter earnings.