REITs: Another Good Year Ahead?

By Abby Schultz, Special to CNBC.com

NEW YORK (CNBC) -- Third time lucky?

Returns for equity real estate investment trusts, REITs, skyrocketed nearly 28 percent each of the last two years. The question for investors is: Can that possibly happen again?

With the economy finally starting to gain traction, it's a valid question. A stronger economy is good for REITs, because it leads to better occupancy rates, more financially secure tenants and higher property values.

But as the economy improves, interest rates also rise -- as they have for the most part this year -- and that increases the cost of borrowing for REITs as they buy properties.

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So can investors expect another year of 28 percent returns? Probably not. But REITs have the potential to do fine, particularly if the economy continues to strengthen.

"In an environment with moderately positive fundamentals driven by a moderate economic recovery and relatively flat or gently rising interest rates, we expect a 15 percent up year; roughly equal to the S&P 500," says John Guinee, managing director at Stifel Nicolaus.

Guinee, however, has some caveats. If the yield on the 10-year Treasury note falls below three percent, making it cheaper to borrow, returns could rise more than 20 percent, says Guinee.

Lower Treasury rates also make REITs more attractive to investors seeking income, since they pay an average dividend of 3.45 percent.

Then again, goes the argument, if the 10-year note rises above 4 percent, returns could become negative.

"The 'yin-yang' is property fundamentals versus interest rates," Guinee says. "Is one strong enough to trump the other?"

Other analysts see the fundamentals of the real estate business strengthening to the point that they outweigh the effects of interest rates on REITs.

"Residential occupancy has started to stabilize, and rents are starting to increase across all sectors," says Ken Weissenberg, leader of the Real Estate Services Group at EisnerAmper. "So, I think as interest rates rise, it'll be more than offset by increases in operating profits."

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