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REITs on The Street: Cheap for a Reason

NEW YORK ( TheStreet) -- It's not surprising that the sell-off in REIT-dom is led by the institutional buyers that have a much higher degree of analyst coverage and much lower risk tolerances.

Of course it goes without saying that a further rise in interest rates creates more competition for fixed-income investors, and that means oftentimes the small-cap names get ignored. Accordingly, small-cap real estate investment trusts have always been seen as riskier bets than large caps. But should they be ignored?

Small-cap REITs often do not have the diverse revenue streams or stable cash flows that allow them to weather difficult economic conditions like their larger-cap counterparts, and they are also more susceptible to wide swings in price due to lower trading volumes. But does that mean they can be dangerous?

Not necessarily. Oftentimes the greater volatility in a small-cap deters action and often invites selling. Because of the lack of Wall Street coverage -- and modest investor interest -- shares in small-cap REITs often remain undervalued for extended periods of time.

Some Small-Cap REITs Flying Under the Radar

By "flying under the radar" the small-cap REITs offer better potential for growth over the long term. Due to the decreased institutional support, there's a better chance small-cap REITs will result in an underestimation of a REIT's operational health and prospects.

For those REIT investors seeking yield, the difficulty is in predicting the exact dividend policies companies will adopt in the coming years. That's a risk. As more investors enter retirement and need to replace substantial proportions of their working-years income by using their investment portfolios, a reliable dividend-yield strategy is a must.

One way to mitigate the risk for the lack of a REIT's dividend history is to examine some of the former non-traded REITs. Since non-listed REITs don't trade on an exchange, the value proposition for owners and investors is to raise "blind pool" capital in a format such that companies can eventually go public and list shares.

By acquiring shares in a public REIT that was formerly a non-listed REIT, an investor has the advantage of researching the dividend history and the management teams track record for managing risk.

Several former non-listed REITs that appear cheap today include Chambers Street Group (CSG - Get Report), Cole Real Estate Investments (COLE) and Whitestone REIT (WSR - Get Report). All of these publicly-traded REITs have attractive valuations based upon their price to funds from operations (or P/FFO) multiples -- a primary valuation metric for REIT investors.

Courtesy of SNL Financial

Give the smaller market capitalization levels or the fact that they are newly listed, these REITs are not known to institutional investors. It could take a while for the big institutional boys to warm up to the unknown players in REIT-dom. Alternatively, the big-cap REITs get most of Wall Street's attention because that is where the lucrative investment banking business is.

By flying under the radar, investors can find value where the index buyers can't. Ben Graham always tried to buy stocks that were trading at a discount to their Net Current Asset Value, oftentimes the ones being ignored by Wall Street and the investing public for no good reason in spite of stellar results or sound operating fundamentals. In other words, Graham would buy stocks that were undervalued and hold them until they became fully valued (and oftentimes "superstars").

However, one thing is for sure: REITs that "fly under the radar" are cheap for a reason.

Courtesy of SNL Financial

At the time of publication the author was long CSG.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.

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