Can

REITs three-peat in 2002?

Investors have been flocking to real estate investment trusts, or REITS, for their robust 7%-plus yield. But after two years of relative supremacy, REITs will find the landscape more difficult as the sector attempts to continue its bullish streak.

Two factors will weigh on REITs in 2002: fundamentals and competition. As REITs approach the late innings of the cycle, investing in the right property sectors and selecting stocks will be the keys to success in the year ahead.

"Certainly, company-specific analysis is crucial," notes Larry Raiman, director of REIT research at Credit Suisse First Boston and a member of the

TSC

REIT Roundtable. "As well, sector and thematic biases are crucial."

So let's peruse the general outlook for REITs and for two property sectors: office and retail.

Modest Targets, Fundamental Focus

If pundits are correct, investors can expect about a 9% return from REITs in 2002. That's not saying much about operating performance, considering the average REIT offers a 7% yield.

"For 2002, we expect

REITs to post a total return of 7% to 10% with the majority of the return coming in the form of dividends," Steve Sakwa, director of REIT research at Merrill Lynch, told clients in his annual outlook for the sector. "Our muted price-appreciation projection of 0% to 3% is predicated on our belief that

net asset value for the REIT sector has plateaued and should trend sideways for the next several quarters, limiting the rise in stock prices."

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Even those targets could be problematic if the economy doesn't improve. Many REITs have long-term leases that provide some insulation from short-term skittishness, but the current slowdown will continue to affect REITs. "Weak economic conditions and significant job layoffs are taking their toll on most real estate markets," notes Raiman. "All

property sectors carry some level of excess capacity and are therefore experiencing vacancy increases and rent decreases. In turn, industry growth rates have fallen from 10% in mid-2000 to 2% to 5% today."

Deconstructing the Office Space

The economic malaise will be felt most in the office sector.

"The biggest story of 2001 is that office demand fell off a cliff," says Steve Burton, portfolio manager at CRA Real Estate Securities and a member of the

TSC

REIT Roundtable. "It happened almost overnight, and it hasn't really improved."

It may get even worse. For example, the Atlanta market was once a poster child for the burgeoning economy, but demand for office space there disappeared last summer. In a market that once pushed 90%-plus occupancy, Atlanta's office market could see 20%-plus vacancies in the coming year. Fortunately, the real estate markets have become more disciplined since the building spree of the mid-1990s, meaning less new supply is coming to market as demand swoons.

Nevertheless, office REITs will feel the pain. "We believe office stocks will have a difficult time outperforming the REIT index," notes Sakwa. "There could be more bad news looming for office supply-demand fundamentals, which should become more apparent in February

and March, when companies report year-end results."

Not all office REITs face a tough year, though. Companies like

Vornado

(VNO) - Get Report

, which is focused on the relatively strong New York and Washington, D.C., markets and long-term lease structures, can probably weather the economic storm better than most.

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In the short term, Raiman says he'd focus on office REITs with little development exposure. "REITs like

Prentiss Properties

(PP)

and

PS Business Parks

(PSB) - Get Report

are not delivering any new developments in 2002 and should not necessarily be valued in a similar fashion to their peers," he explains. He rates both buy, and his firm has not provided banking services to either.

"Office is now a demand story," says CRA's Burton, "and that, in large part, makes it an economy story."

Shopping for Retail Bargains

Merrill's Sakwa thinks regional malls are set to lead REITs higher in 2002, even in a weak economy.

"Regional mall stocks can do well in a sluggish economy due to their long lease structures, the low levels of percentage rent landlords derive from the specialty retailers (about 3%) and attractive valuations," Sakwa says.

His top pick in the sector is

Mills

(MLS)

, a retail REIT focused on value-based centers like suburban Chicago's Gurnee Mills. He rates the stock buy, and Merrill Lynch has provided banking services for the company.

CSFB's Raiman isn't as bullish on regional malls, expressing caution that leasing trends could slow in the second half of 2002 and in 2003.

Moreover, he thinks rising interest rates could pressure earnings of regional mall REITs. "The earnings growth rates of several mall REITs benefited in 2001, owing to large exposures to unhedged, floating-rate debt," he notes.

Raiman believes that expectations of earnings growth above 7% for regional malls will have to come down. "Hence, we forecast the possibility of modest multiple contraction for the mall sector in 2002," he concludes.

A more conservative play, especially given the economy's uncertain future, would be community center REITs, companies that own grocery-anchored "strip centers." Community centers typically perform well as the economic cycle turns. Two to consider are

Kimco

(KIM) - Get Report

and

Pan Pacific

(PNP)

.

Coming next: a look at multifamily, storage and health care REITs as well as the competitive factors that will shape the REIT industry in 2002.

Christopher S. Edmonds is president of Resource Dynamics, a private financial consulting firm based in Atlanta. At time of publication, neither Edmonds nor his firm held positions in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Edmonds cannot provide investment advice or recommendations, he welcomes your feedback and invites you to send it to

Chris Edmonds.