Despite a Solid Quarter, REITs Get the Cold Shoulder From Investors

It isn't that people hate REITs; it's just that there is nothing attracting mainstream investors to real estate.
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After turning in another solid quarter of operating earnings, real estate investment trust executives have once again gotten a cold shoulder from investors. Since reaching a high of 329 on May 13, the

Morgan Stanley

REIT index has fallen nearly 10%, giving back the bulk of this spring's gains.

And yet their operating performance remains strong: The average REIT's Funds from Operations (FFO, a measure of cash flow that excludes real estate depreciation expense) were up 8.3% in the second quarter. That's slightly below the 8.9% growth in the first quarter, but still, almost 90% of all REITs (see table below) either met or exceeded street estimates for second quarter FFO.

Why the disconnect? According to analysts, it isn't that people hate REITs, it's just that there is nothing attracting mainstream investors to real estate. "The average investor just doesn't have much interest in REITs," says Ritson Ferguson of

CRA Real Estate Securities

. "Apathy is a very difficult thing to battle in the public markets, and investors are clearly apathetic toward REITs."

This reality leaves many in the business both surprised and perplexed, especially considering both the attractive valuation and the compelling dividend yield of REITs vs. both the broader markets and bonds. According to

SNL Securities

, the average REIT trades at only 8.5-times next year's estimated FFO, with a yield of nearly 8.5%.

Furthermore, many REITs are trading below the value of their underlying real estate, a handful at discounts exceeding 15%. "The numbers are clearly attractive," Ferguson says. "The dividends are underpinned by solid cash flow, which is growing at a steady clip. All of that is very positive."

Attention From an Unlikely Suitor

Still, REITs are the stepchild of the market, largely ignored by investors outside the insular world of real estate aficionados. And, even worse, many real estate insiders feel there is little the industry can do itself to generate more interest. While the spring saw a mini-rally in REIT shares, the reason wasn't management buyouts, the small flurry of M&A activity, stock-repurchase plans or a large institutional REIT buy program. It was instead the most unlikeliest of sources --

Warren Buffett

, buying into

Tanger Factory Outlets

(SKT) - Get Report

,

Town & Country Trust

(TCT)

and

MGI Properties

(MGI) - Get Report

.

As it later turned out, Buffett's

investments were personal, a result of a desire for the income. As Buffett

distanced himself from the hoopla surrounding his REIT purchase, the spark quickly flickered.

"Buffett's head fake in the sector raised investor interest," says one buy-side money manager. "The internal factors were either irrelevant or followed on the heels of Buffett's filings." Even a multimillion-dollar ad campaign by

NAREIT

, the REIT trade group, couldn't hold long-term interest in the sector.

"When you can make the annual dividend of a REIT in a week of daytrading technology stocks, investors say 'Why wait?,'" says Robinson Humphrey's Chris Marinac.

Since then, a host of REITs have announced stock buyback plans, floated the possibility of management buyouts, and M&A activity, while slowing, continues to be the chatter of many companies. But the moves have failed to gain investor interest.

"Investors aren't interested in the equity-income plays," says Chris Marinac, director of financial services research at

Robinson Humphrey

. "When you can make the annual dividend of a REIT in a week of daytrading technology stocks, investors say 'Why wait?' Longer term, that may not be smart, but right now it's reality."

Some think change may not come for months, or even years. "We'll eventually return to a point where yield becomes an interesting facet in investing," Ferguson says. However, Marinac suggests investors shouldn't hold their breath. "This may be an issue for months to come. It'll take a major shift in sentiment to regain an interest in dividends."

So, what might lead to a change in sentiment possibly propelling REITs higher? For one, a general market correction with REITs holding their prices and becoming a safe haven for turbulent-weary investors. "REITs should benefit from a significant market correction that would help investors appreciate that an income yield and slow, steady earnings growth isn't so bad," Ferguson suggests.

As general valuations continue to rise, more generalists find the names of unfamiliar REITs appearing on their radar. "REITs are becoming more interesting for both valuation and diversification," says Ted Bridges of

Bridges Investment Counsel

, an Omaha, Neb., management firm with a growth bent. "REITs provide a good value play and allow you to get paid while you wait." Still, he appears unwilling to make a major commitment to REITs. "We haven't been in a big rush to enter the sector," he says. "And at the peak, they'd never be more than 5% to 10% of our portfolio, even at giveaway prices," Bridges says.

The caution may be the result of recent history, where REITs haven't lived up to their billing as a conservative investment, providing good protection in a market downdraft. "In recent experience, REITs haven't gone up during market rallies but have followed the market lower," Marinac says.

Yet part of the reason for investor wariness is the unreasonable expectations of investors during the REIT euphoria from 1996 to 1998. "These stocks were treated like growth stocks and expected to perform like highfliers," the buy-sider says. "They got way ahead of themselves and then reality struck. A lot of investors learned a real estate lesson the hard way," a lesson that continues to sour many investors on the future of REITs.

A Radical Prescription

As a result, Marinac is a bit more radical in his prescription for the health of the sector: "At the end of the day, what the sector needs is a recession," he says. "So many investors are skeptical about real estate's staying power in a downturn. They remember the 1970s and 1980s and the decimation in real estate." Marinac, and others, argue that REITs operating performance will remain strong relative to other businesses, even in a broad economic slowdown and that will be REITs opportunity to silence the skeptics.

While the recession cure may sound like major surgery to cure a hangnail, it highlights an important point. The catalyst to rekindle interest in REITs appears to be outside of the sector's control. It also suggests current REIT investors should be prepared to accept dividends as the primary return in the months to come. "It may ultimately come down to long-term cyclical rotation. There won't be a sharp catalyst and it won't happen overnight. Eventually, something will spark interest and investors will come back slowly," Ferguson says.

Realistic, but frustrating. And for those cheering for an industry renaissance, they hope the next catalyst not only attracts investors but also convinces them to hang around the "real" world for a while.

Next week, we'll handicap the handicapped. A review and look ahead regarding the prospects of REITs by the property sector.

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 at

invest@cjnetworks.com.