REITs could be priced for perfection, or so say many pundits after the sector experienced two years of significant growth. After real estate investment trusts grew more than 40% during 2000 and 2001, as measured by the SNL Securities Equity REIT index, any additional appreciation for them becomes a bit of a challenge.

"We expect REITs will generate a 7% total return in 2002," says Goldman Sachs senior REIT analyst David Kostin. "REITs surged 42% during 2000 and 2001, dwarfing the dreadful negative 20% return of the S&P 500 during that same period."

Sure, 7% is a solid return, but that assumes little growth, because the current yield of Goldman's REIT stock universe is a hefty 6.3%. "That's a 110 basis-point spread to the 10-year Treasury," Kostin notes.

Last week's column offered a peek into the future of office and retail REITs. Today, let's look at the multifamily, health care and lodging sectors.

Controlling the Apartment Population

Though apartment REITs underperformed in 2001 -- 10.3% vs. nearly 14% for the average REIT -- they still don't look cheap. The average apartment REIT trades at 10.6 times current funds from operations (also known as FFO, a measure of a REIT's cash flow) compared with 9.6 times for the average REIT.

"Notwithstanding their laggard performance in 2001, many apartment REITs still sell at high multiples," says T. Ritson Ferguson, president and portfolio manager at CRA Real Estate Securities.

Kostin agrees, and Goldman Sachs recommends underweighting the apartment sector. "The traditionally defensive apartment sector is overvalued on virtually all measures," he says, noting the sector's diverse valuation. "Fundamentals here vary greatly by geography."

One large concern for apartment investors in the coming year is the growth of supply as demand slows. "We worry about the construction pipeline because of the mortgage and institutional investment money still available to apartment developers," says Ferguson. "The pipeline is hard to slow down."

Geography also plays a role in Ferguson's analysis, and he remains concerned about Northern California markets. "We are still very cautious on the San Francisco Bay area," he says. "Unless the economy snaps back in a hurry, you have very anemic rent and pressure on occupancy."

Apartment REITs with significant exposure to Northern California include Essex ( ESS), AvalonBay ( AVB) and BRE Properties ( BRE).

While cautious, Ferguson says selective opportunities reside in the apartment space. He likes Camden ( CPT - Get Report) and BRE, though he adds that "BRE has a high multiple but trades at a discount to AvalonBay and Essex."

He also likes Gables a value play that could provide investors with a takeover boost. "Gables is interesting at these prices," Ferguson says. "The stock trades at a discount to net asset value with good quality properties, and I think Gables Chairman and CEO Chris Wheeler is genuine in being open to offers." Wheeler had indicated an interest last year in selling the company.

As for other mergers, Ferguson sees more ahead in 2002. "There will be some merger activity over the course of the year, but probably no more or less than last year," he says, suggesting there isn't a lot of interest in deals from owners of large apartment REITs to buy smaller, lower-quality portfolios. "I don't know that the large REITs want to come in and buy companies like Associated Estates ( AEC) or Mid-America Apartments ( MAA)."

Health Care on the Mend?

Health care REITs were star performers of 2001, providing investors with a total return of 56.2%, according to SNL Securities. Yet the current 8.8% yield for the average health care REIT remains the best among property types.

While attractive to yield chasers, most health care companies are paying out 95% to 100% of their available cash, says Ferguson, suggesting that dividends can't grow without earnings growth. "There's no growth in sight," he says. Yet it could be worse. "The operator crisis has run its course," he explains, "and for the most part, the companies are beyond bankruptcy and markdown risk."

Larry Raiman at Credit Suisse First Boston thinks health care should continue to outperform other property sectors because of long lease duration and above-average yields. He says investors should consider Health Care Property Investors ( HCP) and Healthcare Realty ( HR). He rates both buy, and his firm has not provided banking services to either.

Hotels: Overstaying the Welcome?

Lodging stocks were among the most affected by Sept. 11 because business and leisure travel both evaporated. Yet after the rapid and painful selloff in hotel stocks, the stocks are up 50% or more since Sept. 20, leading many pundits to suggest the sector has rebounded too quickly.

"Lodging stocks are acting like what happened Sept. 11 never happened," says Ferguson. "A lot of the 2003 recovery is already built into the prices of the stocks. Trends for these companies will improve into the year, but the reality is, that means things are only going to be less horrible than they were." He notes that lodging operating companies have mostly recovered to pre-Sept. 11 levels and that hotel REITs have recovered as well, though not as quickly as the operating companies.

Still, some remain bullish on lodging stocks. "Since the weeks after Sept. 11, lodging stocks have appreciated over 50%, causing some to question whether these stocks have come too far too fast," Merrill Lynch lodging analyst David Anders told clients last week. "We don't believe so and would encourage investors to add to or initiate positions in these companies."

His favorite plays are Starwood Hotels ( HOT), Marriott ( MAR) and Orient-Express Hotels ( OEH). He rates all buy, and Merrill has provided banking for both Marriott and Orient-Express.

Although he thinks lodging stocks may appreciate more in the short term, Ferguson thinks real estate investors looking for stable returns and dividends are better off avoiding the volatile sector: "Lodging is to REIT managers as Japan is to international fund managers."


Coming next: a look at the performance of our REIT "Growth at a Reasonable Price" portfolio and a new list of GARP REITs for 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.