In the past 20 days, shares of real estate investment trusts have been blown out of the sky. REITs focused on skyscrapers, malls, hospitals and apartments plunged in sync with bonds after a strong jobs report suggested that an improving economy may make interest rates rise.

Veteran observers say the normally dull group has never experienced a period of such volatility -- and certainly never lost as much value in as short a period of time. Industry standout Chelsea Property Group ( CPG), which has posted only one down year in the past decade, sank 20% from April 2 to April 14. Diversified land developer and manager Cousins Properties ( CUZ), another stellar long-term performer, fell 17%.

Does this make sense? Probably not.

REITs are appealing to investors largely for their fat dividend yields, typically north of 5%. But during the selloff, bears theorized that rising interest rates would make those yields less attractive in comparison with risk-free government bonds. They also figured that higher rates would goose operating expenses at the real estate companies, cutting both yields and earnings.

It's hard to argue with the market when it's making such an emphatic call, but the panic selling may have provided cooler heads with a rare opportunity to buy some of the strongest companies in America at a discount. Indeed, if you have a contrarian bent and a longer time horizon, then REIT should stand for "Rather Enticing Investment Today."

An improved economy, after all, should make most REITs more valuable, not less. Let's take a look at what these companies do, and which should be purchased in this decline.

Don't Mistake REITs for Bonds

Real estate investment trusts are basically companies that own space and charge rent. They aren't homebuilders or commercial developers. They are property owners that specialize in niches such as hospitals, downtown office buildings or shopping malls. Income-seeking investors like REITs because they are required to distribute at least 90% of their income in the form of dividends. But in recent years, investors seeking capital gains have flocked to them, too, as stable, rising rents have provided substantial capital gains.

Chelsea Property, a mid-cap company that owns high-end outlet malls around the country, has advanced 21% per year in the past decade. That's much better than popular growth stocks like IBM ( IBM), Wal-Mart ( WMT) and Home Depot ( HD).

In a better economy, demand for space in offices, apartments and strip malls rises, and these companies can raise rents. That makes REITs more economically sensitive, like cyclicals, than rate-sensitive, like bonds. These businesses have tons of operating leverage, which means that when occupancy rates rise, earnings will move up faster than revenue because they have high fixed costs. Paul Gray, portfolio manager at Kensington Strategic Realty Fund, says, "We actually want job growth and inflation! These companies have as much pricing power as any strong business. A booming economy is good for real estate."

Gray said much of the problem for the group in recent weeks was related more to its recent manic run-up than to rate fears. REITs as a group were up 37% in 2003 and an additional 12% in the first quarter, pushing valuations to extremes. March was the 14th straight month that the sector was up. More money was put to work in REITs in the first three months of 2004, in fact, than in many of the previous entire years.

Much of the latter boost, Gray said, came from momentum-chasing investors who didn't understand the fundamentals of the business and dumped shares at the first whiff of perceived danger. "There was a massive exodus of people who thought REITs were bond alternatives," he said. "But they don't seem to understand that these companies can raise their dividends while bonds cannot."

Gray's Picks

Retail and health care REITs have been hit the hardest, possibly because they had been up the most. Now valuations aren't pound-the-table cheap, but a lot of fluff has certainly been removed by the panic selling. Here are a few names that are worth considering now, according to Gray:

  • Macerich (MAC) owns interests in more than 70 major shopping centers that cover about 60 million square feet of leasable area. The stock plunged from $54 at the start of the month to around $41 a few days ago, but it has stabilized around $43. That kind of move is nothing for a tech stock, but Macerich has risen steadily since December 2000 with barely anything more than a 5% correction. Gray says the company has strong management, a predictable earnings outlook for this year and next year due to its long-term leases, and a tidy dividend of 5.1%.
  • Boston Properties (BXP) owns high-quality assets in San Francisco, New York, Boston and Washington, D.C. Gray says it has a great management team, a stable portfolio of buildings in places where few new ones are being built and lots of operating leverage. The portfolio manager estimates the stock is now trading for a 10% discount to the value of Boston's properties.
  • Koger Equity (KE), a small-cap, is a suburban office-building specialist in Florida that pays a 6.2% dividend. Gray says the company has strong management, good assets that could withstand a rise in rents, and a stock that is trading at a 5% discount to its properties' value.

Barry Vinocur, editor of Realty Stock Review and a longtime observer of the industry, said he believes that many institutional investors who had been waiting to put money to work into REITs, but were put off by valuations, finally started to apply funds on Thursday and Friday last week as panic selling peaked. He believes the best values are the ones with strong earnings growth and a history of big dividend increases. These three sit atop his list:

  • Chelsea Property Group, a developer and owner of trendy outlet malls, traded as high as $60, fell $11 in two weeks and stabilized at $52. "We told readers it was a screaming buy at $49," Vinocur said. Earnings are growing at a compound annual rate of 15%, dividend growth is in the low double digits and management is first-rate, he says. "We think you're hard-pressed to find a company with the track record that Chelsea has -- and it's still firing on all cylinders," he said.
  • Ventas (VTR) owns senior housing and medical care properties in 37 states. Kindred Healthcare (KIND), from which it split, leases a majority of its facilities. Vinocur says CEO Debra Cafaro developed "a dynamite business plan" that has generated much more top-line growth than Wall Street believed possible. The stock was up 105% last year and 114% in 2001, and is still up 6% this year even after taking the hit.
  • Vornado Realty Trust (VNO) owns office buildings, shopping centers and temperature-controlled warehouses throughout North America. Vinocur said he believes many of Vornado's properties in Manhattan and Washington, D.C. are renting below market and can easily be boosted if economic growth continues. Management is excellent, the valuation is good, the yield is 5.3% and there is plenty of room for further earnings and dividend growth. The stock has risen 19% compounded annually for the past 10 years, including a 57% move up last year. After the recent slide, though, shares are flat for 2004.

From a chart perspective, most of these stocks have just traded down to their 200-day moving averages and bounced hard. If Gray and Vinocur are right, that long-term support level should hold, and shares should rebound for the remainder of the year. If shares sink below those levels -- $51.30 for Chelsea, $42.65 for Macerich, $46.90 for Boston Properties, $20.35 for Koger, $20.72 for Ventas and $52 for Vornado -- it would be a sign that major investors are liquidating REITs in anticipation of a weaker economy, not a stronger one.

Bargain real estate doesn't come along very often. Take one home.
Jon D. Markman is publisher of StockTactics Advisor, an independent weekly investment newsletter, as well as senior strategist and portfolio manager at Pinnacle Investment Advisors. While he cannot provide personalized investment advice or recommendations, he welcomes column critiques and comments at jdmmail@fastmail.fm. At the time of publication, Markman had positions in none of the securities mentioned in this column.