This time last year, many experts were saying that the remarkable REIT bull run was sure to end in 2005. Hopefully you didn't listen to them. For the sixth year in a row, REITs are set to outperform the broader stock market. Low long-term interest rates, improving commercial real estate fundamentals and a lackluster stock market have kept investors' cash within the sector. Year to date, the NAREIT Equity REIT Index -- which includes all publicly traded REITs except mortgage REITs -- is up 11.7% on a total return basis. Compare that to the S&P 500, which is up 5.8% on a total return basis. Although much of the gloom forecasts at the end of last year came from sell-side analysts, many buy-side investors also were turning cautious on the group. A similar scenario is
playing out this year. One veteran expecting more modest returns for 2005 was Timothy Pire, portfolio manager of the real estate securities group at Heitman, which has $13 billion of real estate assets and stocks under management for institutional clients. Pire expected REITs to post total returns of between zero and 10% this year. He admits he missed the ball on interest rates. "I thought rates would be higher, and with rates being higher that some of the yield-driven capital would flow someplace else," he says. But interest rates remained low this year, which helped money stay within the REIT sector. Going forward, rates are expected to inch up but not rise too much unless inflation picks up. Doug Poutasse, chief investment strategist with AEW Capital Management, which manages $20.6 billion of institutional capital, has an outlook for REITs in 2006 that is similar to his forecast at the end of last year. He expects REITs to post single-digit returns in 2006 -- with all returns essentially coming from the dividend, with price appreciation being flat. He admits that his more bearish views for 2005 were wrong but feels the outperformance has to end at some point.
"REITs cannot continue to outperform the S&P 500 forever," Poutasse says. "They've now had six straight years of outperforming the S&P 500." So what names will be good in 2006? Pire likes value creators that can develop properties to boost earnings rather than rely on a difficult acquisition environment. Examples include luxury apartment REITs like Avalon Bay ( AVB - Get Report) and Archstone-Smith He also likes strong operating companies, such as Simon Property Group ( SPG - Get Report), the country's largest mall owner. Lou Taylor, a Deutsche Bank analyst, believes apartment and mall stocks will perform best next year. In a recent research note, he says apartment companies could generate upside earnings surprises next year. He also likes Avalon Bay, and is favorable on BRE Properties ( BRE), Camden Property Trust ( CPT - Get Report) and Equity Residential ( EQR - Get Report), along with Simon and General Growth Properties ( GGP) in the mall sector. Taylor believes REITs will post a total return of 8% to 12% next year, helped by low long-term interest rates, good fundamentals and another year of healthy mergers and acquisitions in the group. Pire says one of the worst situations for REITs next year would be if corporate profits start roaring and the economy looks to be stronger than anticipated. This was the environment in 1999, when the NAREIT Equity REIT Index fell 4.6% on a total return basis. If earnings growth looks average, REITs might perform in line with the broader equities, Pire says. And if economic growth looks weak, then yields on the 10-year note could drop further and REITs might outperform once again, he predicts. Get Jim Cramer's picks for 2006.