With the debt markets in disarray, commercial real estate is being re-priced and shares of real estate investment trusts have been sliding. But some argue the stocks have gotten cheap and are pricing in too much danger.

Buying the sector here may just bring more short-term pain -- something even the bulls admit.

On some valuation metrics, however, REITs look attractive.

For instance, the yield on the iShares Dow Jones Real Estate Index ( IYR) is now 4.2%, compared with a yield of 3.94% on the 10-year Treasury Note.

For most of the past two years, the sector's dividend yields have been lower than those of Treasuries, which often compete with REIT stocks for investment dollars because both offer steady payouts.

While the dividend issue is a slight positive, the stocks continue to be more volatile than the broader market, as evidenced by betas generally above 1. Beta is a measurement for a stock's volatility, and a reading above 1 means the stocks are either rising or declining at a much faster pace than the broader stock market's respective moves.

Year to date, the price-only version of the US MSCI REIT Index is down about 17%, compared with a 4% increase in the S&P 500. The big drop comes as concerns over the health of the national economy and the fluctuating credit market have wreaked havoc on commercial real estate pricing.

"The steep decline in stock prices mixed with the occasional sharp upturn has created betas that are unusually high," wrote RBC Capital Markets analyst Rich Moore in a research note last week. "These kinds of betas should not be associated with companies that produce the generally stable earnings results found in the commercial real estate sector."

Sam Lieber, portfolio manager with Alpine Woods Capital, says the big selling pressure in REIT stocks is probably done. The recent drop in REIT prices was largely due to selling from non-dedicated REIT investors -- whose rapid buying helped fuel the sector's boom in recent years, he says.

Going forward, Lieber expects the fund flows into the sector to be less than the past two years, when shares rose sharply.

"A lot of that money came in from hedge funds that needed exposure or individual investors who wanted more exposure," Lieber says.

Lieber's sense is that REIT prices may not be done correcting, but, he adds: "I think a lot of the bad news is in the prices."

Vexing Valuations

Even if dividend yields look good and fundamentals seem solid, the problems in the real estate debt markets continue to hurt valuations, which is why some investors are largely staying away from the stocks today.

"I'm not buying the sector here," says one real estate hedge fund manager who already has REIT exposure. "There won't be any M&A in the sector in a meaningful way. Not in the near-term."

So unless you really love the dividend, buying the sector could be problematic because yields could continue spiking as stocks prices drop, and earnings growth may slow next year with the economy weakening.

At some level, investors continue to be worried about catching falling knives in the sector. To be clear, REITs are in far better shape than homebuilder stocks. But valuation concerns linger.

On the private side of the real estate market, cheap debt helped cause valuations to reach unrealistic levels -- the phenomenon of too much money cashing too few deals. Now, debt availability is severely limited. It's become clear that Sam Zell's sale of Equity Office Properties to Blackstone ( BX) earlier this year marked the top of the market.

"Debt is out there, but it's a lot tougher," says Stephen Coyle, chief investment strategist with Citigroup Property Investors. "If someone is looking for debt with a deal of $100 million or less, it's out there. People are not getting debt on big giant deals. You can't do an EOP (Equity Office Properties) deal today."

The stifling debt market was a subject of much discussion at the NYU Real Estate Institute's annual industry conference last week.

What was clear from participants is that life insurance companies -- such as Prudential ( PRU) and Met Life ( MET) -- are still big funders of real estate debt (at least the more traditional kind, with 80% maximum loan to value.) These companies hold the loans on their balance sheets and are not required to sell them into securitizations, as Wall Street banks do.

However, even if portfolio lenders are still handing out money, they make up just 50% of the commercial real estate lending market, said Adam Raboy, managing director and co-head of origination with Credit Suisse, on a panel discussion.

"We're open for business at a spread and price that borrowers don't want to pay," Raboy says.

The shutdown of much of the credit markets means real estate valuations have fallen by some amount, industry experts agree. The question is how far.

One problem with determining valuations is that deal flow has fallen substantially. Sales of significant office properties fell 70% year-over-year to $4.4 billion in October, according to Real Capital Analytics.

One standard real estate valuation metric is a capitalization rate, or "cap rate." This is equivalent to an annual yield, which measures property income as a percentage of investment price.

Since August, the spread between cap rates and Treasuries is up 75 basis points for suburban office properties, but is up only slightly for central city office towers, according to Real Capital Analytics.

Market cap rates are used by investors to determine REIT net asset values, which roughly equate to the valuation of REITs' property portfolios in the private market.

Green Street Advisors, a prominent independent REIT research shop, says their NAV estimates for REITs have dropped 5% on average from August. The current cap rate Greenstreet applies averages 5.8% across all property sectors.

REIT stocks on average are now trading at a 20% discount to published NAV estimates from Green Street and other research shops, according to data from SNL Financial.

New York, New York

Of course, even if REITs are cheap, someone needs to step up their buying of the sector. In the past, private equity shops would come in to correct prices -- a phenomenon that has stopped short because of the problematic debt markets.

Lieber says his firm, which typically holds REITs in its portfolios, has been buying some stocks in the sector of late, but declined to give names because positions have not been established yet.

One area he is looking at is New York City office market, a segment that has seen its stocks beaten down hard. Among those with a heavy presence in the city are SL Green ( SLG), Vornado ( VNO), Boston Properties ( BXP) and Brookfield Properties ( BPO).

Lieber points to the old saying about New York City: "If you can make it there, you make it anywhere." He expects the downturn in the financial services industry and the large layoffs from Wall Street won't destroy the commercial real estate market in New York.

"This is one of the more interesting markets to look at right now," he says.

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