By Abby Schultz, Special to CNBC.com
NEW YORK (CNBC) -- Third time lucky?Returns for equity real estate investment trusts, REITs, skyrocketed nearly 28 percent each of the last two years. The question for investors is: Can that possibly happen again? With the economy finally starting to gain traction, it's a valid question. A stronger economy is good for REITs, because it leads to better occupancy rates, more financially secure tenants and higher property values. But as the economy improves, interest rates also rise -- as they have for the most part this year -- and that increases the cost of borrowing for REITs as they buy properties.
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Still, other analysts are more cautious. "Most of the REITs we cover currently trade near or above our fair value estimates," said Todd Lucacik, senior equity analyst in real estate at Morningstar."Consequently, while REIT operating metrics should generally improve somewhat in 2011, we don't expect the strong sector stock performance from 2010 to recur in 2011." Paul Simon, CIO of Tactical Allocation Group, would like to buy REITs as an inflation hedge as the economy improves, but he's turned off by what he sees as their lofty levels. "The problem is the valuations, in terms of how we value REITs, they are very expensive by just about every measure we look at," Simon says. Equity real estate investment trusts, a nearly $360 billion market, are required to own 75 percent of their assets in real estate, and to distribute at least 90 percent of their income to investors in the form of dividends. One reason REITs have been so popular is they are among the few yield-producing securities available to investors these days. Dividend yields for some REITs are substantial. CommonWealth REIT ( CWH) and Hospitality Properties Trust ( HPT) boasted a 7.8-percent dividend yield last year, Senior Housing Properties ( SNH) had a dividend yield of 6.7 percent, and National Retail Properties ( NNN)had a yield of 5.7 percent. The average dividend yield of equity REITs in 2009 was 3.7, and in 2010 was 3.5 percent, according to the FTSE National Association of Real Estate Investment Trusts. That compares with an average dividend yield of 1.95 percent for the S&P 500 in 2009 and just under 2 percent in 2010. So far this year, the dividend yield has slipped to 3.4 percent, compared with about a 1.78 dividend yield for the S&P 500. Investors, however, should look beyond dividend rates when analyzing REITs, argues Craig Leupold president of Green Street Advisors, an investment research firm specializing in REITs. Instead, focus on the value of the underlying property value, says Leupold. "Companies can either overpay or underpay their dividends relative to the cash flow being generated," Leupold says. "You need to be careful not to look at them in isolation."