There's no doubt about it: real estate has taken a beating in the nation's latest economic crisis. Housing prices plunged and in some regions are continuing to slump. Malls across the country still sport a lot of plywood sheets where there used to be shiny plate glass windows. And, in some cities, like the insurance industry capital of Hartford, Conn., entire downtown office complexes are still standing empty.

Yet amid this economic and physical wreckage, many Real Estate Investment Trusts (REITs) have managed to perform quite well, and in some cases have turned in stellar performances, particularly in the last two years.

So what about going forward? It turns out that is not an easy, straightforward question to answer.

"REITs are a complicated story," says Mike Grupe, an economist and vice president for research and investor outreach at the National Association of Real Estate Investment Trusts (NAREIT). Different factors are driving the different classes of property, he explains. "What's driving commercial property REITs is the economy," he explains. "We house our families in houses, but we house our economy in commercial real estate, so when the economy is doing well, commercial property REITs do well, and when the economy doesn't do well, commercial property REITs suffer."

First let's consider what REITs are, and where they fit in an investment portfolio.

REITs in one sense are simply publicly traded companies that invest in real estate and that earn money from the income on those properties. But unlike the rest of the companies in the equities markets, REITs by law are required to pass through some 90% of their profits to shareholders as dividends, making them, at least in terms of yield, similar to bonds. Investors have turned to REITS both for their yield, and because, historically, they have not shown much correlation to the equities markets, making them good alternative investments.

However, the financial crisis and resulting market crash in 2008 put a big dent in that kind of thinking. Domestic REITs lost an average of 39.6% in 2008, and globally, REITs fell a whopping 46.4% that same year, roughly tracking the losses in other equities. They also subsequently rebounded much as stocks did, with domestic REITs gaining 31.3% in 2009, and another 27.1% in 2010. Indeed, some analysts have questioning whether REITs are as "alternative" or "non-correlating" as they had been assumed to be, at least, considered a class.

For example, for the year ended March 31, the FTSE NAREIT Equity Index gained 11.29%. Over the same period, the S&P 500 Index climbed 8.54%, the Dow rose 7.24%, and the NASDAQ gained 11.16%. For the first quarter of 2012, the FTSE NAREIT Index rose 10.49%, the S&P gained 12.59%, the Dow was up 8.14% and the NASDAQ rose 18.67%. That is to say, overall, REITs, as a class, were in the same range as the various equity indexes.

That said, there is great diversity within REITs, with holdings ranging from everything from office towers, apartment buildings and shopping malls, to hospitals and biotech research labs, industrial buildings and temporary storage facilities, or even timberlands. And depending upon the particular REIT, or the REIT fund, the drivers of growth and income generation can be quite at odds with what is driving the general equities markets.

Take apartment houses. While the financial crisis and the ensuing leap in joblessness was pulling the rug out from under home prices—with record numbers of foreclosures, housing developments stopped in their tracks, and mortgages almost impossible to obtain—the apartment sector was booming. Apartment REITs during 2011 showed a gain of 15.10%, while manufactured homes, a class to themselves, rose 20.38%.

Looking at just the first quarter of 2012, apartments were up 8.54%, while manufactured homes climbed 5.41%. Also hot were health care REITs, up 13.63% in 2011 and 2.03% in the first quarter of 2012, and self-storage REITs, up 35.22% in 2011 and 4.76% in the first quarter of 2012. At the same time, though, hotels took a -14.31% hit in 2011, but recovered and rose 5.15% in the first quarter of this year, while industrial and office REITs sank 1.47% in 2011 and came back with a 4.41% gain in the first quarter of this year.

As the economy starts to show signs of recovery, and companies start to hire, that improves demand for office space, Grupe of NAREIT says. Since it takes time to bring new office building supply on line, that puts upward pressure on rents and office REIT income improves, and with that, dividends. An improving economy, and more jobs, also boosts malls, as more people start shopping again.

The apartment market, on the other hand, has seen a lift from current market conditions. "The apartment sector has benefited from the weak housing market," Grupe says. "Many families have lost their houses through foreclosure, plus with housing prices still weak and falling, it doesn't give people a lot of confidence that buying a house is a good investment, or that it's a good time to buy now. All that puts apartment housing in a better light." And again, as with office space, there has not been a lot of new apartment housing supply in the pipeline, keeping supply tight, and making it possible for apartment owners to raise rents.

Calling Room Service
Hotels offer a third and also different relationship to the broader economic picture. "In 2010 and early 2011, as the economy started to rebound, hotel REITs were strong," NAREIT's Grupe says. Then, as the economic outlook weakened in the third quarter of 2011, people started canceling vacation plans, and businesses started reconsidering whether they had to travel for in-person meetings when they could talk on the phone, and hotels were hurt. Now with the economy looking better again, hotels are looking better.

Hotels also have the advantage that when the market situation improves for them, they can change their rental rates by the day, where apartments are usually locked into one-year leases, and commercial property leases can run for years.

REITs, at least when you're investing in individual companies, also have to be analyzed in terms of their demographics and even their geographics. "Office buildings are doing great in San Francisco," says John Cheigh, portfolio manager for Cohen & Steers, a fund manager that focuses on U.S. and global real estate investments. "They're doing great because tech companies are doing great and need more office space."

The same holds true, Cheigh says, for office REITs with holdings in West Los Angeles, Cambridge and Boston. "Even in New York," he says, "it's the new economy—knowledge workers, technology and biotech companies, etc., that are the driver, not finance or lawyers."

Don't expect REITs to repeat some of the stellar performances of 2009-2011, most analysts say. Even Ron Kuykendahl, the media spokesman for NAREIT, the industry trade group, while pointing to the industry's hot first quarter this year, suggests that the industry may have a tough time following up on its prior big years. He looks for a lot of acquisition activity, noting that there are a lot of distressed properties available, and that many REITs boast strong balance sheets.

In general, real estate is a lagging indicator, says Marc Halle, a senior managing director at Prudential Investors. "If you see significant job growth, that will lead to more demand for office space and to more business in the shopping malls." In turn, he suggests, investors will anticipate higher income for office REITs and shopping mall REITs, leading to higher share prices and, if that higher income materializes, to higher yields, too.

Philip Martin, a REIT analyst with Morningstar, says that overall, REITs are currently trading at about a 15% premium to fair value in Morningstar's opinion, when dividends are included. Share prices are being supported, he adds, by bond investors and by baby boomers who are nearing retirement, with both these groups looking for income-generating investments at a time when interest rates are generally low.

For his part, Martin says he currently likes health care REITs. "I like that they are less cyclical. They have stable income streams and they have high yields, and should be able to increase dividends," he says. "If someone has a three to five-year time horizon, we try to look for quality companies that can not only sustain but grow their dividends, because we think that we will over that time be seeing rising interest rates and increased inflation."

REITs that Martin likes are Alexandria Real Estate Equities Inc. (ARE), Senior Housing Properties Trust (SNH), Taubman Centers Inc. (TCO) and AvalonBay Communities (AVB).

Alexandria focuses on the laboratory space market as a subset of the health care industry, Martin says. "Their dividend is at the low end, but they have a healthy and improving balance sheet and a very high quality portfolio of properties." This REIT, Martin says, is currently trading in the $71 to $72 range, while Morningstar is valuing it at $87.

Senior Housing Properties, which is also in the health sector, is a REIT that owns and leases nursing homes in 38 states. Currently a hold, not a buy, according to Martin, the stock is trading at $22, but has a Morningstar fair value estimate of $28.

Martin also likes Taubman Centers, a retail mall REIT. While high-end malls catering to wealthier consumers have been faring well, Martin says that the REITs that specialize in such tonier properties are already too expensive.

Taubman, on the other hand, is focused on grocery-centered shopping centers that tend to be located in high growth markets near urban centers, "where there is little development risk." He says, "These are need-driven malls, not luxury malls." Taubman, he argues, "has a solid business model, though at the moment they're trading at a pretty fair premium."

Geographic Distinctions
While the multifamily apartment REIT sector has probably had its run, and is generally looking pricey, Martin says he likes AvalonBay Communities, because of its demographics.

"Our stance on this sector is to focus on REITS that have their holdings in areas where family home ownership is always difficult, like New York City, California, etc.," Martin says. AvalonBay, which has some 200 apartment communities in what it calls 16 "high barrier-to-entry markets characterized by a low supply of zoned apartment land and lengthy and contentious entitlement processes," is focused on the Northeast, Mid-Atlantic, Midwest, Pacific Northwest and California regions. "They benefit from good management a good balance sheet and a portfolio of what we call 'modey' demographics," Martin explains.

For investors who don't feel equipped to do the research necessary to analyze individual REITs, there are of course REIT mutual funds, which allow the investor to make plays in specific real estate sectors, without having to check out individual companies.

"REITs have had a couple of good years, so people have gotten into a more defensive posture now," Morningstar REIT fund analyst Rob Wherry, says. At the same time, he adds, it makes sense for people to hold real estate in any portfolio as a form of diversification. "You only want it to be a few percentage points," he says, "but REITs can certainly play a role." With that in mind, he suggests two funds: ING Global Real Estate (IGLAX) and Vanguard REIT Index (VGSIX).

"I like ING Global Real Estate because of their below-average expense, and their veteran management team," Wherry says. The fund, he notes, has a 10-year annualized return of 10.2%, which beats the global REIT category average of 8.9%. "They also did well even when real estate went out of favor."

As for Vanguard's REIT Index Fund, Wherry says, "This fund, which has apartments, offices, health care and hotel REITs, provides an opportunity for anyone to invest in real estate who doesn't have time to hunt for a fund manager." The fund's return over 15 years has been an annualized 9.6%, right on a par with the REIT average performance of 9.5%. Meanwhile, the fee of .42% is "rock bottom." Says Wherry: "This is one of the better funds we're rating.

With REITs as an industry on fairly solid footing, and with the U.S. economy showing at least modest signs of recovery, there is the potential for excellent performance in most categories of the real estate market.

As analysts point out, demand for office space, mall space and higher-end apartments could grow rapidly, and rental income along with them, if the economy improves and jobs rebound over the coming year or two.

"The big question," says Morningstar's Wherry, "is what happens to Europe, and whether that could lead to investors heading for safer havens like bonds." And, he warns, "If the U.S. recovery, weak as it is, is derailed, that could hurt REITs."

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