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Low rates boost REITs, commercial real estate stocks

As interest rates hover near recent lows, and investors search for anything with yield, commercial real estate is finding its footing yet again, outperforming the broader U.S. stock market.

Stock exchange-listed U.S. equity real estate investment trusts were up 16.25 percent, with a dividend yield of 3.52 percent, in the first half of 2014, according to the National Association of Real Estate Investment Trusts. These results compare to the S&P 500 index first-half 2014 total return of 7.14 percent and a dividend yield of 2 percent.

"The outperformance compared to the S&P 500 index came from REIT sectors representing a broad range of U.S. economic activity, and was supported by good supply and demand balance in commercial real estate markets around the country," said NAREIT President and CEO Steven A. Wechsler.

Commercial real estate has been recovering at a fast clip, led by multifamily apartment demand, self-storage and even some strength in regional malls. Office is improving in major urban markets, but is still hampered by employers who may be hiring more workers but who are downsizing their footprints, using less space per worker.

The real driver for REITs today is the low interest rate environment.

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"That has really been a big tailwind for the group," said Steve Sakwa of ISI Group. "Low interest rates are a positive for REITs because they really offer investors an attractive yield alternative relative to Treasurys or fixed income and you have a growth characteristic to that dividend yield that will go up and increase versus kind of a fixed return over a period of time."

Sakwa is still being conservative on his forecast, as are other analysts who still believe interest rates will rise and take a bite out of REIT returns.

"I think we are going to see a pullback," said David Toti of Cantor Fitzgerald. "I think in the near term there's some potential weakness, but our view at this level, real estate is fairly valued."

Analysts had been concerned last year about the hottest REIT sector—multifamily rental apartment buildings.

They worried that thousands of new units under construction would overwhelm potential demand. The housing recovery surged in 2013, and the expectation was that it would continue apace this year; that didn't happen, as investors moved out and demand from mortgage-dependent owner-occupants didn't pick up the slack.

Rental demand is now stronger than ever and rents continue to rise. Apartment REITs are up about 25 percent as a group year to date.

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Supply of new multifamily units is being absorbed by demand, and market fundamentals are expected to remain strong over the next two years, according to a recent report from Freddie Mac. Analysts there point to an estimated 3.9 million potential households that weren't formed due to the Great Recession, with young adults accounting for close to 75 percent of those pent-up households.

They say that over the next decade, an estimated 440,000 multifamily units may be needed each year to meet the growing demand.

"Over the long run, we expect the demand for multifamily units to be stronger than pre-recession levels. As the economy improves, and most pent-up demand releases, demographic trends will be (disproportionately) favorable for the multifamily sector, due to the young adults comprising a large share of suppressed household formation," said Steve Guggenmos, Freddie Mac senior director of multifamily investments and research, in the report.

While office is still mixed, analysts do expect some growth in the retail sector in the second half of this year.

"It's a little counterintuitive, I'll concede that," said Ross Smotrich of Barclays Capital. "The mall stocks have underperformed, so I think they are set up well for the back half of the year, but there's a very interesting dichotomy here (in) the underlying fundamentals particularly for the A-quality mall space."

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Some of the larger retail REITs like Simon Property Group and General Growth Properties reported strong quarterly earnings. Student housing REITs are also a strong group as is industrial warehouse and self-storage.

"I cannot remember a time when you had such a confluence of strong real estate fundamentals, relatively disciplined supply, good demand and accommodative capital markets. So from a fundamental perspective we are really rather constructive on commercial real estate and institutional quality commercial real estate specifically," Smotrich added.

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—By CNBC's Diana Olick. CNBC real estate producer Stephanie Dhue contributed to this report.

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  • Diana Olick serves as CNBC's real estate correspondent as well as the editor of the Realty Check section on CNBC.com.

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