Commercial REITs Could Have Room To Rally Further

The housing market may be slumping, but REITs that own commercial real estate continue to be one of the best investments in years.

Charles Rex Arbogast / AP The Civic Opera House and 10 & 30 South Wacker building, rear, are Chicago buildings in Equity Office Properties Trust’s portfolio.

These real estate investment trusts, which trade like stocks but distribute nearly all their income to shareholders in the form of dividends, soared 34% last year and are up nearly 12% so far this year.

While analysts have been predicting a pullback in commercial REITs for years, the outsized gains just keep coming. And this week's $23 billion takeover battle for Equity Office Properties Trust, the nation's biggest office landlord, is expected to push REIT shares even higher.

Even so, the sentiment that commercial REITs are overvalued is gathering steam. Many REIT shares were sharply lower on Friday.

“Fundamentals continue to be strong and are improving in some cases, but the overriding concern remains valuations,” said Jordan Sadler, a REIT analyst with KeyBanc Capital Markets. “You never know what the catalyst will be for a pullback and they are certainly setting up for some sort of pullback.”

Near-Term Optimism

That said, the group still could move higher in the near term. For one thing, large institutional REIT investors and REIT index funds will have to invest in other REITs after tending their shares in Equity Office. Blackstone Group, a private-equity firm, won the battle for Equity Office earlier this week against a group led by Vornado Realty Trust, another big REIT.

In addition, analysts expect the Equity Office takeover to spur other deals, which will also drive up REIT shares. There were $119 billion in REIT deals last year, nearly 40% of which involved private equity players.

“There is a lot of (private equity) money out there eyeing up the REIT sector right now,” Robert Haines, a senior REIT analyst with CreditSights, told CNBC.

Office-REITs are currently the market darlings within the commercial real estate sector. Bulls are betting that commercial rents will continue to rise at a robust clip and office-building supply will remain tight because new construction is expensive.

Haines said that Boston Properties and Mack-Cali are attractive takeover candidates because offices have predictable cash flows, and they're located in the supply-constrained Northeast and Mid-Atlantic.

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“Blackstone’s purchase of Equity Office, along with the private equity (interest), provide an excellent floor for REIT prices in the foreseeable future,” said Todd Briddell, chief investment officer of Urdang Securities Management, a $3 billion investment firm based in Plymouth Meeting, Penn. that focuses on real estate.

“If prices fall too much, private equity players will come back and take them private," he added. "The players are providing an excellent barometer for where prices should be.”

Cause for Caution

Still, caution is warranted: “REITs have been on a tear for seven straight years," said Keven Lindemann, director of the real estate group at SNL Financial, a research group based in Charlottesville, Va. "As time continues to pass, you have to assume the chances of a correction or a reversal grows. But I don’t see anything ominous on the horizon at this point. ”

That might not be enough to jump into commercial REITs right now. While investors typically buy REITs for income--nearly two-thirds of REIT’s average returns have come in the form of dividends --skyrocketing share prices have pushed dividend yields lower. While REIT’s 3.8% average yield still beats the broader market’s yield, it has fallen below that of the no-risk benchmark Treasurys.

“The bond market is offering relatively more attractive income-oriented investments than REITs are,” said Lindemann, adding that REITs are still increasing their dividends at a healthy rate. “If you are getting in today, (lower yields) have to be a consideration.”

Investors that want to pay it safe should at least shave their REIT positions back to their initial allocations and reinvest the proceeds into undervalued sectors. And individuals that want to add REITs to their long-term asset allocation should build a position slowly. Putting money in a global REIT fund may also make sense, since investment managers can underweight exposure to U.S. REITs, experts say.

Time to Trim

“If you had exposure to the category for the past few years, we think now’s the time to time to trim because you’ve had staggering gains,” said John Coumarianos, a mutual fund analyst with Morningstar.

Indeed. For the past three years, the Dow Jones Wilshire U.S. REIT Index logged a cumulative three-year return of 89%; its three-year annualized return was nearly 24%. To cast that in another light: the industry’s market-cap has ballooned by more than $100 billion over the past year, according to NAREIT.

Financial planners typically recommend allocating between 5% and 10% of a portfolio to REITs --best accomplished through a diversified REIT mutual fund -- though specific allocations will depend on an investor’s individual circumstances. It also typically pays to keep REITs in a retirement account – such as a IRA or a 401(k) – because the dividends they pay out are taxable at ordinary income rates, not the much more attractive 15% dividend rate.

“The hardest person to address is the person who hasn’t has exposure and wants it now,” said Coumarianos. “The answer to that is do it gradually and stick to the low end of the (5% to 10%) range.”

Tara Siegel Bernard is a news editor at CNBC.com. She can be reached at .