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REITs Still Offer Shelter from the Storm

Dinah Wisenberg Brin,|Special to CNBC.com
Wednesday, 5 Sep 2012 | 11:27 AM ET

REITs remain on a roll.

Favorable industry fundamentals, strong balance sheets and a stabilizing US economy have combined to make real estate an attractive asset for investors, whose portfolios should continue to benefit for some time.

Publicly traded U.S. REITS, fully known as real estate investment trusts, — with combined market capitalization of more than $500 billion — have outperformed the broader stock-market , although investors would be wise to choose holdings based on sectors, geographic markets and company quality.

The FTSE NAREIT All REITs Index also outperformed the S&P 500 over the past three years, with nearly 28 percent in average annual returns, compared with roughly 14 percent for the S&P 500, as of July 31. Annual returns over five years averaged some 4.5 percent for the REIT index, versus 1 percent for the S&P 500.

Low interest rates, rising rents, strengthening demand and limited property supply bode well for REITs, which appeal to investors as relatively safe havens that represent real assets and provide solid dividend income. REITs typically invest in apartments, office buildings, hotels or other property types.

“We like the growth and income story that REITs offer investors,” Philip J. Martin, Morningstar’s director of REIT research and strategy, said. Morningstar, though, believes REITs are trading at a 10-percent to 15-percent premium to fair value, with multifamily housing companies at a 20- percent to 25-percent premium, healthcare REITs at fair value and other segments somewhere in between.

“We’re being very selective in terms of business model, in terms of portfolio, in terms of location,” Martin said.

Improving Fundamentals

Balance sheet strength and dividend growth potential will be differentiating factors for REITs, which need to show they can weather economic uncertainty and dislocation and increase their dividends to outpace rising interest rates and inflation, he said.

Steve Shigekawa, Neuberger Berman managing director and real estate fund co-portfolio manager, said his firm’s outlook for investing in REITs remains favorable primarily because of improving fundamentals.

The firm believes REITs diversify holdings and enhance returns in investor portfolios, giving shareholders exposure to real estate.

In addition, REIT dividend yields are attractively valued now compared with fixed-income alternatives, such as U.S. Treasurys, one factor that may be driving stock performance, Shigekawa said. In 2010, REITs provided investors with $18 billion in dividends, according to the National Association of Real Estate Investment Trusts.

While macroeconomic and political uncertainty persist near term, “our long-term view is positive,” Shigekawa said, adding that REITs with strong balance sheets should weather market downturns.

It’s relatively easy to play the economic cycle with REITs, Morningstar’s Martin said, noting that investors in a defensive mode can lean to less cyclical sectors like healthcare REITs and shift into office, industrial or lodging as the economy improves.

Neuberger’s Shigekawa noted that economic growth and job creation are growing, albeit modestly, which appears to be driving demand for commercial real estate, including office buildings, apartments and industrial assets. Demand for commercial real estate versus the supply coming online is favorable for landlords, he said, explaining that supply across property types remains near historic lows.

Joe Raedle | Getty Images

Meanwhile, the low-interest rate environment has enabled REITs to lower borrowing costs and debt levels and improve balance sheets, which will allow them to grow through acquisitions or development, Shigekawa said.

Analysts and portfolio managers say dig into sector and company specifics when picking individual REIT stocks.

Residential Vs. Commercial

For investors who require multifamily housing in their portfolios, despite the premium valuation, Morningstar likes AvalonBay Communities , which Martin said benefits from owning properties in markets that lack affordable housing. Good supply-and-demand fundamentals are fueling multifamily housing, he said, explaining that many people now find it harder to finance a new-home purchase, or decide to rent out of concerns about eroding housing values or job security.

“However, at some point, purchasing a new home will become easier,” Martin added. Because an increase in home ownership in the next couple of years would weigh on the multifamily housing industry, it makes sense to own REITs in expensive home ownership markets like New York, San Francisco, southern California and Boston, he said.

Morningstar also likes Alexandria Real Estate Equities , which is trading at a 16-percent discount to fair value and operates in a segment with high barriers to entry. Alexandria owns, operates and develops space leased to pharmaceutical companies that need manufacturing and research-and-development facilities. It has room for attractive dividend growth, which will be important when interest rates start to rise and inflation occurs, Martin said.

Regional mall and apartment REITs, which are raising rents, are overweighted in Neuberger Berman’s portfolio. REITs tend to own a large share of the country’s best-performing regional malls, which have strong underlying fundamentals, according to Shigekawa.

Shigekawa also is trying to position the fund’s portfolio to take advantage of northern California’s technology industry-driven strong performance by investing in REITs that own office buildings, rental apartments and retail assets.

Simon Property Group, the largest publicly traded REIT and largest U.S. mall owner, is the Neuberger Berman Real Estate Fund’s largest holding.

“We believe that their management team is one of the best in the industry,” and the company has a strong balance sheet and one of the highest quality portfolios of regional malls and outlet centers, another segment where the firm sees good trends, Shigekawa said.

The Neuberger fund’s second-largest holding is American Tower, which owns wireless and broadcast communications towers. Demand for tower space is growing rapidly because of requirements for smartphones and other wireless devices, Shigekawa said. The company has a strong management team, conservative balance sheet and attractive portfolio of assets, he said.