Commercial real estate was supposed to be the next ticking time bomb for the economy this year, but you wouldn't know it by investor behavior.
Real estate investment trusts, a main proxy for the industry's fortunes, have risen sharply this year, making them one of the top-performing asset classes despite the seemingly formidable obstacles against the group.
"There are favorable tailwinds in terms of real estate fundamentals bottoming," says Joseph Smith, portfolio manager for the ING Global Growth Real Estate Fund. "As the capital markets crisis seems to be over and as these companies have recast their balance sheets, they have superior access and cost of capital advantages."
The benchmark MSCI US REIT Index has risen 8.2 percent this year, while the FTSE National Association of REITs Index is up a gaudy 10.6 percent, doubling the major stock indexes that are in the midst of a 13-month cyclical bull run.
Several factors have caused the REIT resurgence, including a story playing out in the markets Thursday with General Growth Properties, a prominent REIT emerging from bankruptcy.
A multitude of firms, primary among them fellow REIT Simon Property Group, are expected to enter a bidding war for General Growth's assets. The scramble is emblematic of how larger publicly traded companies with substantial amounts of cash tucked away have capitalized on the collapse of smaller banks and other firms in the commercial real estate space over the past year.
"Large public REITS raised about $25 billion in cash in order to have a war chest to buy commercial real estate and other real estate assets as banks failed," says Mike O'Rourke, chief market strategist at BTIG in New York. "The big REITs, since they had access to markets and could raise capital, they'd be the strong hand. As the weaker hands started liquidating they'd be able to buy everything."
Smith warns that REIT earnings are unlikely to turn positive until 2011, but investors still can find good stock opportunities in malls, apartments, hotels and industrials. ING is underweight health care and non-mall shopping centers as well as offices.
"That's a combination of future growth expectations and relative value expectations," he says.
In the case of General Growth, the firm will be split into a mall company and another that owns its non-income producing properties and residential housing business. Activist investor Bill Ackman's Pershing Square Capital, along with Brookfield Asset Management and Fairholme Capital Management, will provide $6.55 billion for the company to repay creditors.
Also helping the industry has been a series of favorable rulings from governing bodies—one facilitating so-called "extend and pretend" practices that let REITs roll over loans that otherwise would have been subject to default, and another from the Internal Revenue Service that lets the companies pay up to 90 percent of their dividends in common stock through 2011.
Both maneuvers are risky from an accounting standpoint, but investors seem content to ride the wave for now.
"Things just became so bad last year that they were seriously discounted and there was expectation of huge liquidations, which didn't occur partially because huge publicly traded REITs raised a lot of cash," O'Rourke says. "The reorganization is occurring full-steam right now. It works out in favor of basically real estate overall and the REIT industry."
To be sure, performance is relative and by at least one measure REITs have underperformed.
Market pros differ on whether REITs have high correlation to other assets, particularly stocks. But the growing evidence over the past few years shows the group closely tied to the performance of small-cap stocks and regional banks in particular because they hold large amounts of commercial real estate and are less diversified than their large-cap brethren.
By that measure, REITs have slightly underperformed the benchmark, which in that case would be the Russell 2000, and more specifically the Russell 2000 value financials, which are up more than 12 percent for the year.
"You would have done better in the quarter if you just bought small-value broker-dealer money managers...or the average small bank," says Ken Fisher, CEO of Fisher Investments in Woodside, Calif.
"This is a fine time to be invested in stocks that are smaller than the market and it's a fine time to be involved with things that have some value in them," he adds. "Within that, I think finance is a fine place to be, but within finance this is not a particularly stellar area."
Indeed, there remains a level of caution about REITs, particularly with continued reports that more bankruptcies and defaults are ahead that have thus far been obscured by government intervention.
"I'd almost feel better if we could see some more visible problems," says Tom Karsten, managing partner at Karsten Financial in Fort Worth, Texas. Karsten says he would wait for a 10 to 15 percent pullback in the group before committing money to real estate, to which his firm shed all exposure in 2007.
"I'd rather be a little late than too early in that space, especially with a lot of the exposure out there," he says. "They've been pretty strong, surprisingly so in my mind with a lot of the fundamentals out there."
Buy strategies are centered primarily on publicly traded companies because of their ability to raise cash, and in particular exchange-traded funds, which are comprised like mutual funds but trade like stocks and reduce volatility.
The most popular ETF for the industry is the SPDR Dow Jones REIT.
Focusing on high-end retailers but remaining diversified is part of the "core satellite" approach that John Stoltzfus, strategist at Ticonderoga Securities in New York, advocates for REITs.
"There's always the possibility that you could find some real trouble somewhere," he says. "That's one of the reasons why a diversified approach to REIT investing is the best approach for most investors."