Additional Exposure
For Dozens of REITs
NEW YORK -- Real-estate investment trusts should continue to deliver positive returns in the mid-single digits over the next six to 12 months despite weak industry fundamentals, said J.P. Morgan analyst Anthony Paolone, who initiated coverage on the group recently.
Mr. Paolone, along with analyst Michael Mueller and associate Joshua Bederman, rolled out coverage on 33 stocks. The trio, which headed up CIBC World Markets' REIT research operations until November 2002, when CIBC shut down the division, joined J.P. Morgan in January.
In a note, Mr. Paolone said REITs should generate modest total returns -- largely due to the group's 7% average dividend yield -- despite the choppy economy and stock market. For this reason, he recommends investors overweight their portfolios with REITs.
Within the REIT universe, Mr. Paolone favors net-lease, shopping-center and regional-mall REITs the most. These sectors are more "defensive" and have looser ties to the ebb and flow of the economy, and generally offer more stable earnings.
He said shopping-center REITs have diversified tenant rosters and provide necessary products. Net-lease REITs generally have stable credit-quality tenants, predictable cash flow and little rollover in leases.
Within these sectors, Mr. Paolone's top picks are Regency Centers Corp., Capital Automotive and Simon Property Group Inc.
As the economy stabilizes, Mr. Paolone recommends investors start shifting toward more "offensive" stocks that offer greater growth.
"We suggest investors switch from a defense to an offense strategy that focuses on maximizing upside -- not simply minimizing downside," he said.
These sectors are ones that have been hardest hit by the weak economy, such as office and apartment REITs.
"We believe these areas should benefit from multiple expansion and higher earnings growth as occupancy levels move back up," he said.
His top pick among such stocks is Boston Properties Inc.
Still, fundamentals remain poor in the real-estate sector. Three years of economic weakness have taken a toll on most property types, causing rents and occupancies to fall, Mr. Paolone said.
But different from the recession of the late 1980s and early 1990s, the industry isn't facing overbuilding problems. This time, job losses -- not overbuilding -- is the culprit.
"Today's real-estate weakness is not due to oversupply, it is from a lack of demand," he said.
As the economy recovers, so will REIT fundamentals, although there likely will be a lag, said Mr. Paolone.
"The same factors that are enabling REIT fundamentals to hold up better than other industries in the downturn are likely to cause them to lag in an upswing," he said.
Long-term leases, for example, give the REITs stable revenue streams through the tough economic environment. However, as the economy rebounds, those same leases will give REITs limited opportunity to boost rents to match the recovery. Instead, they can only respond as leases roll over.
Also, once the economy comes back, it likely will take a few extra quarters for companies to make expansion decisions and lease additional space.
Mr. Paolone doesn't own shares in any of the stocks he recommends in this story. J.P. Morgan has had an investment banking relationship with Regency Centers, Capital Automotive and Boston Properties.
J.P. Morgan had been without a REIT research team since the departure of analyst Stephanie Krewson in October 2002.
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