REITs Outperform
Stocks Again

Real-estate investment trusts have outperformed the broad stock market five years in a row. At the start of 2005, few expected that streak to continue. Analysts and investors worried that REIT stocks were "frothy," while economists predicted the end of low interest rates, a key factor in the REIT run.

With the year half over, those predictions have been wrong. As of yesterday's close, REITs have outperformed the Standard & Poor's 500-stock index by about 6.7 percentage points and the Dow Jones Industrial Average by about eight percentage points, on a total-return basis.

There are two schools of thought about why REITs have done so well. Depending on which one turns out to be right, the REIT run could end abruptly or continue for years.

One group attributes REITs' performance almost exclusively to low interest rates, saying investors are flocking to the stocks because they yield an average of 5%, compared to about 4% for the 10-year Treasury. To these people, the rally ends when long-term interest rates rise.

"It may sound overly simplistic, but interest rates are the driving force," said Mike Kirby, the director of research at Green Street Advisors, a Newport Beach, Calif., research firm.

"If you think they are going to stay low, then there is no reason to get skittish," he said. "If you think they are going to rise substantially, then you should be nervous about REIT prices."

The other school ties stock performance to improving fundamentals such as rising rents, fewer vacancies and higher property values. Investors are drawn by REIT earnings and their potential to grow.

Jim Corl, chief investment officer for real-estate securities at Cohen & Steers Inc., a money manager that invests in real-estate stocks, says the bullish REIT market has more to do with fundamentals.

Unlike the housing market, which is rife with speculation, Mr. Corl said, the rise in values of commercial real estate is driven by the income the buildings throw off.

Apartments, one of the worst-performing REIT sectors recently, have been helped by fewer rental apartment buildings being built. The short supply has driven up property values and rents.

Mr. Corl says rents also are rising in coastal cities with hot housing markets, because more people are turning to rental apartments in the face of steep home prices.

Greg Whyte, an analyst at Morgan Stanley, sees only spotty improvement in the apartment sector. He said the push to convert apartments into condos has helped drive residential REIT stock prices.

But overall, Mr. Whyte said, "the fundamentals would not justify the prices that the stocks are trading."

Job growth in some areas of the country has created a demand for more offices. Mr. Corl said effective rents of offices -- meaning the rents that a company can charge minus the cost of physical improvements needed on the office building -- have gone up. But while office markets in New York and Washington, D.C., have improved, cities like Dallas, Boston and Chicago remain sluggish.

The steady flow of capital into real estate also is pushing up stocks. That flow is reflected in the rising number of joint ventures between REITs and foreign and institutional investors.

Foreign investors, meanwhile, aren't deterred by the rising prices of properties and lower initial returns, which could put off U.S. investors.

So far this year, apartment REITs have sold interests in portfolios valued at more than $2 billion to foreign and institutional investors, according to Real Capital Analytics. There also are about $5.8 billion in deals pending in which foreign investors or institutions are looking to acquire REITs outright.

"There is this huge glut of pension money looking for a home." Mr. Kirby said. "You have investors queued up to plow more capital into the arena."

Mr. Kirby said a sharp rise in interest rates could cool institutional interest in the REIT market. But predicting whether interest rates will rise is fruitless, he said.

"Why listen to the economists," Mr. Kirby said. "I suppose like a broken clock they will eventually be right. But they've been dead wrong for the last two years."

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