Real-Estate Investment Trusts
Rally Again, Defying Predictions

It seems to defy common sense: Real-estate stocks continue to rally -- even as interest rates rise.

Eighteen months ago, many investors began to sell off their real-estate holdings amid warnings that the property market might have peaked. But real-estate investment trusts -- tax-advantaged investment companies whose shares trade on major exchanges -- have continued to outperform the market. This year alone, the Dow Jones Equity REIT Index is up almost 13%, compared with a gain of almost 4% for the Standard & Poor's 500-stock index. It's the fastest run out of the starting gate for REIT stocks in six years, according to SNL Financial, a research firm in Charlottesville, Va.

"The run-up in REIT prices has certainly been surprising, even to boosters of the industry like us," says T. Ritson Ferguson, chief investment officer for ING Clarion Real Estate Securities, a Radnor, Pa., investment-management firm.

The rally has partly been driven by mutual funds and other big investors, some of whom bailed on the sector 15 to 18 months ago and are now buying the stocks again, egged on by recent improvements in the outlook for almost every sector, particularly hotels and offices. REITs have been helped by fund managers and other investors who missed the big run-up and now fear that not owning them is hurting performance records.

Some money managers, having been wrong once before, are reluctant to tell small investors to bail out of the sector. Others factor in an individual's total exposure to real estate -- including homes and investment properties -- to determine whether that person should also be owning real-estate stocks.

Mark Cortazzo, senior partner of MACRO Consulting Group in Parsippany, N.J., says he's "cautiously optimistic" about REITs and tells his investors that these stocks still have the opportunity to outpace conservative investments such as bonds. But the 30% returns REITs delivered in 2004 don't seem sustainable in a time of rising interest rates and climbing insurance premiums. "People need to modify their expectations," he says.

For anyone who has owned REIT stocks over the past five years -- most small investors hold them in mutual funds -- it's been a heady ride. These public companies acquire, manage and operate real estate, and pay no corporate income taxes if they pay out at least 90% of their net income as dividends. They have delivered average total returns of nearly 22.5% over those five years, according to SNL Financial, although the performance varied by property type. REITs that specialize in regional and shopping malls led the pack, with industrial REITs not far behind. Office and apartment REITs lagged, but are seeing improvements in their markets recently.

To be sure, rising interest rates are still a concern for real-estate investors. Obviously, higher rates mean more-expensive mortgage loans, and they also raise the cost of borrowing for real-estate companies. Yet interest rates are still low by historical standards, and at current levels they are more of a concern for residential buyers than in the commercial property sector.

Real-estate experts also point out that incremental rate increases usually accompany an improving economy, which pays off for REITs in the form of lower building vacancies, higher rents and other revenue improvement. "The fundamentals are so good that interest rates can go up a bit and not hurt anything," says Rich Moore, an analyst with RBC Capital Markets.

However, improving fundamentals don't fully explain the run-up in REIT stocks so far this year. What's driving that, real-estate experts say, is all the mergers and acquisitions that are going on in the REIT world and the belief that there are more to come.

Since January 2004, 14 REITs have unveiled plans to exit the stock market and become private companies, with management and their backers often paying well above the companies' market value to buy out shareholders. In the past month alone Blackstone Group offered to buy two REITs, including CarrAmerica Realty Corp., based in Washington, D.C., in a record deal worth $5.6 billion, a price 18% above what the REIT's market value was when rumors of the deal first surfaced.

Other investors are buying REIT shares in hopes that they will be holding them when the companies are bought out at a premium, says Paul Adornato, senior analyst for REIT research at Harris Nesbitt, the U.S. research and investment-banking subsidiary of Toronto-based BMO Financial Group. "There's a segment of investors that are just speculating and not wanting to miss out on M&A action," he says.

However, as REIT stocks continue to rise, the gap between where the stocks are trading publicly and what private investors are willing to pay could close, says Jeff St. Denis, an SNL Financial analyst.

Adding to the fuel, the REIT sector spiked last week after the New York Post reported a rumor that Boston Properties Inc., an office REIT, will sell two New York City office towers to a Dubai investor for as much as $2.2 billion, or about $1,000 a square foot. Boston Properties didn't return phone calls seeking comment.

REITs started to slide again by early this week, and analysts cautioned investors against being too greedy. Yet other money managers argue that these short-term spikes are less important than the broader story of REIT stocks coming into their own as an investment class -- transformed from a risky alternative investment to a conventional portion of any investors' portfolio.

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