Don’t Trust REITs’ Recent Comeback

05/27/2008 12:00 am EST

Focus: MARKETS

Peter Slatin

Founder and Editor, The Slatin Report

Peter Slatin, editor of the Forbes/Slatin Real Estate Report, says the recent strong performance of real estate investment trusts may not last amid the economy's weakness.

Once again, after being humbled in 2007, real estate investment trusts are beating up on the broader stock markets.

As of the end of trading on May 8th, the Nareit Equity Index was up 7.0%; the Standard & Poor's 500 index fell 4.1%, the Dow Jones Industrial Average declined 2%, and the Nasdaq Composite index had lost 7.6%. [Meanwhile,] the world of REIT mutual funds saw its seventh consecutive week of positive investment flows. (REIT indexes closed at about the May 8th levels by the end of last week-Editor.)

And REIT yields continued to provide a healthier return than ten-year Treasuries, offering a 4.74% return vs. the T-note's 3.78%-a nearly 100-basis point spread. That is a nice bonus, considering that too-high REIT share valuations drove income investors away in recent years.

Does this mean it's time to jump back into REITs? Although the conventional wisdom has long held that commercial real estate would remain above the housing morass-and it largely has, until now-we believe that there is an excellent (more than 75%) chance that commercial markets in virtually all property types will suffer similar problems.

In the REIT world, the value of corporate property holdings is simply likely to decline with broader asset prices, pulling down net asset values. Depending on how steep this price decline is-and we think it could be at least 20% for most property types and in most markets-that could also shrink share prices back to 2007 levels and below.

The real challenge for real estate companies in a downturn is maintaining and even growing income. Shrinking commercial and investment banks, along with hemorrhaging insurance companies, will leave some big holes in those office markets. So, the real estate companies that operate in [stronger] markets are also likely to weather the coming storm better than those in less stable areas.

Bubbling away under-and over-all this is the credit crisis. While analysts are beginning to suggest a loosening in the debt markets, it is still far too soon to say that the crisis is over, and events could rapidly slam shut any door daring to creak open. But while [a few recent REIT unsecured bond offerings] have been successfully received by investors, they are still a long way from representing a turning point.

Given all that, we think it's misleading to suggest that REITs and other real estate companies are due for a big bounce back this year. They have already picked up some, but the economy, including deepening inflation and weakening jobs markets certainly suggest that those gains are fragile and that further gains will not come easily, if at all.

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