Analysis: A great economy might grate REIT stocks

By Ilaina Jonas

NEW YORK (BestGrowthStock) – A good economy this year can help real estate investment trusts. A great one might hurt.

REITS were hot in 2010, helped by low interest rates that kept down the costs of borrowing for the capital intensive sector. The outlook for this year is not quite as strong because an improving economy is expected to lead to higher interest rates that will dampen earnings, even though it should boost rents and demand for office space and other real estate.

“If you think of commercial real estate as a lagging cyclical sector, then there are probably other sectors people can get more excited about and have a better growth prospects in an improving economy,” said John Wenker, senior managing director for FAF Advisors.

The firm has $2.5 billion of assets under management in its real estate securities arm.

Higher rates could make growth industries much more attractive, as happened during the late 1990s when investors shunned REITs for the expanding technology sector.

And when the benchmark 10-year Treasury rate rose in the fall, REITs underperformed the market.

Low rates for most of the year helped make REITs one of last year’s stars. Their average 3.81 percent dividend was about a point higher than the 10-year Treasury rate. Their total return, including the dividend plus the stock price appreciation, was 28.5 percent, compared with 15.06 percent for the S&P 500.

REIT investors do not expect such a stellar performance this year, in part because of the tough comparison with 2010. They see the total return in the high single digit percentages to the low- to mid-teens.

Wall Street analysts expect REIT dividends to grow by an average of 4.5 percent this year, according to SNL Financial.

Over the past two years, REITs cut their dividend to the bare minimum to conserve cash and strengthen balance sheets.

Now that the economy has improved and many REITs have repaired their balance sheets, investors expect REITs go beyond the minimum dividend.

“They’re going to pay out a bigger percentage of their earnings because they feel better about the future,” said Jon Cheigh, portfolio manager of Cohen and Steers, which has $31.2 billion in assets under management.

He expects the dividend to grow by 10 percent annually over the next two years.

A stronger U.S. economy can lead to higher rents, occupancy, better earnings and greater dividends, which in turn will boost REIT shares.

“Real estate fundamentals and good old fashion earnings growth and dividend growth are going to drive share prices,” said Jay Leupp, executive vice president of Grubb & Ellis Co, which manages $4 billion in real estate assets.

He favors General Growth Properties Inc (GGP.N: ), Associated Estates Realty Corp (AEC.N: ) and Developers Diversified Realty Corp (DDR.N: ), among others.

But all types of commercial real estate are not expected to perform equally.

Commercial real estate properties with shorter leases can respond more quickly to changes in the economy. The short-term leases for apartments and hotels have already lifted their earnings. Investors expect that to continue.

Not so with office properties, which are more directly dependent on employment growth.

“You just don’t need a recovery in the economy for CEOs to feel confident and say: ‘Yes, I want to sign a 10-year lease,'” Cheigh said. “You need CEOs to feel very confident, not just more confident.”

For warehouse and distribution centers, investors believe occupancy will increase this year, but higher rents will not follow until next year.

For investors who want exposure to REITs in general, Wenker suggested blue chip names, such as Simon Property Group Inc (SPG.N: ), Boston Properties Inc (BXP.N: ), AvalonBay Communities Inc (AVB.N: ) and Equity Residential (EQR.N: ), would hold their own.

Smaller cap stocks, such as Essex Property Trust Inc (ESS.N: ), Equity One Inc (EQY.N: ) and SL Green Realty Corp (SLG.N: ) also have good growth prospects, he added.

(Editing by Andre Grenon)

Analysis: A great economy might grate REIT stocks