Many investors shudder at the thought of real estate, with the cratered U.S. housing market—down 35% from its peak—still generating headlines. And worries about a return to recession at home and the growing Eurozone debt crisis aren't allowing investors much comfort about other sectors, either. But experts say real estate, in the form of real estate investment trusts, could be the counterintuitive bright spot over the next year.

Indeed, REITs are one of the best games in town for income-hungry clients. During these dicey times they can provide a steady stream of dividends.

Of course, the sector suffered through a harsh summer like most investments. The FTSE NAREIT All REITS Index, the broadest US REIT Index, shed 6.14% in the first nine months of the year; the S&P 500 slid 8.68% in that time.

And many observers do not see the economy recovering without at least a partial housing recovery, which many see as several years away.

But commercial real estate is a different animal and it is, broadly speaking, in good shape. "Cash flow growth rates for U.S. REITs will be appreciably strong," says Chip McKinley, a portfolio manager with real estate specialist Cohen & Steers. He notes that cash flow is projected to grow more than 11% this year. Although he expects that to deteriorate to mid-single digits next year for US publicly traded REITs, it is still healthy.

Other professional investors are upbeat too, according to PwC's Real Estate Investor Survey. At the end of the second quarter buyers were "aggressively pursuing deals as they continue to see signs that the industry's overall fundamentals are stabilizing and even improving in certain sectors and regions," Susan Smith, editor of the report, writes. The survey reports that most investors, notably pension funds, are setting their sights on top-performing assets in strong markets. Meanwhile, distressed assets are starting to trade as regulators lean on banks to get rid of non-performing loans. "Another sign the U.S. commercial real estate industry is on the mend," she writes.

The Slow Moving Animal Wins the Races

The rosy outlook for REITs sounds contradictory as many observers, including McKinley, expect the U.S. to re-enter recession later this year or early next. But they are sanguine about REITs because they tend to lag the broader economy. "They are cyclical, but not immediately cyclical. It's a slow-moving animal," McKinley says.

Leases for office buildings and shopping malls can range from seven to ten years; industrial buildings and warehouses have tenants locked in for three to five years. "It takes time for the leases to roll over or for vacancies to tick upward," McKinley says. At the shorter end of the scale are apartments, which tend to have one-year leases. Hotels are the shortest, with leases of a single night. So it's not surprising that hotels are the most sensitive to economic shifts. Those owned in REIT portfolios tend to be high quality, but that offers little protection from sharp shocks. They tend to cater to business travelers, so when businesses curtail travel budgets, the belt-tightening hits the hotels quickly and in a big way. (At the height of the last crisis, 2008, hotels were a bad place to be.) Conversely, the shock will take a while to work its way into the system of an office building. These buildings have a collection of leases with an eight-year average. So the office sector, which will not react to economic cycles nearly as quickly as hotels, is a more defensive play for investors, one that McKinley likes.

Even within office space, there are gradations. Properties in central business districts tend to be prime grade office towers with large corporate tenants unlikely to take bankruptcy in the face of economic difficulties.

Those in the biggest cities, like New York, Washington, D.C., Boston and San Francisco tend to be the highest quality. Suburban office space, especially in the middle of the country, is different. Still more stable than hotels, these properties are having a more difficult time keeping tenants. And quality varies according to the local market.

In New York City, office buildings are having difficulty because of layoffs in the financial industry. The high-quality offices in mid-town Manhattan are not as defensive a play as comparable properties in downtown San Francisco, which are prospering thanks to a strong tech industry. In fact, slowly improving demand for space is driving occupancy rates there higher.

But length of lease is not the only variable to consider in REITs. The top performer in recent years has been on the shorter end of the duration spectrum: apartments. In the wake of the mortgage bust, "housing as a vehicle to grow your personal net worth has lost its luster for a whole generation," Marc Halle, senior portfolio manager for Prudential Real Estate Investors, says.

As a result, there has been anemic demand for new houses and high demand for rental units. Halle adds that the demographics are only helping boost apartments, with 1 million new members of Generation Y coming into the housing market every year. The apartment sector of the NAREIT All Equity REIT Index gained 47% in 2010. With the market turmoil, it eased back to gains of just under 2% this year by September 30. Still, that puts it ahead of nearly every other sector in the index.

Even Real Estate Buyers Like A Sale

A key point in REITs' favor is the lack of new supply in all sectors of US commercial real estate. Halle points out that it generally takes three to five years to get new buildings built.

Since the crash in 2007, when lending dried up there has been virtually no new construction.

And with 2% GDP forecast for next year, Halle doubts there will any major new projects started then. He figures that means supply will be static until 2015 or 2016. "That's important because every real estate recession has been caused by excess supply, not lack of demand," he says.

Halle believes that the long-term view for the industry is good, with no new supply coming online and vacancy rates nearing a bottom, as occupancies rise.

Still, he notes that rental rates are correlated to GDP, and most real estate investors agree that for sharp improvement, the industry needs to see U.S. jobs growth. Because of how long it takes to bring on new supply, Halle believes the industry will be well positioned when the economy improves, which he believes will happen in two to three years. But for now, he notes that real estate also has the benefit of a typically has a low correlation to equity markets, so REITs are not likely to move in lockstep with ailing stocks.

What's more, REITs are on sale at the moment, trading at a discount of about 10% to 15% to their net asset value, or the value of the properties they own. Since 1990, REITs have typically traded at about 2% premium to their underlying value, Halle says.

McKinley expects publicly traded REITs to outperform the private commercial real estate market—which is the vast majority of the commercial real estate market—for several reasons. First, REITs tend to own better quality assets in better quality space-constrained locations. Second, the management teams at REITs are generally more skilled. Plus, they also usually have access to cheaper capital than their competitors. McKinley cites Simon Property Group, the largest U.S. REIT, as an example. (It's also a top holding of Halle's.)

The company, which owns a collection of high-quality regional malls all over the U.S., has 10-year debt that is trading below 4.5%. McKinley calls the rate "shockingly low," saying it is an indication of investors' high confidence in the company's ability to generate free cash flow and to service their debt for a long time.

This cheap cost of capital comes in handy a couple of ways: the company can use it to retire more expensive debt on its balance sheet, or trade it in for cheaper debt, thus lowering its costs.

It can also use its cheap currency to pay for properties, a competitive advantage. Because it has a cheaper currency than competitors with weaker balance sheets, it can afford to pay more for properties, yet still stick to its targets for internal rate of return.

For these reasons, McKinley expects Simon and other REITS with investment grade debt to do well, continuing to see their cash flow growing into the middle of a possible recession. That could mean withstanding the recession better than their peers. Plus, having snapped up quality properties when prices were low, it should mean outperformance when markets improve.

Similarly, McKinley expects REITs with lower-graded debt to outperform their competitors in the private real estate market, which has had much less access to capital after lending tightened.

According to NAREIT, REITs have raised $43.4 billion in public equity this year through September 30. So, it is looking likely to beat the $47.5 billion the industry brought in over 2010.

Getting Paid to Wait, Not Bad

Adding to REITs' attractiveness is their healthier-than-average income. To avoid taxes, REITs must pay out at least 90% of their taxable income as dividends to shareholders.

The FTSE NAREIT All REITs cash dividend yield is 5.23%, compared to 2.13% from the S&P 500. Last year, REITs shelled out about $18 billion in dividends to investors, according to NAREIT.

Given the market choppiness, McKinley says that for an investor who has not had real estate holdings, now is probably not the time to build a portfolio.

However, some REITs are becoming more attractive as prices drop. "There are opportunities for those who are patient. We're getting closer to the bottom. There's been a lot of capitulation. But it's prudent to be more patient and buy on the dips," McKinley argues.

Halle agrees, noting the markets really need to see some stability from Europe and a sense of direction from policy makers here in the United States. But "now is not a bad time to get in," Halle says. "You get paid a dividend yield while waiting for growth to happen."


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