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Rising Rates Won't Wreck REITs

S&P says higher bond yields won't hurt the pace of M&A activity in the sector

From Standard & Poor's Equity ResearchPrivate equity buyers continue to sniff around the real estate investment trust (REIT) industry. And that was one of the biggest topics of conversation at the recent REITWeek2007, an annual investor conference sponsored by the National Association of Real Estate Investment Trusts.

The advance of the yield on the 10-year Treasury note above 5% and tightening commercial lending standards are leading some prognosticators to speculate that transaction activity will begin to slow. We don't agree. Although some leveraged buyers may indeed be removed from the market, we believe there is still an ample supply of liquidity from both private equity funds and foreign investors who are benefiting from the weak U.S. dollar. As a result, we expect that any significant decline in REIT stock prices could renew buyout activity.

Demand Will Remain Strong

Another broad trend discussed throughout the conference was the belief that supply-and-demand dynamics remain tilted toward demand outstripping supply in most areas of the market. This key dynamic has been supported by a healthy domestic economy driving demand and limited new supply growth across most REIT subsectors. Historically, the end of many positive real estate cycles has been brought about by a dramatic increase in supply that far outpaced demand. Based on our observations, and the commentary from a number of conference participants, we do not see this type of scenario currently unfolding in the U.S.

Within REIT industry subsectors, we found management presenters generally upbeat about business, economic, and leasing trends. Apartment operators, such as Home Properties (HME; S&P investment rank, 4-STARS, buy; $54) and Equity Residential (EQR; 2-STARS, sell; $48) noted fewer renters are moving out to purchase new homes. AvalonBay Communities (AVB; 3-STARS, hold; $122) provided second-quarter revenue guidance suggesting leasing trends remain solid in supply-constrained coastal markets.

REITs owning and operating office properties confirmed S&P Equity Research's positive outlook on this subsector. Presenters, including Boston Properties (BXP; 3-STARS; $111) and Brookfield Properties (BPO; 4-STARS; $26), seem intent on ramping up project development pipelines, which are generally providing higher returns on investment than acquired properties. In addition, operators in supply-limited urban markets, including SL Green (SLG; 4-STARS; $136), are looking for opportunities to recapture tenant space as a means of marking rents up to market levels.

Private Equity Will Loft Shares

Across the lodging REIT sector, companies like Host Hotels & Resorts (HST; 3-STARS; $24) and LaSalle Hotel Properties (LHO; 3-STARS; $44) continued to highlight the positive price environment in the urban upscale and luxury segment created by limited new supply and healthy business demand. While the current cycle enters its fourth year of strong fundamental growth, and some observers have begun to question its sustainability, a number of the REITs indicated a belief that the outlook remains favorable.

S&P Equity Research continues to see the health of the U.S. economy as the key variable for this industry. While many of the publicly traded REITs have slowed their acquisition activity given what some view as full pricing here in the U.S., private equity players remain active in the sector, a trend S&P Equity Research expects will continue to support share prices in the group.

Analyst Willey follows shares of real estate investment trusts for Standard Poor's Equity Research Services. Shepard is an analyst for Standard Poor's Equity Research Group.

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