REITs: Finding Gems Amid the Rubble

Pros see attractive opportunities in beaten-down shares of some real estate investment trusts

After a terrible 2008, real estate investment trusts are having an awful 2009. A seemingly unending stream of bad news from struggling mall operator General Growth Properties (GGP) and dividend reductions from a host of other REITs have battered share prices.

That across-the-board carnage is creating some undervalued bargains, fund managers say. They're snapping up shares in some of the more specialized trusts they expect can weather tough economic times, including Public Storage (PSA), Ventas (VTR), and Alexandria Real Estate Equities (ARE).

Jay Leupp, manager of the Grubb & Ellis AGA Realty Income Fund (GBEIX), sees some timely bargains. Leupp, who was a REIT equity analyst on Wall Street for 12 years before switching to the investing side in 2006, is buying selected REIT stocks and preferred issues paying yields of more than 10%. "It's a great time to be highly selective in some of the best names in the sector," Leupp says.

The Allure of Health Care

REITs that own rental apartments are one area of interest. Leupp's funds have bought BRE Properties' (BRE) C-series of preferred shares, yielding 12%, and Associated Estates Realty's (AEC) B-series, yielding over 15%. The apartment business "isn't recession-proof—I don't think anything is—but it's certainly recession-resistant," he says.

The health-care business also tends to remain strong in weak economic times, supporting the value of REITs that own health-care facilities. Shares of Ventas, which owns nursing homes, medical practice offices, and assisted living facilities, are deeply undervalued and yield about 9%, says Robert Gadsden, manager of the Alpine Realty Income & Growth Fund (AIGYX). Leupp's fund bought shares of Alexandria Real Estate Equities, which owns pharmaceutical and bioscience laboratory space.

Another favorite of both managers is common and preferred shares of Public Storage, the leading owner of storage warehouses. The company's strong cash flow is more than three times the amount it needs to cover fixed charges, Leupp notes. "They've got the strongest balance sheet," Leupp says. "They're the gold standard of the entire REIT space."

Dismal Performance

Alas, REITs don't buy gold; if they did, their overall performance might not have been so crummy. The price of the SPDR Dow Jones Wilshire REIT exchange-traded fund (RWR), which tracks the value of 82 publicly-traded trusts, has dropped 36% this year, after slipping about 45% in 2008.

The latest blows came as General Growth, the second-largest mall operator, struggled to avoid bankruptcy. The company has already missed some debt payments and is trying to get its bondholders to agree to put off some of what they're owed. On Mar. 19, Moody's downgraded General Growth to C, its lowest rating above default. And the next day, Citigroup announced it had foreclosed on a mall in Louisiana due to a maturing mortgage General Growth didn't repay. Shares of General Growth, currently trading at less than a dollar, hit a high of more than $44 last May.

Dividend cuts and substitutions have also kept the sector out of favor, since most investors own REITs for the income they produce. To maintain standing as a REIT, the trusts must pass along 90% of their earnings as dividends to shareholders. But last year, the Internal Revenue Service began allowing REITs to count dividends paid in the form of stock toward meeting the 90% payout test. That helps the REIT conserve cash but leaves investors with more shares and possibly higher taxes if they sell immediately.

More Paper Instead of Cash

Mall owner Simon Property Group (SPG) was the latest to announce a so-called pay-in-kind dividend strategy. The company said that despite a vote by shareholders, who overwhelmingly wanted cash, its upcoming 90¢-a-share dividend would consist of 10% cash and 90% stock.

"For now, being fed a stock dividend may be even worse than an IOU, because all it represents in the short term is a tax liability with no cash," said the anonymous former Wall Street financier who writes the industry-watching REITWrecks blog in a recent posting. "Unfortunately, I can't imagine any capital-starved REIT not electing to take advantage of this revenue ruling (at least to some extent). Undoubtedly, this will further erode confidence in the sector and prolong the recovery in REITs."

Malls have been one of the hardest-hit sectors, because of the drop in consumer spending and numerous retail chains closing stores. That has made it difficult for mall REITs to raise money to pay off maturing debt.

Gadsden says the downturn hasn't hit all mall operators equally, however. Simon Property, which was able to issue $650 million of new bonds on Mar. 20, has the cash on hand to pick up additional desirable locations from distressed competitors, he says. Still, it's only suitable for investors with a multiyear outlook: "You can make a lot of money over the longer term, but it's going to be tough sledding here for a couple of years."

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