Riding the REIT Roller Coaster

A year ago, the commercial real estate market was very ugly. Property values had dropped 40 percent and it looked like it was going to be very, very difficult to work our way out of the mess. There was a looming maturity of mortgages written between 2005 and 2007, the peak bubble years. A lot of these mortgages had five-year maturity triggers and were coming due. Very often all of the equity was wiped out, and mortgage holders were going to take a hit. It had elements of the housing mess, where it looked like no new mortgage financing would be available.

Now it's pretty easy to see that the level of distress will be fairly low. Commercial real estate had been referred to as the next shoe to drop for the economy. It's just not going to be that kind of issue. Property prices are up 20 percent from their trough, and that has done a lot to mitigate the problem. Financing markets are working a lot better.

Real estate investment trusts are up well over 100 percent off their March 2009 lows, to the point where we believe they are priced on the rich side of a fair range. We are not willing to call them overpriced just yet, though. When I compare what real estate and REITs can deliver over the long haul to how corporate bonds are priced, REITs look pretty fairly valued. The average yield is 3.5 percent.

When I look at REITs vs. stocks, though, they don't look attractive. REITs have been trading at a price-earnings ratio of about 20, while the Standard & Poor's 500-stock index has traded at a p-e closer to 14. These numbers are usually a lot closer to each other.

Historically, this has been a signal to load up on stocks other than REITs. We are not pounding the table on any REIT sector. Our list of buys is stock-specific. Avalon Bay (AVB)—which owns high-quality apartments in good coastal markets like New York and the Bay Area—is one of the best apartment companies in the country. It has been helped by the decline in homeownership. I think people are going to be very wary of the old American dream as it was once defined. If the homeownership ratio stays at or below where it is—a good bet—that creates a good set of dynamics. Job growth and declining homeownership drive apartment demand. I assume we're turning a corner on job growth, so you may have both dynamics working.

Among mall REITs, we have a buy on Simon Property Group (SGB). It is the 500-pound gorilla in malls. Like Avalon, it's the crème de la crème of its sector, and it isn't much more richly valued than its peers. I can buy Simon at basically the same type of pricing as an average mall REIT.

In hotels our biggest name is Starwood (HOT). It benefits from the fact that the franchising model is doing quite well—if only because we are seeing an awful lot of brand growth in foreign markets, particularly Asia, Turkey, and Brazil.

The Stats: Mike Kirby is chairman and director of research at Green Street Advisors, a real estate research firm based in Newport Beach, Calif. Kirby co-founded Green Street in 1985. The performance of Green Street's buy recommendations has been an annualized 25.7 percent from February 1993 to May 2010.

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