Should You Invest In Real Estate Investment Trusts (REITs)?

With a broad-based sell-off in 2008, many REITs are now trading well below Net Asset Value (NAV), and average yields exceed 9%. Year to date, equity REITs are down about 47%.

We remain neutral on the sector. While valuations are compelling, we have lowered our 2009 outlook; our 2009 FFO [funds from operations] estimates have been for the most part cut across the board. We also expect more dividend cuts as companies try to conserve cash.

The economy will get worse in the first half of 2009, and we expect a much tougher operating environment for REITs. REITs with heavy 2009 and 2010 debt maturities pose the most near-term risk, so look for companies with clean balance sheets, lots of cash, credit availability, low overall debt and limited development exposure.

Volatility will remain in the coming months as commercial real estate re-prices to account for the new reality of constrained credit and weaker fundamentals. Cap rates are increasing across all sectors, as such, there could be more attractive buying opportunities, although higher cap rates inherently decreases the value of a company’s holdings.

OPPORTUNITIES

We would overweight apartments, health care and select retail.

Apartment REITs are one of the best performing REIT sectors in 2008. Apartment landlords have benefited from the rapid decline in home sales, which has created a larger pool of renters. This will continue, although more competition has been added from houses and condos that cannot be sold. Look for rental rate growth in the sector to slow or stop; landlords will no longer be able to put through rental increases due to tapped out customers.

Health care has also one of the best performing sectors in 2008. This is still one of our favorite sectors going into 2009. Health care is possibly the most “recession proof” REIT sector; healthcare spending will continue to outpace inflation.

A couple of names we like:

Equity Residential (EQR) — The largest apartment REIT has geographically diverse portfolio, strong balance sheet and plenty of liquidity. The company has addressed near-term debt maturities.

HCP, Inc. (HCP) — A health care REIT with diverse health care portfolio is good in long-term markets. The company is moving toward more private pay sources, and has taken care of most 2009 expirations.

WEAKNESSES

We would underweight office and residential developers. The success of office REITs is correlated with job growth and corporate expansion, which has been non-existent in 2008 and will get worse in 2009. Many companies are not taking new space as they wait to see what happens with the economy.

On the other hand, a lack of new supply coming on line will benefit office owners over the next couple of years.

One name we do not like:

Mack-Cali (CLI) — An office REIT with holdings in suburban markets concentrated in New Jersey. The company’s major geographic markets are weakening due to job losses; occupancy and rent growth will suffer.

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