Can REITs Continue to Rally in 2011?

After trouncing the S&P 500 two years in a row, REITs may still have room to run in 2011.

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Despite the ailing economy and fragile real estate market, real estate investment trusts (REITs) have performed well over the past two years. Investors were rewarded with double-digit returns in both 2009 and 2010, following a 40 percent loss for the category in 2008 when global financial markets crumbled.

The redemption of REITs, which own commercial real estate properties such as apartment complexes, shopping malls, and office buildings, has been rapid so far. According to Brad Case, vice president of research and industry information at the National Association of Real Estate Investment Trusts (NAREIT), REITs have gained 176 percent since hitting bottom in March 2009, but they're still down about 25 percent from their peak in February 2007. But after a stellar 2010—REITs beat the S&P 500 by 13 percent—and faced with a sluggish economic recovery, many investors are wondering if the REIT rally might be over.

Investors are right to be cautious, says Jeung Hyun, portfolio manager at Oakland, Calif.-based Adelante Capital Management. "We've had two good years, so the absolute bargain-basement price isn't available anymore," he says. "People are concerned about valuations." Moreover, as financial markets continue to stabilize during the recovery, REITs won't likely be able to sustain the dramatic gains of 2009 and 2010. "I don't think we're going to have a repeat performance," says S&P industry analyst Royal Shepard.

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Nevertheless, experts say REITs should continue to improve along with the economy. Demand for commercial real estate, such as office buildings and malls, waned during the recession, but economic improvement and job creation could resuscitate the sector over the next few years. "It's driven by jobs more than anything else," says Shepard. "More employees occupy more office buildings and go out and shop at retail malls and such. That's a recovery we see continuing at a fairly moderate pace as we continue to see job creation over the next year."

Even with the national unemployment rate hovering around 10 percent, NAREIT's Brad Case says he's already seeing glimmers of recovery in the sector. "The commercial real estate economy is starting to improve," he says. "We seem to have hit bottom in terms of vacancy rates and rent growth. Investors have to keep in mind that real estate is at a low point. It can barely get worse."

The real proof, however, will be whether incremental improvements in the economy can stimulate the market enough to further reduce vacancy rates and allow landlords (such as REITs) to increase rent prices. "That's really what REITs are focusing on now that occupancy is picking up a bit," Shepard says. "We're looking for a 5 percent increase in average rents on new [office] leases in 2011." Shepard says the apartment sector could see an even steeper rent rate hike—between 5 and 10 percent—in part because of the scarcity of new construction over the last couple of years. "Non-residential construction activity has really fallen dramatically over the last couple of years," Shepard says. "We estimate that it fell 14.9 percent in 2010 and we're looking for another decline in 2011, so that means less new competition for existing landlords like REITs."

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After slashing payouts to the bare minimum during the worst of the financial crisis, some REITs should increase their dividends as earnings continue to pick up, Shepard says. To avoid paying taxes, REITs dish out at least 90 percent of their net income in dividends (the main attraction for income-oriented investors), but when times are good, many pay out even more. "We think 2011 is going to be a real change in terms of dividend increases being announced," he added. In 2010, the FTSE NAREIT All REITs index yielded more than 4 percent, a little more than twice that of the S&P 500. But to sustain those kinds of numbers, occupancy and rental rates have to pick up. "That's what really drives cash flow, which drives that dividend, which is what historically yield investors have looked to REITs for," says Morningstar analyst Andrew Gogerty.