Richard Imperiale, manager of the Forward Uniplan Real Estate Investment Fund in Milwaukee, agrees there are more risks in the REIT sector compared with a couple of years ago. Price volatility has increased. Overall, earnings should grow at just 3% this year.
Nevertheless, he says the fundamentals still look good. The credit ratios of the large- and medium-cap REITs in his portfolio remain strong. Positive factors that support higher valuations include less severe real estate market cycles, better financial health, more competition for good properties among private buyers and low relative net-asset values.
Imperiale's mean reversion analysis shows that if over the next year REIT prices go back to their all-time low net-asset values, including the dividend, the total return would be -12.9%. The total return if prices move up to the average net-asset value would be 14.1%. This 1.1 to 1 risk-reward ratio makes the sector look attractive, he adds.
"Given the continued weakness of the economy and its impact on the cash flow of REITs, we believe investors should focus on credit quality and safety of dividends of REITs," he says. "You can buy strong REITs at reasonable prices and get paid to wait for the economy to recover."
Imperiale has made slight changes in his portfolio. He has moved some office, industrial and apartment assets out of the Southeast and into the Pacific and Mid-Atlantic states.
He is accumulating shares of attractive companies on market pullbacks. For example, he added to his stake of Hospitality Properties. The REIT buys hotels and leases them back to major operations. Recently, Candlewood Suites defaulted on its leases. However, the REIT has a $30 million security deposit to cover the loss. Imperiale expects the company to release the property to a stronger hotel company, such as a Host Marriott.
His largest holdings, which make up nearly 25% of the portfolio, include Chelsea Property Group, Simon Property Group, AMB Property, Duke-Weeks Realty, Home Properties of New York and Vornado Realty Trust.
Martin Cohen, manager of Cohen & Steers Realty Shares, sticks with the cream of the REIT crop because he expects the economy to improve. He believes the economy will grow 3% in the second half of 2003 and 3.5% in 2004. "We continue to invest in offices, industrial and regional malls because we anticipate a strengthening economy," he says. "Vacancy rates are peaking in important markets. New construction of offices has declined. That is a good sign occupancy rates and rents will grow. The mall sector will be the beneficiary of an improved economy."
The hotel sector has been showing recent strength, and he expects that to continue; he has 6% of the fund assets invested in Host Marriott, Starwood Hotels and Hilton Hotels, but is avoiding the apartment sector due to overbuilding and lack of demand.
Cohen says several favorable trends will sustain REIT prices. Big institutional money is flowing into REITs; the net demand by institutional investors over the past 18 months was $10.2 billion. Index funds are buying REITs because they've been added to several S&P indexes. More companies are repurchasing shares because their REITs are trading below net-asset value. And institutional investors are diversifying their portfolios with REITs.