Real estate investment trusts, and the exchange-traded funds that invest in them, have defied expectations recently by outpacing most other market sectors and thriving against the backdrop of a shaky real estate market, a slowing economy and rising unemployment.
The rebound that started in the spring of 2009 followed a nearly two-year drubbing of real estate stocks that drove the FTSE NAREIT All REIT Index down more than 50%. During the worst period between September 2008 and March 2009, several real estate ETFs lost more than 60% of their value.

Investors who moved back into the asset class soon after its darkest hours had passed, however, were well rewarded. At the end of July, the real estate index was up nearly 54% for the year, while the SPDR S&P 500 Index ETF (SPY) returned only 14%.

Despite strong recent returns for the group, Paul Simon of Tactical Allocation Group in Birmingham, Mich., isn't impressed. "I think REIT ETFs are fully valued by a number of metrics at this point," he says. "Their yields aren't that attractive compared to some bonds or utility stocks. And the economy faces a lot of headwinds, which will make it hard for companies to raise rents."

Cautious Outlook
Many analysts share a cautious outlook on the real estate market and the REIT exchange-traded funds whose fortunes hinge on it. Job growth, which has a strong influence on the commercial real estate that these investments focus on, has been stagnant or trending downward this year.

Despite the strong performance of real estate stocks, the commercial real estate market remains weak in many areas. A double-dip recession could further crush the commercial market, making it even more difficult for real estate companies to obtain credit. While rising property values, low borrowing costs and access to credit would benefit REITs over the long term, the convergence of all those positive trends anytime soon appears unlikely.

High stock prices are also an issue. Because dividend increases haven't caught up with the surge in prices since last spring, the yields have plummeted. Eighteen months ago, the major diversified U.S. REIT ETFs sported dividend yields in the 7% to 8% range. Now yields stand at about half those levels.

"It's clear that U.S. REITs are not paying the level of dividend yields that they have in the past," observes Dan O'Connor, managing director of global real estate forecasting at Charles Schwab. "The key to dividend growth is a rise in income from properties, which is being constrained by the recession and high unemployment. Payouts will grow over time. But it's going to be a gradual process."

With the real estate market still in intensive care, investors need to be more selective in their exposure to the group, warns Kenneth Leon, vice president at Standard & Poor's Equity Research. "Navigating through the weak economic outlook for commercial real estate and finding the more stable sub-industries with exposure to REITs are important now," he says. "Clearly, unfavorable market conditions can put pressure on cash flow and pose fundamental risk for a REIT to maintain its tax qualification by having to pay dividends."

Yet there are also reasons for longer-term optimism. Stock offerings launched during the last year have helped many REITs clean up their balance sheets. With their access to capital markets, publicly traded REITs are in a better position to ride out the recession and scoop up attractive properties at distress sale prices from their financially strapped competitors. A cyclical upturn in the economy would give the sector a big boost. And with interest rates on bonds and other income-producing investments so low, even the shrunken REIT yields look decent by comparison.

Those prospects encourage some analysts. "We believe investors are viewing REITs as a more attractive investment today than they have in the past few years," says Carol Kemple, a REIT analyst with J.J.B. Hilliard, W.L. Lyons. "Several of our covered companies have raised their dividends this year, and we believe a few more will increase their dividends later this year or next year. Now that REITs have improved their balance sheets, we believe the next area of focus will be to improve occupancy and rents, and for some companies to look for attractive acquisitions."

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