August was the cruelest month. After Standard & Poor's downgraded U.S. credit, the stock market swooned for its worst round of bloodletting since the collapse of Lehman Brothers in 2008, prompting fears of a double dip recession.

And real estate investment trusts were not immune to the carnage. Classic REIT names like Vornado, Boston Properties, Simon Properties and Public Storage all saw red arrows and low-single-digit percentage point drops early in the month.
But was it deserved? Perhaps. But perhaps not.

"Real estate." It's the kind of thing people have likely said through clenched teeth in the past couple of years. After all, it was the source of most U.S. financial misery in the 2008 financial meltdown, the well from which we've drawn mostly tears.
Much of this pain came from an extended home building spree, which has led to sinking home values, foreclosures and evictions. But an economy that's been toxic to homeowners has meanwhile been tonic to landlords. Rather than buying houses, after all, Americans are becoming renters.

And though not all real estate is doing well in every city, REIT stocks have benefited from new inflows of equity, cleaned up balance sheets and a constrained supply of quality buildings in gateway cities where it's easier to hike up the rents. Better yet, a lot of them have renegotiated new leases in the last couple of years, giving them better purchase to weather a storm.

That's just some of the happy news for REITs, the companies that buy and manage properties such as retail outlets, malls, office buildings, apartments, health care facilities, etc. But more important to investors is that REITs also are continuing to offer higher yields than bonds in this cash-strapped, low interest-rate era. Real estate investment trusts are legally required to pay out 90% of their taxable income to investors annually. That's one of the reasons global capital has sought them out in hopes of juicing extra yield, a sexy proposition at a time when bonds are paying almost zero. Some investors are even seeing REITs as fixed income alternatives, a source of long-term yields that have kept ahead of inflation.

The promise of total return has sent investors piling in and REIT stocks soaring over the past couple of years. The MSCI U.S. REIT index returned nearly 275% from its trough in March 2009 to the beginning of August 2011. The FTSE/NAREIT equity index was up about 225% for that period. The NAREIT index returned about 27% in both 2009 and 2010 when the S&P 500 index returned just over 23% the former year and 15% in the latter.

This is a far cry from three years ago in 2008, when REITs suffered a staggering fall from grace. Those indexes lost almost half their value that year, despite these securities' vaunted promise of diversification. The SPDR Dow Jones Wilshire ETF REIT exchange-traded fund fell 42% for the year, partly erasing the 328% in returns it had gathered from 2000 to 2006.

But the crisis wasn't due to bad fundamentals like oversupply, say REIT proponents, so much as it was the result of the debacle in the credit markets. REITs are a capital-intensive business that live and die by access to pools of financing, and they suddenly found themselves beached whales with no water-finding no financing from tight-fisted lenders who were working to recapitalize their own balance sheets.

Many REITs had also by that time succumbed to the urge to leverage up (like a lot of other companies and other people, for that matter, in the go-go pre-fall years) and that left them further vulnerable to a crash. Choked with debt, hurt by falling stock prices and without the ability to refinance or to move buildings off their books in a flooded market, many of them were suddenly cash poor and had to cut their sacrosanct dividends.

That distortion has led many people to misunderstand REITs' real strengths and weaknesses, however, say advocates. And three years on, now that construction has stagnated on new buildings, these stocks own space that's in high demand with low cap rates. They are, in other words, benefitting from a classic supply/demand imbalance.

"I'd say if three years ago, if all vectors were moving in the wrong direction, they are now all moving in the right direction," says Jon Cheigh, a senior vice president at Cohen & Steers and manager of the Cohen & Steers Realty Shares fund. "On the supply side, you're not really seeing new office buildings and apartments being built, so that means there's no new competition."

As the economy improves, that means people are chasing less space.

Though Cheigh says the economic outlook has not been entirely rosy, "We have some positive economic growth coupled with no new supply. That usually means you're seeing occupancies in real estate go up and you're seeing rents go up. You're seeing that most dramatically in hotels and apartments. But for the most part, you're seeing it across the board."

Marc Halle, a senior portfolio manager overseeing global real estate securities for Prudential Real Estate Investors, agrees with that assessment of the market. Ironically, he says, the sluggish gross domestic product growth-an anemic 2%-3% GDP-is helping real estate investment trusts: New construction hasn't taken off the way it would if GDP were 7%, and yet corporate profits are still rising, boosting margins and (slowly) employment and putting people in offices.

Philip Martin, a REIT strategist at Morningstar, adds, "We have relatively healthy commercial supply; we're not oversupplied on a national level. Certainly, market by market or region by region, we might be a little oversupplied, but it's not a five-year oversupply issue."

Now that REITs have rebuilt their balance sheets, they're also in a position to play some offense. "You've seen REITs be very acquisitive over the last 18 months," says Cheigh, "buying high quality commercial real estate throughout the country but in the better markets and then financing that through new bond issuances or new equity." This mostly means buying in gateway cities such as New York, Washington, D.C., Boston and San Francisco and downtown core business districts where new construction is lacking even as people slowly go back to work.

The turnaround has allowed companies to start meaningfully increasing their dividends again after slashing them in the past 24 months. "Last year, 2010, companies grew their dividends probably somewhere between 15% and 20%," says Cheigh. Still, he warns, "They look like big increases but some of them are just closer to where they were before they had to cut them."

He thinks that dividends will grow 10% a year over the next five years. "I'd say just the collecting of rent, the availability of capital on the balance sheet side, the acquisitions and the dividends-it's lots of things taken together that are driving the stocks."

One of those is prominent landlord Equity Residential. "They've been very aggressive in buying and improving the quality of the portfolio," Cheigh says. "They've bought a lot of apartment buildings in New York that are doing very well and their cash flows and earnings are growing at double digits. As a result, it's been helping them pay out higher dividends."

In its earnings call in late July, Equity Residential said that it had 95.4% occupancy in its portfolio. With vacancies down, rents are going up, which has boosted the company's funds from operations, (or FFO, analysts' preferred measure of a REIT's cash-generating ability, rather than of earnings per share, which includes depreciated assets that confuse the analysis). After slashing its dividend in 2009 (the way other companies did), Equity Residential boosted its quarterly dividend in the fourth quarter of 2010 for an annual rate of $1.47 per share, and it expects the new dividend for 2011 to be $1.56 to $1.59, in a payout that it designed to equal 65% of normalized FFO for the year. Payouts at that level give certain companies more room to maneuver and maintain their dividend payments, says Martin, as well as grow them.

Another giant REIT player often found gracing the top spot in portfolios and indexes is Simon Properties, the nation's largest mall landlord, which in late July reported funds from operations per share of $1.65 for the second quarter, an increase of almost 20% from the year before. Its portfolio of regional malls and Premium outlets saw a 9.4% increase in same-store sales per square foot. The company raised its quarterly dividend from 60 cents to 80 cents in the fourth quarter of 2010 and has signaled it will raise it again in the fourth quarter of this year. Its dividend yield rose to 2.90%.

Boston Properties, an owner of skyline candy buildings in New York, Washington, D.C., Boston and San Francisco, said its funds from operations per share in the second quarter increased 16% to $1.23 per share from $1.12 per share a year earlier. The company owns 152 commercial real estate properties.

So the question is now, with all the equity coming into the space and the yields improving, are the prices of REITs getting ahead of themselves? "Valuations look good but they're not cheap anymore," says Halle. "REITs' valuations already anticipate some of that growth. If the anticipated growth of NOIs comes through, REITs are cheap. But no one throws their entire bet down on the table at once; you kind of wait and see how it's going to work out. And as the earnings start to come through, which should be in the next 12 months as earnings start to increase-we think they will-REITs we think are a good bet."

Morningstar's Martin says that the FFO dividend payout ratios today stand at 70% across the industry. The average across the industry historically has been 72%.

"When you have a payout ratio averaging about 70%, that gives REITs pretty good cushion and some real dividend protection," he says. "It gives you dividend protection if you should need it, but it also gives you the ability to grow dividends as well. I would be much more concerned if I see an FFO payout ratio hit more than 85%. That concerns me a bit. Certainly 90% or above. I'm questioning the potential dividend protection and the potential dividend growth rate."

An example of a company he likes is Alexandria Real Estate Equities, which he put on Morningstar's "Best Ideas" list. Alexandria is a science and lab REIT that leases to biotech firms, universities and pharmaceutical labs, which makes it a competitive niche player. He says this company's adjusted funds-from-operations payout ratio is 43.9%. "That is a very conservative payout ratio," he says. "With that kind of a payout ratio, they have pretty attractive free cash flow, they have some real dividend protection. If they wanted to bump their dividend 20%-I don't think that's going to be the case, but let's just say they wanted to-[their payout ratio] would be at 52.7%. That would still be conservative."

Martin also likes other companies in the health care REIT space, like Ventas and Health Care REIT, which are growing dividends and able to hang on to long-term leases that help them better weather downturns. "They've done some M&A and they've made significant acquisitions-large portfolios that give them some scale, some efficiencies that they can bring into their portfolio."

Also, he says, health care companies can sustain higher payouts, such as Health Care REIT, which he says was strong enough to maintain its 90% adjusted free cash flow dividend payout ratio through the downturn because its management was so strong.

"Health care REITs generally have a higher payout ratio and they typically grow their dividends at 2% to 5% a year. Whereas, you know hotel REITs are much more cyclical. They are very closely tied to the economy. If I see an FFO to payout ratio of 80% there, I get concerned."

Since 1990, Martin says, equity REITs have increased annual dividends by an average of 5% while average inflation was 2% over that period. "Over the next two to three years, we estimate that REITs will be increasing their dividends at 5% or better."

Michael Grupe, executive vice president of research and investor outreach at NAREIT, says that the REIT markets have gone through typical seven-year cycles of growth and decline, usually because of oversupply and market quirks like the late 1990s' tech bubble, which he says sucked all the oxygen out of hard assets like real estate. He believes that the roots of the last REIT decline actually started a year before the 2008 collapse of Lehman Brothers and the cyclical problems were obscured under the cloud of bank chaos.

"There was a two-step decline in the financial crisis," he says. "The initial decline represented typical weakness similar to the past representing fundamental weakness in the economy. The second was about the credit market freezing as a result of the crisis. [REITs] have recovered from March 2009, but they have not fully recovered because there is still economic uncertainty related to the economy."

That brings us to the current market debacle. If the whirlpool is sinking all boats, that might be unfair to REITs, which analysts think are in better shape than the market would suggest. Halle says that in a volatile market, REITs' long lease maturities and lower debt make them good defensive plays.

"An important difference between now and 2008 is that many public REITs have significantly delevered their balance sheets, increased coverage ratios and staggered debt maturities," Halle says. "In 2011, the companies, and real estate fundamentals, are stronger and healthier.  We expect the risks of dividend cuts, forced balance sheet deleveraging or impairments should be greatly diminished in the event of a further downturn in the equities market."

Martin says that the REITs' yields and payout ratios will offer some downside protection if prices fall and says that a study he's working on suggests that they outperform in periods of low GDP and low interest rates. He also thinks the recent downturn has shaved down valuations enough to make REITs even more attractive from a yield standpoint.

"It's providing opportunities," he says of the August maelstrom. "I want to wade back in. Up until a couple of weeks ago, the REITs in our opinion were trading 15% to 20% above fair value. Many of them have come back to trading at or below fair value."