REITs Return 19.73% in First 11 Months of 2009, Fidelity Reports

BOSTON, MA—Despite a dark cloud hovering over the commercial real estate scene these days, Boston-based Fidelity Investments advises investors not to count this sector out of the trading arena.

Especially Real Estate Investment Trust stocks.

In its annual year-end review, Fidelity states, “Given that real estate was at the epicenter of last year's economic meltdown, it may surprise you that many real estate stocks have rebounded this year.

“The FTSE NAREIT All REITs Index, which represents the full universe of U.S. publicly traded real estate investment trust (REIT) stocks, had returned 19.73% year to date, as of November 30, 2009.”

"In my opinion, the year-to-date rebound has been mostly due to the realization that we're probably not going into the Great Depression, part two, and that most public commercial real estate companies are not going bankrupt," says Mark Snyderman,  (top right photo) manager of Fidelity Real Estate Income Fund (FRIFX).

"As a result, in my opinion real estate stocks have gone from being undervalued to being roughly fairly valued."

Because of this, Fidelity believes that, despite today's challenging economic conditions, some exposure to the $2.25 trillion commercial real estate sector still has potential long-term benefits for investors with a diversified portfolio.

Here is Snyderman’s full analysis of the REIT investment market:

What are REITs?

REITs are companies that invest in commercial real estate including office buildings, shopping centers, apartment complexes, and hotels. REITs qualify for special tax treatment that may help them generate a more attractive yield compared with a typical corporate stock.

To maintain its special tax status, a REIT must meet numerous requirements. Two of the main requirements are that, in general, a REIT must hold 75% of its assets in certain types of real estate assets, and 75% of its gross income must come from specified real estate investments and activities (such as rents and mortgages).

In addition, a REIT generally must distribute 90% of its taxable income to shareholders in the form of dividends.

There are two broad categories of REITs: equity, which own properties that seek to generate revenues from leases and rents; and mortgage, which seek to generate revenues by lending money to real estate investors or by purchasing existing mortgages and mortgage-backed securities.

Various pension funds, university endowments, and other institutional investors have long allocated a portion of their portfolios to commercial real estate investments. How?

In some cases by directly buying buildings, and in others, by buying the stocks of REITs, bonds issued by REITs, and commercial mortgage-backed securities.

Challenges in today's market

When the residential housing market bubble began to deflate in 2007, the commercial real estate market still managed to perform relatively well.

This is partly because the supply/demand cycles are quite different between residential and commercial property.

After Lehman Brothers collapsed last fall, however, the ensuing financial panic spread to the commercial real estate market. As a result, the FTSE NAREIT All REITs Index plunged 37% in 2008.

Since then, the weak economy has led to rising vacancy and loan default rates, and many REITs have reduced their dividend payments. While REIT stocks and bonds have rebounded off the market lows of last March 2009, the sector still faces several challenges.

"When you look at the fundamentals, they've been weak," says Snyderman. "There has been less demand for commercial property space, so vacancies have been increasing across all property types.

" This means that rents have been going down. When all is said and done, on average I would expect cash flows for commercial properties to decline 10% to 15%."

While commercial real estate cash flows are falling, Snyderman notes that commercial property values have declined much more, in many cases by about a third from their peak in late 2007.

This is because investors are less willing to pay as high a premium for certain types of commercial property as they had in the past, due to the level of uncertainty surrounding the future cash flows these properties can generate.

In the period leading up to the 2008 credit crisis, owners of commercial real estate were able to acquire and finance properties using low-cost debt.

The recent stress in the financial system has resulted in a sharp contraction in the availability of debt financing, placing additional pressure on property values.

Highly-leveraged owners have struggled to refinance maturing debt, leading to loan defaults on a number of well-known properties. It's likely that lenders will continue to experience deterioration in the credit quality of their commercial real estate portfolios in the near-term.

However, Snyderman feels that the decline in commercial property values is nearing an end for five reasons.

 "First, capitalization rates, the ratio between a property's net operating income and its market value, which have an inverse relationship to property prices, are 8%-9%—roughly in the vicinity of their long-term average.

· Second, while REIT fundamentals are still weakening, I believe that this is already priced into the market.

· Third, from the research I've done, it appears to me that there is some pent-up demand for commercial real estate property—money is on the sidelines and is waiting to be put to work.

· Fourth, the overall economic backdrop appears to be improving, which will certainly help this sector, among others.

· And last, the new supply situation is currently favorable.

New construction in the commercial real estate space has been below levels that would seem reasonable to accommodate the combination of future economic growth and the replacement of old and out-of-date buildings.

When you take a look at all of these factors working together, it tells me that we're close to the bottom," he explains.

(Wall and Broad Streets, New York City,  middle right photo)


· As well as being cautiously optimistic in the short term, Snyderman believes that the long-term outlook for commercial real estate remains similarly positive.

· From a balance-sheet perspective, even though cash flows are down, many REITs haven't borrowed beyond their means. In addition, many have adequate amounts of cash on hand, which may help them withstand the lingering effects of the credit crisis.

· Furthermore, some REITs raised significant amounts of capital in 2009 through public debt and equity markets.

· Finally, Snyderman thinks that most REITs will be able to refinance their long-term debt over the next few years, and while future loan terms may be more expensive, he believes these expectations are already included in current REIT valuations.

· From an overall supply/demand perspective, construction of new commercial property has come to a virtual standstill. With little new supply coming on the market, he thinks lease rates could rebound nicely when economic growth resumes and demand for commercial space rebounds.

Potential investor benefits

While the recent woes of the real estate sector may cause investors to question the outlook for REITs, we believe that an investment in commercial real estate for the long term provides an opportunity for capital appreciation, as well several other benefits, including:

Attractive yields. Because they are required to pass on at least 90% of their taxable income through dividends, REIT stocks and bonds have historically offered attractive yields.

In late 2008 and early 2009, however, most REITs made significant cuts to their stock dividends. Despite these cuts, REIT equities yielded an average of 3.9% as of November 30, 2009.1

"The questions for equity REIT investors now is: Will these companies go back to raising their dividends, and what are they going to do with extra cash they're keeping?" says Snyderman.

Diversification.

Historically, the performance of REIT stocks has not been closely correlated with the U.S. stock market. Correlation measures the performance of two investments and the degree to which they move in the same—or opposite—direction. Correlation values range from -1 to +1, and the lower the value, the higher the degree of diversification.

As an example, for the 20-year period ended September 30, 2009, the average correlation of the S&P 500® Index and FTSE NAREIT ALL REIT Index was 0.53.

More recently, however, for the three years ending September 30, 2009, the correlation has been 0.83, the highest level in history.

While REIT stocks may move in synch with stocks over the near term, "I believe that as the market continues to recover from the 'Great Recession,' correlations will revert to their historic norms," notes Snyderman.

Potential inflation protection.

Because commercial real estate is a tangible, hard asset, it can provide a degree of protection against rising inflation, as inflation increases the cost of constructing new buildings, making existing buildings more valuable.

In addition, many retail and office leases include automatic rent escalation clauses that protect property owners during the term of the lease. Apartment leases are usually for shorter terms and don't include such clauses. However, property owners may be able to raise rates between leases to keep pace with inflation.

REIT risks

Real estate is a cyclical industry that is sensitive to interest rates, economic conditions (both nationally and locally), property tax rates, and other factors. In addition, general risks (such as issuer risk, volatility, etc.) associated with stocks and bonds can also apply to the stocks and bonds of REITs.

Some REITs invest in foreign markets, which can be more volatile than U.S. markets due to increased risks of adverse issuer, political, regulatory, market, or economic developments.

Real estate funds are often nondiversified, meaning they can invest a greater portion of assets in securities of a small number of individual issuers. As a result, changes in the market value of single investment can cause greater price fluctuation than would occur in a more diversified fund.

How to invest

· Sophisticated and risk-tolerant investors might be interested in individual REITs if they're comfortable analyzing cash flows and risks.

· Most investors looking for exposure to commercial real estate may want to consider a diversified mutual fund or exchange-traded fund (ETF) that invests in REITs.

· Many of these vehicles focus exclusively on REIT stock investments, while a smattering may also include REIT bonds and other real estate-related securities in their portfolios.

· Be sure to check the prospectus for more information on a fund's or ETF's specific strategy.

· Also note that real estate investments are intended as a supplement to your investment portfolio, not as a core holding.