Rates a Big Factor in Real Estate Prospects This Year

As the real estate sector continued to hold investor interest, REITs turned in a total return of 8.3% for 2005, going by the NAREIT Composite Index, outperforming other market benchmarks for the sixth year in a row.

For 2006, industry analysts expect that the outlook for real estate investment trusts will be dependant largely on interest rates and the performance of the broader stock market.

Michael Grupe, director of research, National Association of Real Estate Investment Trusts, said that for 2006 most Wall Street analysts are looking for total returns of up to 10% in the REIT sector, taking into account only equity REITs for the most part (considering only equity REITs total return for 2005 was 12.2%, according to the Washington-based REIT industry trade association).

As for mortgage REITs, they are more dependent on what happens with the interest rate environment.

The current environment in which the yield curve is relatively flat constitutes a more challenging environment for them than one in which the yield curve is steeper.

Overall, Mr. Grupe sees the outlook for the year as fairly upbeat.

"Most real estate analysts and economists seem to be looking for strengthening of the underlying real estate fundamentals in 2006. I think the economy is expected to continue growing. The demand for space in most areas is expected to pick up somewhat," Mr. Grupe said.

Internationally, the REIT structure continues to gain acceptance, with about 20 different countries having adopted some variation of it, according to him. (As well, the U.K. will be adopting it in 2007 and the German government is looking into it.)

This gives real estate investors worldwide more options, allowing U.S. investors to buy into overseas properties and overseas investors to invest in U.S. REITs.

As for a trend that emerged last year, of public REITs being bought out by private investors, Mr. Grupe sees that as investors taking advantage of arbitrage opportunities between private and public market pricing and relatively low interest rates.

If those factors continue into 2006, there may be more of such deals, he believes.

John Kriz, managing director, real estate finance, Moody's Investors Service, believes that the going-private trend happened due to private investors continuing to compete for assets and looking to the REIT sector as an investment avenue.

"Public stock prices can be a good gauge on which firms may be more vs. less vulnerable to other offers," he noted.

Over 80% of the ratings the credit rating firm has on REITs have stable outlooks. And the rest are mostly positive outlooks.

So the overall rating outlook for the sector from Moody's is for "stable ratings with a slight upward drift."

While mortgage REITs could be challenged by the current flatter yield curve environment, as it tends to squeeze their net interest margins, such an environment could actually be an advantage for equity REITs, according to Mr. Kriz.

This is because private property buyers that rely on funding linked to short-term rates might find it more difficult to compete against REITs that have more financial flexibility.

Moody's has taken a number of positive rating actions, particularly in the lodging sector, and they are also more upbeat on the health care sector.

Multifamily properties could benefit, too, in 2006 if would-be homeowners find it more difficult to purchase a home.

"Another variable to watch for in 2006 is the condominium market and to what extent there might be a backup in that market potentially resulting in condominium properties being put on the market for rent, which may compete against multifamily REITs."

J.P. Morgan Securities' REIT research group is forecasting a return in the high-single digits for the sector.

A continuation of last year's economic scenario in terms of moderate job growth, low long-term interest rates and a "choppy" broader equity market, would be the best-case scenario for REITs, the J.P. Morgan group believes.

Even then, "the risk levels for the group remain higher than they have been historically."

REITs that make the best use of the cash flow they retain are expected to do better than others.

The J.P. Morgan team's REIT stock picks for the year are: Alexandria Real Estate Equities (office), PS Business Parks (office), Reckson Associates (office), ProLogis (industrial), Archstone-Smith (multifamily), Essex Property Trust (multifamily), CBL & Associates Properties (retail) and Kimco Realty (retail).

SNAPSHOT: REIT Industry Total Return

2004 30.41%

2005 8.3%

2006 10% est.

Source: NAREIT

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