At a time when everyone seems to be debating the downshifting in residential real estate, some other real estate vehicles have been careening down Wall Street like a bunch of Lamborghinis in overdrive.

They’re called real estate investment trusts, or REITs (rhymes with “treats”), and they offer investors a way to get in on the property game without becoming landlords and having to answer calls to fix toilets.

These publicly traded corporations invest solely in real estate and are as diverse as the real estate world itself, with trusts specializing in apartments, offices, retail space, hotels, hospitals, self-storage, factories and even live-work lofts.

(Mortgage REITs are a different beast with a different set of rules: They don’t buy real estate — they buy real estate mortgages.)

Overall, REITs represent a tiny part of the stock market — they account for less than 1 percent of the Standard & Poor’s 500 index, for instance. Still, REIT holdings account for a significant share of property nationwide. According to some estimates, REITs own between 10 and 20 percent of all investment-grade property in the United States.

Developed in 1960, REITs are companies that primarily own, hold and manage properties and then sell shares of their business on the stock market. Since they are required to disburse 90 percent of their earnings in dividends, they have been associated with slower growth and steady dividends.

But in the past few years, the reputation of REITs as sources of slow and steady income has morphed: They are now the high-growth darling of the new century. As the commercial real estate market has surged, the Dow Jones All REIT index has jumped nearly 24 percent annually over the past five years — often beating out other stock market indexes. Its year-to-date return since Oct. 31, 2005, topped 31 percent. Interestingly, the highest performing REITs — apartment REITs — share the closest connection to the housing market. But they showed a staggering annual rise of more than 45 percent.

How could what’s bad for Joe Homeowner be so good for Jane Investor? According to Brad Case, an economist for the National Association of Real Estate Investment Trusts, the decline in the residential real estate market has naturally given a boost to apartment REITs.

“The story behind that is that house prices are high,” he says. “So people who have … sold their homes are often deciding to wait until prices come down (to buy new ones). They are renting — nationally, vacancies are low and rent growth has been strong. There are also young households who would be buying a house right now if the prices weren’t so high. So they are renting apartments as well.”

Sounds reasonable enough, though such macro-theories are as difficult to prove as they are to disprove.

To further bolster his argument, Case notes that last year, self-storage REITs, the second-strongest sector, had returns of more than 32 percent — evidence that people are steering clear of residential real estate.

“The success (of self-storage REITs) ties in with the housing market,” he says. “People have sold houses but they haven’t bought yet. They’re putting their stuff in storage and they’re waiting.”

Does this make these REITs a good investment in the future? It’s difficult to say, because investors in apartment and self-storage REITs seem to have already pushed beyond their current earnings. In a sense, investors are betting against the residential real estate market changing any time soon. As long as people are scared to buy homes, these REITs may continue to rise.

But by 45 percent a year?

Of course, there are skeptics. This week, Ralph Nader cautioned that the REIT run-up portends its own kind of bubble trouble.

Although Nader might not be your go-to guy for investment advice, he makes an important point. Typically, investment real estate is considered a fair deal at 10 times its net annual earnings. But now many REITs are valuated at 30 to 55 times their earnings. Suggesting that the REITs are absurdly inflated, he wonders: “Apartment and other commercial buildings are bought to make profit. Why would a buyer pay, not 10 times the net annual income, but 30, 40, 50 or more times?”

Indeed, as the price of REITs has risen they have become a very different investment animal. Their stock prices have shot up, but their dividend yields have plummeted. Currently, many REIT dividends are lower than risk-free money-market accounts — a predicament that has many analysts scratching their heads and predicting that the REIT boom must soon come to an end.

Earlier this month, The-Street.com’s Nicholas Yulico noted that REITs had fallen 4 percent in the previous week, “again raising fears among some that the sector could post disappointing returns.” (The performance has since recovered a bit but is still down more than 2 percent.)

Case admitted that many analysts have questioned whether the REIT boom of the past few years has created its own bubble. “REITs have been performing so well that people are asking if they are overpriced like housing is in some areas like, say, San Francisco. But we think that’s far from the case.”

Of course, since the REIT industry butters his bread, Case can’t be expected to bite the hand that feeds him. But he does make an interesting point that whatever the reasonable value of these stocks, there is still a lot of money pouring into the industry. In what was widely characterized as the biggest real estate deal in history, Blackstone Group, a private equity company, bought out Equity Office REIT — the biggest publicly held office building owner nationwide — for $36 billion last month.

“Blackstone Group is very successful. They don’t make a lot of mistakes,” Case says. “This signals to the investor that commercial real estate is a well-priced investment.”

But the argument that the bad housing market is naturally good for the apartment market doesn’t necessarily hold true. The softening housing market is responding to real economic forces: People can’t afford homes. Their incomes can’t sustain the monthly expenses. Maybe there will be more renters in the years ahead, but that doesn’t translate into endless profit lining the pockets of property owners. Yes, people have to live somewhere, but people in financial straits will also go to great lengths to reduce their housing costs.

By the same token, if the overall economy isn’t strong, people won’t be opening new stores or renting new offices.

In the long run, the real estate market is like a mirror: It’s not predicated on positive thinking or speculation but on a healthy economy for individuals. And that’s why one has to ask whether REITs are the best thing since sliced bread — or has American real estate mania simply moved from the living room floor to the stock market floor?

Source:

http://www.sfgate.com/cgi-bin/article.cgi?f=/c/a/2006/12/03/REGMDMN3201.DTL