Since this site began, comments cautionary about REITs have been posted. Not surprisingly, the market behaved exactly opposite to the cautionary observations. Despite negative signals, REIT shares outperformed the S & P 500 for the third quarter. However, on October 20, 2010, an article in the Wall Street Journal by A. D. Pruitt titled “Caution on REIT Earnings” a new alarm bell sounded.

There are interesting observations in the article such as “Hotel and apartment companies are expected to be the strongest” and Host Hotels & Resorts Inc., last week said third quarter funds from operations were flat.” And, Mike Kirby of Green Street Advisors was quoted as saying “I think earnings will be weak. The idea we’re going to have robust earnings is just not going to happen.

The article cites as the reason for the relatively strong performance of REITs that “investors are looking past the current weak fundamentals and into next year where a strong recovery is expected to take root”.

Next there is the observation that dividends at some REITs may come under pressure if rents and occupancy rates continue to fall and there is an observation that office vacancies are at a 17 year high..

Finally, one REIT analyst is quoted as saying that earnings by apartment operators should improve sharply because demand for rentals has surged amid the housing crisis.

What does all of this mean? Most importantly, the article alerts the reader to the fact that there are still problems in the commercial real estate sector and there is anticipation of an improvement in 2011 but no solid evidence to support that anticipation. REIT performance can not improve until occupancies increase and rents begin to move upwards. Upward rental movement in office space can not be assumed to be meaningful until vacancies in a particular sub-market fall below 10%. Vacancy is the main factor limiting rent growth followed by increased supply through new construction. Right now, there is very little threat of increased supply by virtue of new development but, rest assured that when occupancies exceed 90% the developers will begin to work again.

Office vacancy will not decline until business growth is established and the signal for that event will be measurable declines in unemployment in the service sector. There is no current indication of massive change in 2011 or in the immediately foreseeable future.

Many office building still have old leases at above current market rates that are “burning off” and the downward adjustment of those leases at renewal will negatively impact REIT cash flow.

The retail sector must be expected to continue facing “infill” problems as vacated department stores and in-line shops look for tenants. Changing retail patterns such as increased internet transactions will continue to erode traditional store sales. Strip malls face challenges as changing supermarket sizes and competition from operators like Costco, Wal Mart and upscale chains like Bristol Farms cut into the traditional market customer base. Older, small supermarkets are being closed in favor of newer and larger stores as the leases terminate leaving some strip malls vulnerable to a complete loss of viability. A major upward movement of consumer spending may be the catalysts needed to resolve the challenges facing the retail sector but will probably require a major surge in employment and payrolls. These factors make investments in retail REITs tricky at best.

Despite optimism for increased apartment demand, those forecasting that demand may be counting too heavily on the fact that people are not buying homes and will become renters. However, the foreclosed homes, by default, become part of the rental pool competing with apartments. And, there is every reason to fear that the pace of forclosures will rise in the near term. Plans will be developed to cause absorption of vacant homes by linking rental with a purchase option. Most importantly, rental demand of any kind, apartment or residence, is absolutely linked to employment. Unemployed people may be ready and willing to occupy a home or apartment but, without a job, they are not financially able to do so.

The bottom line is that real estate is very local in nature and not all sub-markets will experience the same dynamics at the same time. Thus, macro statistics are of little help in analyzing a REIT owning properties in several markets with varying types of debt structures. Further, every REIT has a different portfolio of properties and it is those individual properties, along with debt structure, in a given REIT, that provide a guide to the future performance of that REIT. So, no reliance should be placed on industry wide statistics in selecting a REIT investment. Finally, dividend yields are not yet at a level where there would appear to be a good reward vs. risk ratio. Successful investing in REITs today requires much more than a shotgun approach. It is essential to focus not only on the balance sheet and current dividend but also on the types of properties in the portfolio, the leasing structure of the individual properties and the debt structure

REIT investors should be very cautious in this market environment.

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