Commercial Real Estate's Recovery Should Boost REITs Earnings

by: Brad Case

The newest quarterly report from Dividend Capital, authored by Dr. Glenn Mueller, should give investors more confidence that--as I've predicted several times--total returns are likely to be strong going forward for investors in publicly traded REITs. To summarize Dr. Mueller's analysis,

All five property types had improved occupancies in the second half of 2010, placing the commercial property sector firmly in the recovery phase of the cycle. New construction remained at 40-year lows, which should lead to continued occupancy increases in 2011.

Of the 13 detailed property types considered, Dr. Mueller identified one as fully advanced in the "recovery phase" and poised to enter its "expansion" phase, and a second as just behind it in a fairly advanced recovery phase. The other 11 he identified as either at the absolute bottom of the cycle--at the beginning of the recovery phase--or slightly further along in their recovery.

I've argued several times (including here) that part of the reason for the impressive rebound in investment returns for publicly traded REITs--which have recovered at an annualized rate of 65% per year from their market bottom at the end of February 2009--is because investors believe earnings growth will be especially strong. The two drivers of earnings growth will be (1) improvements in operating fundamentals, as Dr. Mueller notes, and (2) opportunities to acquire assets at good prices from distressed sellers, owing to the advantage that publicly traded REITs have in terms of access to equity and debt capital on favorable terms.

More importantly, publicly traded REITs represent probably the best way for almost every investor to access the real estate asset class, which plays a crucial role in retirement investing. Real estate has a low correlation with non-REIT stocks, bonds, and other (non-fundamental) asset classes; low correlations make it possible for investors to keep more of their portfolios in high-return asset classes without increasing portfolio-level volatility. Studies by Ibbotson Associates and Morningstar (sponsored by NAREIT, my employer) suggest that retirement portfolios should generally have something like one-fifth allocated to publicly traded REITs to take advantage of this diversification benefit.

The important thing for investors to keep in mind is that almost all of the recovery to date in REIT returns has been recovery from the liquidity crisis of October 2008 - March 2009: they've barely begun the recovery from the Great Recession. In fact, REITs are still down 14% from their pre-Recession peak, and up only 9% from September 2008, which was 20 months into the Recession but just before the liquidity crisis hit.

There will be differences in returns among individual REITs, and among property types, of course, but the drivers of the coming growth in earnings are common to all publicly traded REITs: access to capital and improving operating fundamentals. That means that investors are free to choose their favorite individual stocks or to invest in the asset class through broad-based REIT ETFs or mutual funds.

Here's a quick rundown of the available domestic REIT ETFs, both broad-based and by property type; investors can find more information at NAREIT's web site:

  • PowerShares Active U.S. Real Estate Fund (NYSEARCA:PSR)
  • iShares FTSE EPRA/NAREIT North America (NASDAQ:IFNA)
  • iShares Cohen & Steers Realty Majors (NYSEARCA:ICF)
  • iShares Dow Jones U.S. Real Estate (NYSEARCA:IYR)
  • iShares FTSE NAREIT Real Estate 50 (NYSEARCA:FTY)
  • iShares FTSE NAREIT Industrial/Office Capped (NYSE:FIO)
  • iShares FTSE NAREIT Mortgage Plus Capped (NYSEARCA:REM)
  • iShares FTSE NAREIT Residential Plus Capped (NYSEARCA:REZ)
  • iShares FTSE NAREIT Retail Capped (NYSEARCA:RTL)

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I am long Vanguard REIT Index Fund and ING Global Real Estate Fund.

Disclaimer: The opinions expressed in this post are my own and do not necessarily reflect those of the National Association of Real Estate Investment Trusts ((NAREIT)). Neither I nor NAREIT are acting as an investment advisor, investment fiduciary, broker, dealer or other market participant, nor is any offer or solicitation to buy or sell any security investment being made. This information is solely educational in nature and not intended to serve as the primary basis for any investment decision.