Stocks in REITs Climb High Despite Broader Real Estate Worries

The iShares Cohen & Steers Realty ETF (ICF) offers a fairly straightforward and cautious approach to the notoriously volatile real estate sector, largely avoiding mortgage real estate investment trusts REITs and rarely straying far from the largest REITs of the commercial real estate world.

That approach has yielded appealing results so far in 2008—a year in which the broader real estate industry has been thoroughly shaken up. ICF gained more than 7% year to date through Sept. 19, topping the S&P 500 index by more than 20 percentage points. Moreover, the fund compared favorably during that period to other ETFs and mutual funds focusing on the real estate sector. ICF outperformed more than 70% of the funds in Morningstar’s real estate fund category and beat several similar REIT ETFs, such as iShares Dow Jones Real Estate.

ICF also held up well during the unprecedented events that unfolded on Wall Street recently. The run of bankruptcies and shake-ups among top financial firms is sure to leave some top ICF holdings struggling to find tenants for high-end office spaces in New York and other cities, and continued economic turmoil and weakness in the housing market could dampen interest in the properties these REITs own. Nevertheless, ICF posted gains for the month and the week ending Sept. 19 (8.8% and 2.8%, respectively).

ICF invests in a basket of about 30 domestic REITs that hold multifamily, industrial, retail and office properties. The fund tracks the Cohen & Steers Realty index, which emphasizes diversification by geography (using nine regions, with recent heavy stakes in the South Atlantic and the Pacific Coast) and property class and focuses mostly on large, diversified firms. By limiting its exposure to no more than 8% for any one REIT, ICF manages single-trust risk.

In 2008, the top holdings have paced ICF’s strong performance. Half of ICF’s top ten holdings were up more than 20% year to date (through Sept. 19), and two gained more than 30%. For the most part, the top performers hold properties that either have exposure to foreign markets or hold properties that tend to do well when the broader economy is struggling.

Public Storage (PSA), whose shares posted a 17% three-month return (through Sept. 22), is a good example of the former (with a touch of the latter, actually). The firm recently purchased Shurgard, the largest self-storage firm in Europe and the third-largest in the U.S. Self-storage firms can outperform in economic downturns, especially one fueled in part by home foreclosures, which force consumers into smaller homes with a lot of extra stuff to store. The firm’s broad geographic footprint may also be helping shares.

Equity Residential (EQR) is one example of a REIT that could benefit from a weak economy and a poor housing market. The firm owns about 165,000 apartments in 25 states, and the demand for many of these units has increased since home foreclosures began to spread across the country last year. Moreover, there is currently a nationwide shortage of apartments, despite widespread vacancies of homes and condominiums. And finally, many of the apartments that Equity owns rent for middle-range prices, and demographics suggest there will be no shortage of potential tenants for those units in the coming years. Equity shares were up nearly 13% in the three months ending Sept. 22.

A few of ICF’s recent holdings are expected to feel a direct impact from the shifting landscape of the U.S. financials industry. Boston Properties (BXP) (shares down 5.0% year to date through Sept. 22) and Vornado Realty Trust (VNO) (down 6.7% in the last month, but up 6.3% YTD), for instance, receive 38% and 28% of their revenues from New York tenants, respectively. Each firm receives at least 1% of those revenues from property leased by the now-bankrupt Lehman Brothers.

Bank of America’s (BAC) purchase of Merrill Lynch (MER) is also likely to produce more office vacancies, as the bank tries to consolidate operations. None of these developments changes the fact that these office buildings are some of the most lucrative and desirable properties on the global real estate market, but in the short term, the Wall Street turmoil could spell a rocky transition period for office-focused REITs.

That said, ICF was ranked No. 10 on our ETF Momentum Tracker Sector Momentum table last week, up from 24 as recently as Aug. 5. The fund could get a boost if signs emerge that the broader economy is stabilizing. With so much volatility in the stock market in recent weeks, the tendency of REITs to perform out of sync with the overall stock market has an appeal. But REITs are by no means stable investments, and even a fund with a less risky approach like ICF is highly exposed to the intense fluctuations of real estate markets. ICF could be an effective entry point into REIT investing, but investors shouldn’t count on the fund sustaining its recent performance without interruption.

Comments

[Alan Young:]

Rather than simply plugging one particular ETF, it would nice if you could tell us *why* REITs are gaining. It makes for more intelligent investing.
If you don't know, it's just performance-chasing.

2008 Sep 25 10:39 AM

[Chris B:]

Aalan,
That's because the real economy keeps chugging on, even as a dozen or so investment banks lose money and dominate the headlines. Look at non-investment bank earnings. Look at retail bank earnings. They're doing OK.

More specifically the author does explain EQR.

2008 Sep 25 01:45 PM

[{5U}:]

Let's see how they will be able to continue growing earnings with tighter credit and a slowing economy.

And I hate to break it to you Chris but the economy runs on credit. There is a lag effect on growth. It will be come more apparent over time and the historically low P/E ratio uber bulls point to will look lower since the cost of capital will be higher and the growth rate lower, if not negative.

In the short term, cheer on the Paulson Plan and get giddy. We rallly and then will wake up with a hang over.

Again.

2008 Sep 27 12:14 AM

[Richard Woon:]

I see that one of the top holdings is ProLogis (PLD). You'll think I'm crzay but I think it is seriously overleveraged and will be the next Lehman. I've done a comprehensive analysis at my blog. I'd love to get your candid review of my analysis.

2008 Sep 30 05:59 PM