REITs, or real estate investment trusts, and their related ETFs have long been eyed as the “next shoe to drop.” So far, though, that shoe is still up in the air. Is it still primed for a fall?

As early as 2008, stories were warning that the commercial real estate market would fall through the floor and that hundreds of billions of dollars of commercial mortgages would default, says Michael Kahn for Barron’s.

Here are the ten ETFs with the largest increase in value traded (VT) for the week ending May 01, 2009. The ranking is based on a simple comparison of the five-day average value traded (closing price times volume) versus the 50-day average.

Swine flu related ETFs had a significant increase in trading this week, but not enough to crack the top 10. iShares MSCI Mexico (EWW) is #32 in our rankings with a 58% increase in VT. One newsworthy ETF, iShares MSCI Taiwan (EWT), made the list with a +12.4% gain for the week and a 104% surge in value traded.

The biggest real estate bankruptcy is now a fact. To all those who have been buying equities in REITs in the past two weeks, congratulations. Once the liquidations start, those dreaded "market tests" will become a reality and will reprice the entire CRE market. Rouse and 165 other units are also included in the bankruptcy, but several properties that are part of JVs are not included.

In the meantime, Ackman is getting even more entrenched in one side bets in real estate, providing a $375 million DIP loan to the company. His thesis that the company is worth more in bankruptcy than out, will be tested as early as today.

The Canadian real estate income trust sector has never been hit harder than it was in 2008, but for the trio of analysts at Canaccord Adams who cover the industry, there's hope for a turnaround next year.

In a report published this past Friday, Shant Poladian, Jonathan Kelcher and Yashwant Sankpal told clients noted that the S&P/TSX Capped REIT Index is down 44% year-to-date versus a 37.4% drop in the S&P/TSX Composite Index. The worst year prior to this year based on the ten years of historical data available, was 1998 when the sector declined 8.5%, they added.

You have to go back to the mid-1970s to find spreads to Treasuries this wide. At that time, the REIT industry was a tiny fraction of its current size, and REITs hadn’t even matured into a recognized, readily investable asset class. In all likelihood, we will soon be adding a position in the Vanguard REIT Index ETF (VNQ) to our model portfolios.

The current yield of 5.7% on the REIT index is approaching the 6.3% average REIT index yield over the past 10 years. Although our view of REITs is much less negative than it was in 2007, we are still neutral at best regarding the asset class. REITs are not cheap, but they don’t look expensive either, given the current interest rate environment.

When we discuss portfolios with our clients, we use the type of information provided in the tables below, and other information, as background to provide wide perspective on the current state of the markets.  You may find them useful in your own deliberations.

The first table is a list of representative funds for major categories:

The first thing to emphasize is that no real estate ETF is exposed to single family housing, which is causing so much grief to individual Americans. With the recent withdrawal of the Adelante Shares line of real estate ETFs, the field has shrunk considerably. There are now five broad or large cap ETFs suitable as a core holding:

How are REITs holding up in today's market? REITs have significantly outperformed other major market benchmarks, trumpets the National Association of Real Estate Investment Trusts (NAREIT) in its latest monthly update: The FTSE NAREIT All REIT Index fell by 4.14% since the start of 2008, but this compares favorably, points out NAREIT, with the Dow Jones Industrial (down 7.53%), the S&P 500 (down 9.05%), the Russell 2000 (down 10.27%), and the NASDAQ Composite (down 14.36%).

This holds true too for last week's performance, as seen in the chart below: REIT stocks outperformed, inter alia, the Dow Jones Industrial, European stocks and emerging-market stocks. However over the past 52-week period, REIT stocks were the worst performing of them all, with a loss of 22%.

A reader left a question asking how much to allocate to REITs in a portfolio. He noted David Swensen's 20% suggestion and wondered if that number is too high. The reader also asked about foreign REIT exposure.

To me this is like asking how much to put in commodities. For either question, there is no shortage of smart people and well-written white papers suggesting big numbers to these asset classes.

Prices of U.S. commercial real estate could fall up to 15% in what would be the worst decline since the 2001 recession, Bloomberg reported Wednesday. "People aren't willing to do deals right now," said Howard Michaels, chairman of Carlton Advisory Services. "The expectation is that prices will come down." In July, investors bought the fewest commercial properties in almost a year and apartment building purchases were down 50% from June. Last month, the Archstone-Smith Trust postponed its $13.5 billion sale to a group led by Tishman Speyer Properties until October. Mission West, which owns commercial properties in Silicon Valley, said two weeks ago that its $1.8 billion sale might collapse because a bank has withdrawn funding. "There are so many deals falling apart," said David Lichtenstein, CEO of commercial property owner Lightstone Group. "People who can get out are getting out." Morgan Stanley industry analyst Matthew Ostrower forecast that average prices for commercial properties could fall 5-15% in the next two years. The cost of commercial mortgages, which have risen in tandem with rising defaults in the subprime sector, has stopped a record-breaking rally in commercial real estate. "No one's going to want to sell in this environment, because you're not going to get your price," said James Corl, CIO for real estate securities at Cohen & Steers Inc.

Some analysts and investors believe that the heavy selling was too extreme and that some REITs - particularly those in the office and retail sectors - could stage a comeback. Indeed, just as the residential housing slump has produced some steals for home buyers, the REIT sell-off may similarly yield some good deals for stock-market investors. [Emphasis added.]

Similar articles were written in 2000 and 2001 about Cisco (CSCO), as the networking giant fell from $80 to $55-$60. The fawning press, and clueless analysts wrote that the all-mighty Cisco was also a "bargain" because it had fallen 25%.

Broad International REIT Index ETFs
iShares S&P World Ex-US Property Index Fund (WPS)
SPDR DJ Wilshire International Real Estate ETF (RWX)
WisdomTree International Real Estate Fund (DRW)
iShares FTSE EPRA/NAREIT Global Real Estate ex-U.S. Index Fund (IFGL)

The funds and tickers are:

• iShares FTSE NAREIT Residential (REZ)
• iShares FTSE NAREIT Industrial/Office (FIO)
• iShares FTSE NAREIT Retail (RTL)
• iShares FTSE NAREIT Mortgage REIT (REM)
• iShares FTSE NAREIT Real Estate 50 (FTY)

iShares FTSE NAREIT Residential Index Fund (REZ)

At -13.7%, do not look for a rebound anytime soon. Maya Roney for BusinessWeek reports soft home sales are likely to continue through May, a time when home sales are traditionally the highest. [click to enlarge]

ITB 1-yr chart: