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5 Stocks to Ride the Real Estate Rebound

High-quality real estate investment trusts will emerge from the recession stronger than ever.

Real estate investment trusts may be back from the abyss, but that doesn't mean they're back to normal. Between March 6, when the group bottomed, and May 8, the MSCI U.S. REIT index surged 63%, an indication that the worst may be over. Still, investors looking for the kind of steady, low-risk returns that used to be the sector's hallmark will be disappointed. Many top-quality REITs have been shoring up their battered balance sheets by cutting dividends and issuing new shares, which dilutes the value of existing shares. And even the most optimistic real estate outlook for the remainder of 2009 calls for falling rents, more tenant bankruptcies and diminishing property values.

REITs own all types of properties -- shopping malls, apartments, office buildings, self-storage facilities -- and make their money by collecting rents. By law, they must pay out 90% of their taxable income as dividends, making them good stocks for income-oriented investors. (Some REITs that invest only in mortgage securities are more akin to bond funds.)

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So why bother with REITs now? For one thing, their prices are compelling. From their February 2007 peak to their March 2009 trough, REITs lost more than three-fourths of their value, on average. "Real estate stocks have been beaten down so badly that if we get any kind of modest economic recovery, I think there is upside in the shares," says Ralph Block, writer and editor of the newsletter The Essential REIT.

In addition, REITs have traditionally been a good inflation hedge -- property owners can usually raise rents every year -- and their share prices typically don't move in concert with those of other stocks, making them good choices to diversify a portfolio.

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That hasn't been true lately, though. After a great run during which share prices rose steadily for almost a decade, REITs have encountered the same kind of trouble that has bedeviled many homeowners: They borrowed too much money, based on overstated property values and inflated estimates of rental-income growth. Now, lenders are reluctant to offer new loans or extend existing ones. That's bad news, given that $500 billion to $1 trillion worth of commercial real estate loans will come due over the next two and a half years, according to Standard & Poor's.

The resulting cash squeeze has already claimed a victim in shopping-mall owner General Growth Properties, which filed for bankruptcy protection in April. Others are likely to follow. Even healthy REITs are conserving cash by cutting dividends or, thanks to an emergency ruling from the IRS, by paying as much as 90% of their dividends as shares rather than cash, an option that expires at year-end. During the first quarter, 55 REITs, or roughly half of all publicly traded REITs, cut or suspended their dividends, compared with 43 that did so in all of 2008.

Surprising reaction. With few remaining options, many REITs are raising cash by issuing new shares. Curiously, doing so has turned out to be a plus. The sector's recent rally coincided with the flurry of new shares, and REITs, to their relief, have had little trouble finding ready buyers for them. "It has been a source of confidence rather than a source of complaint," says Jay Leupp, who manages several REIT funds for Grubb & Ellis Alesco Global Advisors. Investors are apparently more relieved that REITs are moving to strengthen their financial position than they are concerned about share dilution.

In evaluating individual REITs, it's important to distinguish between the ones raising cash out of desperation and those that are building war chests for buying properties that may hit the market at fire-sale prices. You should also look for REITs that have port-folios of high-quality properties in major markets, a diversified tenant base, enough cash from operations to cover debt and dividend payments and, ideally, no major loans coming due in the next couple of years. Below are five relatively safe REITs, from a variety of sectors, that look attractive.

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Mall collector. On the surface, things don't look good for Simon Property Group (symbol SPG). The Indianapolis-based REIT recently cut its quarterly dividend by one-third, to 60 cents a share, and said 80% of it would be paid in stock. But Simon owns many of the most desirable regional shopping malls and is a good bet to remain among the strongest REITs. "High-quality malls are not going to go away," says newsletter editor Block. Simon has raised more than $2.6 billion in new capital this year through stock and bond offerings, and it has access to billions more through short-term loans. When weaker rivals are forced to dump properties to raise cash, Simon will be able to snap up the best of them. The stock yields 4.5%, although only 20% of this year's remaining payout will be in the form of cash.

Office holder. Vornado Realty Trust (VNO) owns a blue-chip portfolio of office buildings concentrated mostly in the New York City and Washington, D.C., areas. Both are expensive markets that are hard for newcomers to penetrate -- a significant advantage for Vornado, based in New York. On the downside, though, Vornado must cope with its share of troubled tenants from the financial industry, including Citigroup, a major client. But after issuing $710 million worth of new shares, Vornado has about $3.4 billion in cash and borrowing capacity it can use to increase its holdings when opportunities arise. The firm also owns 176 retail properties and Chicago's Merchandise Mart. The stock yields 7.3%, although 60% of the 95-cent quarterly dividend will be paid in shares through the remainder of 2009.

Apartment owner. The poor job market will make it tougher for landlords to collect rents, much less raise them. But at the same time, apartment REITs, such as AvalonBay Communities (AVB), should benefit from a shift away from homeownership now that the real estate bubble has burst. Based in Alexandria, Va., AvalonBay owns 173 mostly upscale apartment buildings in hard-to-enter markets along the East and West coasts. The firm recently raised $741 million in loan proceeds, giving it plenty of cash to meet obligations and expand. The all-cash, $3.57-per-share annual payout appears secure.

Health-care specialist. REITs that focus on health-care facilities, such as hospitals and nursing homes, have held up better than most. Among the strongest operators in this subsector is Ventas (VTR), which owns more than 500 facilities in 43 states. More than 60% of its income comes from senior housing, which is not immune to a bad economy; squeezed seniors can trade down to cheaper facilities or move in with children. But the Chicago firm's well-diversified portfolio also includes hospitals, skilled-nursing facilities and medical-office buildings. It has a strong track record and a conservative balance sheet. An annual cash dividend of $2.05 per share results in a 6.8% yield.

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Lab landlord. Alexandria Real Estate Equities (ARE) specializes in renting laboratory space to pharmaceutical and biotech firms, university researchers, government agencies, and other health-sciences concerns. Its 156 properties are clustered in major research centers, such as eastern Massachusetts, suburban New Jersey and the San Francisco Bay area. The Pasadena, Cal., firm's highly specialized focus allows it to attract top-notch tenants, such as Genentech and Novartis, and sign them to long-term leases. To conserve cash, Alexandria recently slashed its quarterly dividend by more than half, to 35 cents per share. The current yield of 3.8% is modest, but the growth prospects for Alexandria's unique portfolio of properties should provide investors with a handsome total return over the long run.