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Can REITs Keep Going and Going?

The coming year won't be bad for REITs, but don't expect a repeat of 2006's returns.

Each year from 2000 through 2005, real estate investment trusts (companies that invest in commercial and residential property) delivered market-beating returns. After performing so impressively for so long, it wouldn't have been a huge surprise if REITs took a breather in '06. So how did they do? They merely crushed the market, returning 30% in the year's first ten months.

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Obviously, this kind of performance can't continue indefinitely. REIT values have reached lofty heights. Yields, averaging 4% for property-owning REITs, are roughly half the historic average. The coming year won't be a bad one for REITs, but don't expect anything like '06. Figure on total returns of 7% to 9% in 2007 as investors digest their earlier gains and focus on whether commercial-property values will continue to ascend as the economy softens.

One reason REITs should continue to deliver gains despite their lofty value is that landlords are in a sweet spot. As occupancy rates for office space and rental apartments surge beyond 90%, owners can jack up rents when leases expire. Rents for prime space in such hot spots as New York City and Washington, D.C., are rising at double-digit rates. And demand for industrial, retail, health-care and lodging properties is similarly robust.

Most of those rent increases drop to the bottom line. Joe Betlej, who runs Ivy Real Estate Securities fund, thinks REIT earnings will swell 8% to 9% in 2007, which will underpin a 4% average increase in dividend distribution. Among individual REITs, Betlej favors Brandywine Realty (BDN), which owns offices and industrial properties in Philadelphia, Richmond and New Jersey, and Brookfield Properties (BPO), which owns offices in Denver, Minneapolis, the Northeast and Canada. Amos Rogers, manager of SSgA Tuckerman Active REIT fund, likes Boston Properties (BXP) and SL Green Realty (SLG), which specialize in offices.

An excellent choice for fund investors is T. Rowe Price Real Estate (TRREX; 800-638-5660), a member of the Kiplinger 25. Managed by David Lee, it returned an annualized 26% over the past five years by investing mainly in REITs. For a low-cost, indexed approach, consider the Vanguard REIT exchange-traded fund (VNQ), which seeks to copy the results of the MSCI US REIT index. The ETF charges a minuscule 0.12% annually for expenses.

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