5 Safe REITs for the Recovery

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 6, the MSCI U.S. REIT index surged 48%, an indication that the worst may be over. Nevertheless, 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 earnings as dividends, making them good income-producing stocks. (Some REITs that invest only in mortgage securities are more akin to bond funds.)

So why bother with REITs right now? For one thing, their prices are compelling. From their February 2007 peak to their March 2009 trough, real estate shares lost more than three-fourths of their value, on average. Even after the recent rally, many top-quality REITs yield 5% to 9%. "Real estate stocks have been beaten down so badly, 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 Essential REIT, a newsletter.

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In addition, REITs have traditionally been a good inflation hedge -- property owners can usually raise rents as their costs increase -- and their prices typically don't move in concert with those of other stocks, making them good portfolio diversifiers. (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 reorganization in April. Others are likely to follow. Even healthy REITs are conserving cash by cutting dividends or, thanks to an emergency ruling by the IRS, by paying as much as 90% of their dividends as shares of stock rather than cash, an option that expires at the end of the year. During the first quarter, 55 REITs -- roughly half of all property REITs -- cut or suspended their dividends, compared with 43 that did so in all of 2008.

With few other options, many REITs have been raising cash by issuing new shares. Curiously, doing so has turned out to be a plus. Fortunately, the sector's recent rally began just as many REITs were issuing new shares and, to their relief, 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. Apparently, investors are more relieved about the ability of these REITs to shore up their balance sheets 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 a war chest for buying properties that may hit the market during the sector's shakeout. You should also look for REITs that have portfolios of high-quality properties in major markets, a diversified tenant base (so a bankruptcy or two among them won't be catastrophic), enough cash from operations to cover debt and dividend payments, and ideally, no major loans coming due in the next couple of years. Below we describe five relatively safe REITs, from a variety of subsectors, that look attractive.

Mall collector. On the surface, things don't look good for Simon Property Group (symbol SPG (opens in new tab)). 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. It also announced after the close on May 6 that it plans to issue up to 23 million new shares, on top of 17 million shares it floated in March. The stock fell 5% on May 7, to $52.05.

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. Simon shares yield 4.6%, although only 20% of this year's remaining payout will be in the form of cash.

Office holder. Vornado Realty Trust (VNO (opens in new tab)) 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, headquartered in New York City.

On the downside, though, Vornado must cope with its share of troubled tenants from the financial industry, including Citigroup, a major tenant. But after issuing $710 million worth of new shares, Vornado has about $2 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. At $47.95, the stock yields 7.9%, 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 (opens in new tab)) should benefit from a shift away from homeownership now that the real estate bubble has burst. "There is a larger pool of renters by choice and by necessity," says Grubb & Ellis's Leupp.

Based in Alexandria, Va., AvalonBay owns 173 mostly upscale apartment buildings in hard-to-penetrate markets along the east and west coasts. The firm recently raised $741 million in loan proceeds and another $400 million in a private-equity offering, giving it plenty of cash to meet obligations and expand its property portfolio. The all-cash, $3.57-per-share annual dividend -- which, at a share price of $54.61, results in a 6.5% yield -- appears secure.

Health-care specialist. REITs that focus on health-care facilities, such as hospitals and nursing homes, have held up better than most. Given the aging population, that should continue to be the case. Among the strongest operators in this subsector is Ventas (VTR (opens in new tab)), 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 a child. But the Chicago firm's well-diversified portfolio also includes hospitals, skilled-nursing facilities and medical-office buildings. It also has a strong track record and a conservative balance sheet. The stock closed on May 7 at $27.88. With Ventas currently paying an annual cash dividend of $2.05, the shares yield 7.4%.

Lab landlord. Alexandria Real Estate Equities (ARE (opens in new tab)) 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, Novartis and the Massachusetts Institute of Technology, and sign them to long-term leases. To conserve cash, Alexandria recently slashed its quarterly dividend by more than half, to 35 cents. At a price of $34.62, the current yield of 4.0% 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.

Contributing Editor, Kiplinger's Personal Finance