Q: Given the recent sell-off in real estate stocks, what is your view on on the REIT sector?

Amid ongoing concerns about softening housing conditions and the meltdown in the sub-prime lending market, many investors have been fleeing real estate-related stocks.  However, their reaction may be overdone, as some sectors are still doing well.

In the past month, investors have been selling off their shares in real estate investment trusts, the publicly traded stocks of companies that invest in and own properties ranging from apartment complexes, office buildings, and shopping malls.  The Dow Jones Composite REIT index (^RCI 274.17), a benchmark for the U.S. REIT market, is down about 9% since reaching an all-time high in February.  However, after beating the broader stock market for seven consecutive years, the index is still up nearly 3% for the year and up about 25% over the past twelve months. 

The recent decline can be attributed to the broader stock market correction during the same period, as well as continued weakness in the housing market, which has been weighed down by the recent sub-prime and foreclosure shakeout. 

While residential real estate continues to struggle in many parts of the country, commercial real estate, which is driven by job growth and the economy, remains relatively healthy.  According to California-based CB Richard Ellis Group (CBG), commercial building occupancy is growing nationally and rents have climbed about 4.25% over the past year.  In fact, rents in Manhattan reached a record $53.43 per square foot during the first quarter, as vacancy rates declined to 5.7% on limited supply and steady job growth.  This may be reflected in quarterly results of office REITs such as Boston Properties (BXP), Mack-Cali (CLI), and Vornado Realty Trust (VNO), which have a strong presence in New York.

Despite some concerns about current valuations, as real estate prices have soared in recent years, office REITs, particularly in urban locations, continue to offer the best opportunities.  Boston Properties, Mack-Cali, and Vornado are just a few examples.  Those companies operate in strong, land-restricted markets such as New York, San Francisco, and Boston, and should continue to benefit from strong commercial real estate trends.

In addition, since REITs are total return vehicles, they also offer dividends and capital appreciation, which arguably makes shares less volatile than the broader market over the long term.  The average office REIT currently has a dividend yield of about 4%. 

While yields are low by historical terms, and funds from operations multiples are high, growth expectations compensate for any weakness and continue to support our long-term view on the office REIT sector, which tends to have low correlation with stocks and offers a hedge against inflation. 

--Richard Jahnke, Briefing.com