Rallying REITs Could See 20% Returns in 2010


While the financial markets have pulled back significantly over the last several weeks, real estate investment trusts (REITs) have continued to show solid gains, and they have the potential to do even better by the end of the year.

Through the end of April, REITs were up 17%, but since the end of May, their gains have been cut to 11%, according to the National Association of Real Estate Investment Trusts (NAREIT). Those returns still far outpace the S&P 500, which was down 1.68% as of June 10 and the Dow Jones Industrial Average, which was down 1.23% through the same period.

REITs have experienced the classic scenario of a sector beaten down badly by economic conditions: It contracted and repositioned itself, paving the way for a roaring rebound when conditions improve. The subprime mortgage meltdown that went critical in 2007 ultimately forced REITs to deleverage, and to do stress tests prior to the credit crisis and financial meltdown that ravaged the markets in 2008. REITs lost about 38% of their value in 2008, but since then, many recapitalized and strengthened their balance sheets in time to benefit from last year's recovery rally. Now, some REITs are sitting on cash and are in position to make acquisitions of distressed properties as struggling companies continue to sell assets in the aftermath of the Great Recession.

Michael Torres, CEO of Adelante Capital Management, says REITs that are involved in commercial and residential real estate are particularly well-positioned to deliver outsized gains through the rest of 2010. His firm, which handles $2 billion in hard real estate assets and REIT investments, has 90% of its stock portfolio in REITs, with the other 10% in real estate-rich companies such as Starwood and Marriott -- companies that hold large amounts of properties, but are not REITs.

Torres believes "Existing buildings are the game today." With real estate values having fallen so significantly in recent years, Torres says that well-capitalized REITs that own buildings in great locations and have loyal tenants who pay consistent rents will benefit tremendously when property values eventually stabilize and begin rising again. In times of high unemployment, demand for new office space wanes, making collecting rents from existing tenants a REITs lifeblood.

REITs Return Profits As Dividends

In spite of a lot of negative chatter about real estate over the last year, REITs have demonstrated strong growth. According to NAREIT, REITs gained 99% between March 31, 2009 and March 31, 2010 as the economic recovery took hold, and Torres believes that even with continuing volatility, REITs could end up gaining more than 20% in 2010.

Whether they reach those lofty return numbers or not, Rose Greene, a certified financial planner for LPL Financial, often turns to REITs when diversifying client portfolios. Since REITs must return most of their profits to investors in the form of dividends, they can boost a portfolio's overall gains, especially in volatile periods like the one we are experiencing this year. Since they track real estate, REIT's generally don't mirror the performance of the Dow or the S&P 500, but "they generate a good current income with great upside potential," Greene says.

Investors can gain broad exposure to REITs through the iShares Dow Jones U.S. Real Estate ETF (IYR), which is up 10.06% year-to-date. Top holdings include Simon Property Group (SPG), Vornado Realty (VNOD) and Equity Residential (EQR).

Ryan Detrick, senior technical strategist for Schaeffer's Research, says playing the real estate ETF will allow investors to capitalize on the continuing surge in commercial real estate and housing, two areas that they expect to outperform.

"We expect both areas to double the overall market," said Detrick. "The S&P 500 is flat right now, but we think the S&P will gain anywhere between 10% and 15% by the end of the year, and we wouldn't be shocked if those area doubled that -- gaining 20% to 30% on average."