Real estate investment trusts (REITS) are usually most attractive to buy and hold when interest rates are low, and supply and demand factors in the real estate industry favor growth in property values.  REIT shares tend to be inflation-sensitive as values increase and dividends rise with higher rentals.  As real estate is a cyclical industry, the risk-return relationship is maximized when investments are made over the long-term.

REIT returns are very sensitive to changes in the dividend yield (annual dividend per share/current market price per share).  In the aggregate, changing dividend yields represent the manifestation of changing investor sentiment with regard to risk premiums, expected inflation, and lease rates.

After a slow period that lasted for nearly 2 years, REITS are once again making the news.  Midst the insecurity pertaining to interest rates and inflation, why have investors been taking a second look at this asset-based sector?  The desire of investors to diversify their portfolios through proven income generation and potential for long-term growth, as opposed to putting money into various fly-by-night tech stocks, appears to be fueling the momentum. 

In publicizing the REIT sector, Wall Street is attempting to satisfy the needs of conservative investors who prefer dividends, but who also want to avoid the direct interest rate-risk exposure provided via bonds and utility stocks.  Well-known high-financiers as Warren Buffett have recently reminded investors that REITs offer more than only dividends.

According to the National Association of Real Estate Investment Trusts, REIT stocks have rebounded quite well in 2000.  Through July 31, 2000 the average REIT provided a total return of approximately 20%, outpacing most market indices.  The sector has also been immune to the day-to-day jitters in the NASDAQ and S&P 500, one of its biggest selling points.  Although REITs may repeat their robust performance of 1996/97 to only fall into a trough a year or two afterwards again, new REIT IPO's are still scarce, stock buybacks are in practice, and occasional mergers and consolidations are occurring.  Fortunately, this is a different scenario than three years ago.

From a valuation standpoint, REITs are trading at their most attractive since 1990/91.  Anxious of a threatening slowdown in property and rental markets, investors were bidding REIT stocks to quasi-recessionary levels, despite various positive developments in the sector.  According to Timothy P. Vick of Arbor Capital Management, at the end of 1999 investors were so confident of a drop in real estate markets that REIT stocks demonstrated a median dividend yield of 9.9% at the beginning of 2000, approximately 3.4% higher than 30-year Treasury bonds, marking the highest yield-spread in close to 10 years.

Despite the waking up of REIT stocks on Wall Street, those who want to invest in the sector for income should be aware that not all REITs are of the same breed, primarily due to the cyclical nature of the real estate industry's different segments:
 

 When buying REITs for yield, the dividend is only as good as the underlying earnings, and earnings usually move in tandem with expansion.  Higher interest rates have made it more difficult for REITs to finance new acquisitions, and have decreased the rate of return potential on newly acquired properties.  Since short-term rates have been rising faster than long-term rates, REITs that hold short-term debt will be most vulnerable to an earnings slowdown.

In today's venture climate, it is important that investors be careful not to assume that all REITs are pure-value plays.  On paper, many REITs trade below the value of their underlying properties, but these valuations may mirror an optimistic appraisal of the properties' sales values.

Rising interest rates also can benefit the real estate industry by forcing REITs to hold back on aggressive expansions into overbuilt markets.  Higher rates have raised the hurdle rate on acquisitions and developments, and as expected, acquisition activity has slowed over the past year and should continue in that direction.  Some REITs are liquidating their property portfolios and buying back stock, an indication that high-return property investments are more difficult to attain.

Over the next 12 months, it might be prudent to focus on REITs with a sustained record of rising dividends, pricing power, and earnings growth.  In other words, REITs whose primary income is rent may serve as the best inflation hedges.  Hotel room prices, as well as office and apartment rents, have been growing at 3x to 5x the rate of inflation.  In the present credit-crunch, investors should also focus on REITs that are maximizing returns on their existing portfolios, either by finding new sources of revenue or by slashing operating costs.

Moreover, before acquiring a REIT stock in today's volatile market, an investor should pose the following fundamental questions: