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Industry Outlook

The U.S. Real Estate Investment Trust (REIT) industry has sustained the improving trend this year, driven by a largely increased inflow of funds as institutional investors allocated more capital to the industry. This has helped the group generate market-beating returns.

The FTSE NAREIT Equity REIT Index had total returns of 6.3% in the first quarter of 2011 vs. 4.8% and 5.4% for the NASDAQ Composite and the S&P 500 Index, respectively. This was preceded by a solid back-to-back returns performances by the industry, as the above referred benchmark index returned roughly 28% each in 2010 and 2009.

Investors looking for high dividend yields also favored the REIT sector. Solid dividend payouts are arguably the biggest enticement for REIT investors as the U.S. law requires REITs to distribute 90% of their annual taxable income in the form of dividends to shareholders. The dividend yield for the FTSE NAREIT All REIT Index by the end of first quarter 2011 was 4.2% compared to 3.4% for the 10-year U.S. Treasury Note.

The standout performance in the REIT industry (as of May 24, 2011) was that of the timber REITs (a total return of 15.43% as measured by the FTSE NAREIT Equity REIT Index), followed by self-storage (13.75%), diversified REITs (13.62%), regional malls (12.90%), office (12.26%), apartments (11.90%), and mixed-use REITs (11.85%). The relatively underperforming sectors were shopping-center REITs (5.11%) and lodging/resorts (-2.63%).

A combination of factors has helped the group stand out. During the crest-to-trough period of 2007 to 2009, REITs took on far less debt than private real estate investors, and many were able to sell at the top of the market when private equity investors were still buying.

Importantly, during the downturn REITs were able to acquire properties from highly leveraged investors at deeply discounted prices. This enabled them to add premium high-returns assets to their portfolios. Furthermore, REITs have been able to raise capital to pay off debt, making them an increasingly attractive investment proposition.

Since late 2010, mergers and acquisitions have gained pace, as publicly traded REITs have benefited from access to the public markets to fund transactions. Healthcare REITs had announced $11.25 billion worth of acquisitions in 2010, led by the $6.1 billion purchase by HCP Inc. (HCP - Analyst Report), the largest medical REIT in the U.S. HCP acquired ownership interests in 338 post-acute, skilled nursing and assisted living facilities from HCR ManorCare Inc., a leading privately owned provider of skilled nursing facilities.

Redefining the market dynamics, ProLogis (PLD - Analyst Report), a leading global provider of distribution facilities, also merged with its rival AMB Property Corp. (AMB) in early 2011 in an all-stock deal, creating a behemoth of sorts in the industrial real estate sector.

The combined entity would have a pro-forma equity market capitalization of approximately $14 billion and a total market capitalization of over $24 billion. The merged company will be treated as an UPREIT -- an innovative business structure that forms an umbrella partnership between property owners and REITs.

The developments indicate signs of stabilization in the commercial real estate (CRE) market. According to data provided by Deloitte, CRE transaction volume surged from $54.7 billion in 2009 to $122.7 billion in 2010 -- an increase of 124.3%.

The spurt in CRE transaction volume has also continued through the first quarter of 2011, growing 69.5% year-over-year to $30.5 billion. Furthermore, Jones Lang LaSalle Incorporated (JLL - Analyst Report), a leading full-service real estate firm, anticipates direct investment in CRE to swell to over $350 billion in 2011 -- the highest levels since 2008.

OPPORTUNITIES

With a continued decline in the single-family homeownership rate across the U.S. and gradual improvement in the overall economy, apartment REITs have performed strongly in first quarter 2011. We expect this sector to remain comparatively stable in the coming quarters, as renting has emerged as the only viable option for customers who could not get mortgage loans or are unwilling to buy a house at present.

In this environment, we remain bullish on AvalonBay Communities, Inc. (AVB - Analyst Report), one of the best-positioned apartment REITs, primarily focused on developing multi-family apartment communities for higher-income clients in high barrier-to-entry regions of the U.S. AvalonBay has Class A assets located in premium markets, such as Washington DC, New York City, and San Francisco, where the spread between renting and owning is still high despite home price declines.

In addition, AvalonBay has a reasonably strong balance sheet with moderate near-term debt maturities and adequate liquidity. Consequently, the company can capitalize on potential acquisition opportunities due to distressed selling from owners and developers who cannot refinance their properties, which augurs well for its top-line growth.

We are also bullish on The St. Joe Company (JOE - Analyst Report), an operationally diverse real estate company. St. Joe is the largest private landowner in Northwest Florida, and is one of the largest real estate developers of the region, engaged in town, resort, and industrial development in addition to land sales and commercial real estate operations.

The opening of the Northwest Florida Beaches International Airport, developed by St. Joe, is the first new international airport opened in the U.S. since the 2001 terrorist attacks, and is expected to become a major growth driver for the region. The airport greatly increases the future value of its holdings, and provides an upside potential for St. Joe.

The company also launched Venture Crossings Enterprise Centre at West Bay -- a commercial development spanning 1,000 acres adjacent to the new airport, for industries, offices, retailers and hotels, which will likely have a positive economic impact on the region in the long run.

Another stock worth mentioning is Plum Creek Timber Co., Inc. (PCL - Analyst Report), a timber-REIT that owns one of the largest and most geographically diversified private timberland in the U.S. Plum Creek’s diversified timber and land base provides excellent operational flexibility to respond to changing market conditions amid challenging macroeconomic environment.

In addition, the upsurge in demographic trends driving housing markets and demand for real estate properties across the nation provides a strong economic backdrop for the company to demonstrate solid financial performance in the future. The company is also likely to continue to defer harvest and sell off non-core timber assets in order to fund its dividend and maintain significant liquidity. This defensive behavior seems appropriate given the company’s stated objective of maximizing long-term value and maintaining a stable dividend payout.

WEAKNESSES

A significant chunk of REITs are raising capital through property level debt and equity offerings. Although both debt and equity financings provide the much-needed cash infusion, they could potentially burden an already leveraged balance sheet and dilute earnings. Property level debt is also harder to obtain and more expensive as commercial real estate prices remain under pressure.

We are bearish on Regency Centers Corporation (REG - Analyst Report), a self-administered REIT that owns, operates, and develops grocery-anchored retail shopping centers in the U.S. Regency has an active development pipeline, which increases operational risks in the credit-constrained market, exposing it to rising construction costs, entitlement delays, and lease-up risk. As such, we are skeptical about the long-term earnings potential of the company.

In addition, most of the REIT’s properties are concentrated in select markets in California, Florida and Texas, leading to concentration risk. Furthermore, the possibility of store closings at many Regency stores adds uncertainty to earnings, and it might have to re-let large big box spaces at significantly lower rents in a tough leasing environment. This clouds the REIT’s earnings power, which accounts for our negative view of the stock.

We also remain skeptical about the prospects of Host Hotels & Resorts, Inc. (HST - Analyst Report), the largest lodging REIT and one of the largest owners of luxury and upper-upscale hotels. The majority of Host Hotels’ properties are concentrated in the luxury and upper-upscale segments, which had been the weakest performing segments during the economic downturn. While the outlook for these markets have improved, the pace of the improvement remains quite uneven and unsteady.

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