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The U.S. Real Estate Investment Trust (REIT) industry had a lackluster third quarter after a relatively strong run in the first half of 2012, with a below-par performance in the months of August and September. However, on a macro aspect, the industry was well on course to steamroll the negative investor sentiments as historically REITs have two positive months for every negative month in a bull market. To add a feather to its cap, currently REITs also have been in a three-and-a-half-year cycle into the bull market with an average return of about 20% in each year, preceded by a two-year downturn.

The uptrend in the year-to-date diffusion index further suggested that economic growth was broadening across sectors and indicated a higher probability of a firmer foundation for future growth. Barring minor hiccups, overall equity prices moved northwards as geopolitical noise remained relatively congenial with the Pandora’s Box of the eurozone crisis remaining well in control.

In addition, the U.S. GDP growth was comparatively healthy at 2% in the third quarter as consumer spending picked up, along with higher government outlays and gains in residential construction. With an expected GDP growth of around 2% in the remainder of 2012, the overall industry offered a harbinger of a slow yet steady revival of the economy. Employment data was also encouraging with an average monthly gain of 146,000 jobs for the third quarter, significantly up from 67,000 per month during the previous quarter. Furthermore, the unemployment rate plummeted below the 8% mark for the first time in the last four years to 7.8% and was expected to be 7.9% in the next year.

During the third quarter of 2012, the FTSE NAREIT All REITs Index recorded total returns of 1.85% compared to 6.35% for the S&P 500. For the first nine months of the year, however, the trend was reversed with the FTSE NAREIT All REITs Index reporting total returns of 17.57% compared to 16.44% for the S&P 500.

A combination of factors has helped the listed REIT sector to stand out and gain critical mass over the past 15 to 20 years, the most notable among them being a healthy dividend payout. Total returns of 15.74% for the FTSE NAREIT All REITs Index (as of October 26, 2012) included a share price return of 11.92%.

Investors looking for high dividend yields have historically favored the REIT sector. Solid dividend payouts are arguably the biggest enticement for REIT investors as 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 Equity REITs Index as of October 26, 2012, was 3.41% compared to 1.76% for the 10-year U.S. Treasury Note.

During 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-return assets to their portfolios.

Furthermore, REITs managed to raise capital to pay off debt, owing to a large inflow of funds as institutional investors allocated more ‘dry powder’ to the industry, making them an increasingly attractive investment proposition. In 2011, REITs raised $51.3 billion in public equity and debt, out of which $37.5 billion alone was raised though public equity despite a highly volatile market. During the first nine months of 2012, publicly traded U.S. REITs have already surpassed that and raised an aggregate of $54.3 billion in capital, which included $36.9 billion in equity.

Moreover, according to data from NAREIT, debt ratio of equity REITs (total industry debt as a percentage of its total debt and equity market capitalization) by the end of second quarter 2012 was 34.6% – significantly lower than 51% at the end of second quarter 2008 and prior to the Lehman Brothers collapse due to the ‘Great Recession.’ In addition, REITs typically have a large unencumbered pool of assets, which could provide an additional avenue to raise cash during a crisis. These in turn have provided the requisite wherewithal to the REIT industry to make strategic acquisitions over time to fuel its inorganic growth engine. Moving forward, the REIT industry is likely to maintain the uptrend in growth for the remainder of 2012. The outlook remains by and large positive.

However, given the positive note in investor sentiment, a number of factors still persist as a thorn in the improved market scenario. With heights of political uncertainty due to the imminent presidential elections in the U.S., investors might play a ‘wait and watch’ game before committing on better investment opportunities. In addition, rising concerns about the ‘fiscal cliff’, with over $600 billion in government spending cuts and tax increases slated to kick start in 2013, is taking its toll as most companies are reducing capital expenditures. These in turn could put a ceiling on equity returns in the next year.

Furthermore, the strategic move to focus on austerity measures among European countries could impede regional economic growth, leading to a dearth of investor confidence in the European financial and fiscal system. In addition, economic growth in emerging markets, particularly the BRIC countries, is expected to be lesser than in recent years, driven by a relative weakness in the developed world and related uncertainties in the global business climate. All these factors could cumulatively contribute to an equity market headwind in the remainder of 2012 and in 2013.

In a nutshell, the long-term prospect of the REIT industry looks favorable with a mild cautionary note. Year to date, the standout performance in the industry was that of the Timber REITs (a total return of 32.75% as measured by the FTSE NAREIT Equity REITs Index as of October 26, 2012), followed by Infrastructure (22.97%), Shopping Centers (22.82%), Industrial REITs (22.37%), and Regional Mall (22.25%). The relatively underperforming sectors were Apartments (3.77%), Lodging/Resorts (4.70%), and Diversified REITs (5.11%).

OPPORTUNITIES

We are bullish on Plum Creek Timber Co. Inc. (PCL - Analyst Report) that owns one of the largest and most geographically diversified private timberlands in the U.S. The company produces lumber, plywood and medium density fiberboard in its wood products manufacturing facilities. Plum Creek’s diversified timber and land base provides excellent operational flexibility to respond to changing market conditions amid a 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. Housing starts are expected to be up 25% in 2012, and increase from 750,000 starts in the current year to 900,000 in 2013.

Plum Creek benefits from large economies of scale and capitalizes on the increasing value of timber over time to offset several negative effects of cyclical commodity pricing. Furthermore, Plum Creek makes prudent investments in the growth of its timberland assets and harvests trees at the most ‘economically mature’ point in the life cycle of a tree. The company also acquires attractive timberlands and uses advanced practices to improve productivity of its forests, which augments its timber inventory.

We also remain bullish on Simon Property Group Inc. (SPG - Analyst Report) the largest publicly traded retail REIT in North America, with assets in almost all retail distribution channels. The company’s international presence gives it a more sustainable long-term growth story than its domestically focused peers. The geographic and product diversity of the company also insulate it from market volatility to a great extent and provide a steady source of income.

The company has one of the strongest comparable sales per square foot in the industry. Comparable sales in the combined portfolio were $562 per square foot during third quarter 2012, compared to $514 in the prior-year quarter. In addition, Simon Property generally enters into long-term leases with companies, which insulate it from short-term market swings that have weighed on other players in the industry. With a favorable supply/demand relationship, rising earnings estimates, robust growth projections, and a healthy dividend yield, Simon Property offers an enticing upside potential going forward.

Another stock worth mentioning is Prologis Inc. (PLD - Analyst Report) that acquires, develops, operates and manages industrial real estate space in North America, Asia and Europe. Prologis had merged with the erstwhile namesake company in an all-stock deal to become a behemoth of sorts in the industrial real estate sector. The combined entity had brought two of the most complementary customer franchises on the same platform and created a $44 billion worth of asset pool at their disposal at the time of merger. The merger had led to potential cost savings through operational synergies and had created a stronger platform for value creation and sustainable growth in the long term.

In addition, Prologis provides industrial distribution warehouse space in some of the busiest distribution markets across the globe. The properties of the company are typically located in large, supply-constrained infill markets at close proximity to airports, seaports and ground transportation facilities, which enable rapid distribution of customers’ products. This has enabled the company to gain a significant pricing advantage over its competitors.

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.

Although overall market fundamentals remain positive for Apartment REITs, we are a tad bearish on Apartment Investment and Management Company or Aimco (AIV - Analyst Report) as it is popularly known as. Aimco is one of the largest owners and operators of multifamily apartments in the U.S., with a strong portfolio of Class ‘B’ and Class ‘C’ properties primarily catering to the middle-income market. The company is currently restructuring its portfolio and expects to sell almost all of its affordable properties over the next four- to five-year period to concentrate entirely on the conventional real estate portfolio.

Aimco also expects to reduce its investment in non-target markets and consequently increase its investment in target markets through redevelopment and acquisitions. Despite attempts to reposition its portfolio, much of the company’s portfolio still resides in areas where housing is relatively cheap. As the company continues to sell non-core assets and buy in higher growth, infill areas, we expect continued earnings dilution.

We also remain skeptical on Host Hotels & Resorts Inc. (HST - Analyst Report), the largest lodging REIT in the U.S. 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. The hotel industry is also cyclical in nature, and is heavily dependent on the overall health of the U.S. economy, which is yet to spring back to its full vigor.

Unfavorable macroeconomic conditions in the past have compelled customers to cut back on discretionary spending and prefer lower priced brands over premium ones. Consequently, demand for Host Hotels had reduced comparatively and if the trend reoccurs in future, the company would be under severe stress to maintain profitability.

Moving forward, limited supply of new construction coupled with the growing demand for high-quality properties bode well for the earnings prospects of REITs, in particular those that have assets in high barriers-to-entry markets. To sum up, we firmly believe that despite a few pitfalls, REITs still make a worthy investment proposition during the remainder of 2012 and in 2013.

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