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By Jeremy Glaser | 07-11-2011 10:04 AM

What to Seek in a REIT

REITs look overvalued in general, but certain business models and individual names still look especially attractive.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser.

I'm here today with Philip Martin--he is a REIT strategist--and Jason Ren--he is a senior analyst of REITs here at Morningstar--to take a closer look at the commercial real estate industry and see if there is any opportunity for investors today.

Gentlemen, thanks for joining me.

Jason Ren: Thanks for having us.

Philip Martin: Thank you.

Glaser: So, I want to start of broadly in talking about the commercial real estate industry. We hear a lot about how residential real estate is not doing very well, but we hear less in the news about commercial real estate. How have things been going since the end of the recession? Are rents coming back on the certain sectors that are doing better? What's your general outlook in that space?

Martin: Well. I think from an Economics 101 perspective just to start broad, when you look at commercial real estate versus residential real estate, commercial real estate really doesn't have the oversupply problems that residential has, so commercial real estate is benefiting from that.

Our overall general view is that because of the healthy supply fundamentals right now, commercial real estate will rebound more quickly [than it has] coming out of past down cycles ... And then by sector, certainly different sectors are benefiting a bit differently based on where their core focus is--so health care versus lodging, versus office, versus industrial all have different fundamentals and different key drivers.

Ren: Right. So, when we're thinking about real estate, we try to think about, "Well, are they near-term leases or long-term leases," and we're finding that the sectors that rely a bit more on near-term leases--so hotels, apartments, self storage--they lost ... pricing going through the downturn fairly quickly, But conversely, as the economy has improved a bit, sentiment has improved and stabilized a bit, they are seeing pricing power come back fairly quickly. For the sectors that rely a bit more on longer-term leases to business clients, the pricing power isn't there yet.

Conversely, we also like to look at REITs that we consider to have a sustainable competitive advantage in terms of growing cash flows defensively over time. The ones that we consider to have a moat, they are doing better, so they're having high occupancies that are leading to rate growth.

Glaser: So certainly it sounds like the commercial real estate industry is a lot healthier than the residential side. Has that translated into better results for the REITs? Are they reporting better earnings, and is that having an impact on the stock price for holders of REITs?

Ren: Aside from the hotel space, which for a while there was kind of a disaster, but for many of the other sectors, the fair stability in occupancy really led to fairly minor deterioration in property-level profitability through the downturn, and now it's improving at a healthy clip as the fundamentals have come back.

We think that valuation has come back a lot quicker than fundamentals, and part of that is because the REITs fell harder than the market when the crisis hit because they were caught in a bind with regard to refinancing concerns, because REITs are required to pay out 90% of their taxable income as dividends to shareholders. So, for part of the recession, people were concerned whether REITs [would be able to] refinance and at what rate, and now that they've been able to refinance, fundamentals are improving, that's resulted in fantastic returns for REIT shareholders.

In our view, we think that those returns, valuations have come up a little faster than fundamentals have. So we think that the overall space is around 15% to 20% overvalued, but we do think that there are some opportunities in the REITs.

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