Some 4- and 5-Star REITs for Your Radar Screen

At Morningstar, we have always been fans of real estate investment trusts. These companies' hefty dividends, high returns on capital, and stable cash flows make for attractive investments with negligible business risk. Unfortunately, the market has been in on this secret, bidding REIT shares through the stratosphere. For seven years in a row, the primary U.S. REIT index has trounced all the other major U.S. equity market benchmarks. With prices so frothy, we've rarely had any 4- or 5-star stocks to recommend.

Not anymore. Thanks to a crummy start to 2007, REITs are roughly flat for the year to date compared with an 8% gain for the S&P 500. While the performance isn't appalling, it is surprising considering the operating environment. New development is constrained across most property types, giving way to higher rents and occupancies. Payroll employment growth continues to be solid as companies add staff and lease more space. Interest rates remain low, providing REITs with cheap capital to buy more buildings and expand into new markets.

So why have REITs taken a knocking? No one reason can be cited for the sell-off, but a number of different factors have contributed to the downturn. First, concerns about the slowing residential real estate market may have bled into REITs and prompted some selling. Second, the economy's hiccups over the past three months--sluggish consumer spending, disappointing housing starts, and weak GDP growth--probably weighed heavily on REITs. Economic growth fuels demand for new space, and influences the rate at which REITs can raise rents. Third, with REITs up by more than 300% overall since 2000, long-term investors decided to take profits.

The last reason resonates the most with us, as it is something we suggested in our 2007 REIT outlook report. At that time, our average star rating for REITs was 1.6, indicating our belief that the average REIT offered a low return relative to its risk. Following the recent slump in REITs, our average star rating has risen to 2.4. This is by no means a buy signal, but it is one of our highest average star ratings for REITs in recent years. We still believe some sectors are grossly overvalued--apartments being one--but we also see several sectors in which good values can be found.

REIT Statistics by Sector
Property Sector	Average Star Rating	% Above Fair Value Est.	Price/FFO Estimate	Dividend Yield TTM
Apartments	1.10	61%	20 times	3.7%
Self Storage	2.33	10%	17 times	4.5%
Retail	1.75	30%	17 times	4.1%
Hotel	2.69	10%	11 times	2.6%
Industrial/Mixed	2.67	7%	14 times	4.4%
Office	2.58	15%	18 times	4.1%
Health Care	3.60	-8%	14 times	5.6%
Equity REIT Avg.	2.39	18%	16 times	4.1%
Data as of 05-25-2007

Health-Care
Health-care stands out as the best bargain in REIT-land. These landlords of hospitals, assisted-living facilities, or other types of health-care real estate possess fantastic growth prospects that come without the risks of traditional health-care companies. For instance, health-care REITs are protected from cuts in Medicare and Medicaid reimbursement courtesy of their long-term leases and carefully selected operators. This  article discusses the sector's economics and outlook, as well as our favorite names in the group. One of these companies,  Ventas (VTR), is hovering between 3 and 4 stars.

Ventas (VTR)
Economic Moat: Narrow
Business Risk: Average
From the  Analyst Report: "Ventas has a stellar record of creating shareholder value. Average annual returns on real estate assets are more than 15%, the highest in our REIT coverage universe. Management has a history of identifying properties with great investment returns, generating new revenue opportunities, and creating ample free cash flow for reinvestment."

For more risk-tolerant investors, we recommend Universal Health Realty (UHT) and Senior Housing Properties Trust  (SN)H. Both of these companies have higher risk profiles than Ventas, but we believe current stock prices offer commensurate compensation.

Universal Health Realty (UHT)
Economic Moat: Narrow
Business Risk: Average
Star Rating: 4 Stars
From the  Analyst Report: " Universal Health Services (UHS) originally spun off Universal Health Realty as a way to rid itself of costly real estate debt. Since then, UHR has evolved into a highly profitable health-care property owner."

Senior Housing Properties Trust (SNH)
Economic Moat: Narrow
Business Risk: Above Average
Star Rating: 4 Stars
From the  Analyst Report: ""Senior Housing is a health-care real estate investment trust that owns an enviable portfolio of properties. About 85% of annualized rent comes from private-pay independent and assisted-living facilities, a more stable source of revenue than Medicare and Medicaid."

Industrial
The industrial sector holds a few gems at current prices. Industrial REITs own warehouses and distribution facilities that have greatly benefited from the boom in global trade. Corporations' emphasis on efficient supply-chain solutions and structural changes throughout the rest of the world--such as the European Union's role in transforming Europe into a boundary-less market and China's move to relax foreign investment restrictions--have also ushered in new demand for industrial properties. One of our better industrial REITs,  First Potomac , has seen its shares drop significantly because of one-time expenses, in our opinion.

First Potomac 
Economic Moat: Narrow
Business Risk: Average
Star Rating: 4 Stars
From the  Analyst Report: "The firm specializes in flex buildings, which can be converted into a variety of uses, such as bulk warehouse or office space. We think this customization is a draw for tenants and contributes to the company's high tenant retention rate of 88%."

Office
Office REITs accounted for about half of the $120 billion in mergers and activity in 2006, pushing office REIT shares up in anticipation of more takeovers. Since then, the office sector has also seen its shares decline despite the presence of strong market fundamentals. Vacancy continues to tick lower and new supply remains in check. Rents have also taken off, although we don't believe the market can sustain double-digit rent increases forever. Such rents may already be forcing businesses to relocate to surrounding suburbs, which favors landlords like  Brandywine (BDN)--one of our best office buys.

Brandywine (BDN)
Economic Moat: Narrow
Business Risk: Average
Star Rating: 5 Stars
From the  Analyst Report: "We believe regionally focused firms have an edge over their national counterparts. Real estate is still a local business, and a dominant local presence means clout with tenants, leasing agents, and city authorities. A regional economic slowdown could hurt niche players much more, but smart landlords mitigate such risk through tenant and industry diversification. We think Brandywine is one such landlord."

These Prices Won't Last Long
Given the favorable operating environment, we're confident that REIT share prices will eventually rebound and continue on their upward trajectory. Institutional investors continue to throw more money at REIT stocks--a pie that is shrinking with more privatizations such as Tishman Speyer and  Lehman Brothers'  pending takeout of  Archstone-Smith . Furthermore, initial yields on property transactions remain low in a sign that demand for commercial real estate remains healthy. We would take advantage of attractive valuations today, knowing that tomorrow could bring another catalyst that sends REIT shares higher.