REITs Are Down, but for How Long?

THE enduring rally in real estate investment trusts finally ended this year as turbulence in the credit markets rattled the confidence of commercial investors and effectively halted the frenetic pace of REIT privatizations.

The Avalon at Mission Bay apartments in San Francisco were developed by AvalonBay Communities.

Now the question on some people’s minds is whether the downturn means that a lingering bear market is looming.

For more than seven years — from November 1999 through January 2007 — REIT shares soared in value, providing giddy investors with average annualized returns of 23.6 percent, according to the National Association of Real Estate Investment Trusts. (In 2006 alone, REITs climbed by an average of 34.4 percent.)

But the market is poised to finish 2007 sharply lower. This year through Thursday, the REIT composite index compiled by the trade association had a negative return of 11.39 percent. The index of equity REITs, which own commercial property and constitute the bulk of the market, has fallen 8.63 percent.

Meanwhile, losses for mortgage REITs, which originate loans and invest in mortgage-backed securities, were a staggering 43.5 percent, on average.

By contrast, the Standard & Poor’s 500-stock index is up around 6.4 percent so far in 2007.

“It’s been a very ugly year,” said Mike Kirby, a principal of Green Street Advisors, a real estate research company in Newport Beach, Calif., echoing the sentiment of many others. “It’s one of the worst performances we’ve seen in REIT land in a long time.”

Industry analysts and money managers, though, had been predicting for a while that the REIT market would run out of steam.

Fortunes reversed, they say, just as a giant private equity firm, the Blackstone Group, was completing its billion acquisition of Equity Office Properties Trust, the nation’s largest office landlord. “That was when the market peaked,” Mr. Kirby said.

Indeed, part of the reason for the REIT run-up was the record number of mergers and acquisitions, about half of which involved leveraged-buyout deals by private firms with voracious appetites for commercial property. (As investors tried to predict which REIT companies, or sectors, might be singled out next, share prices surged.)

Last year, there were 23 announced transactions totaling 6.15 billion, including the assumption of debt, according to SNL Financial, a research company. But so far this year there have been only 18 transactions totaling .69 billion, SNL said. Only one deal has been announced since July 25.

Analysts attribute the falloff to a reluctance among financial institutions to provide loans for buyouts in light of the credit squeeze that swept through the subprime mortgage market as the housing market softened.

Because REITs themselves typically have only moderate levels of debt, analysts say, they have generally fared well in the credit crisis; the noted exception, of course, has been mortgage REITs.

Nonetheless, concern has grown that the credit problems may eventually weaken the economy and therefore hurt demand for commercial space.

“Real estate fundamentals are still in pretty good shape by historic standards,” said Ross L. Smotrich, a senior managing director and REIT analyst at Bear Stearns. “Occupancy is in the low- to mid-90 percent range across the board by geographic and property types, and there’s positive rental rate growth.”

But even though these business fundamentals are relatively strong, securities prices have dropped. REIT performance, Mr. Kirby noted, “had been pretty decent at the operating level and poor at the share level.”

Whether REIT shares stay depressed is open for debate. The last bear market, in which annualized losses averaged 13.18 percent, lingered for 23 months until November 1999, according to the REIT trade association. The one before that lasted 14 months, from August 1989 to October 1990, it said; average annual returns during that market were a negative 20.86 percent.

“REITs have been in a bear market pretty much all year,” said Ralph L. Block, the author of “Investing in REITs” (Bloomberg Press, 2006) and the publisher of The Essential REIT, a newsletter. “I think the key to forecasting what REIT stocks do in 2008 is determining whether the U.S. is going into a recession.”