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REITs revalued

April was a cruel month for real estate investors, but maybe not the cruelest.

Prices for real estate investment trust stocks hit their all-time high on -- when else? -- April Fool's Day. Over the next two weeks, the Morgan Stanley REIT index plunged as much as 15 percent from its high of 662.5 as a stronger-than-expected jobs report stoked fears of rising interest rates. Then the March inflation rate came in higher than economists had anticipated.

Maybe investors shouldn't have been surprised. In the first quarter real estate stocks were trading at an average 23 percent premium to their net asset values -- dramatically higher than their historical average of about 3 percent.

"These stocks were simply overpriced," says Jon Fosheim, a principal at Green Street Advisors, a Newport Beach, California, research firm. By late April the sector was trading at a multiple of about 15, down from 18.5 before the sell-off, with about a 5 percent premium to net asset value.

Though the index bounced back a bit after its precipitous drop, analysts warn that prices have further to fall. Some expect at least a few REITs to announce dividend cuts later this year. Since yield is a key attraction of real estate stocks, that threat is significant.

"We're part of the way there," says David Shulman, Lehman Brothers' senior REIT analyst and a lone -- and loud -- bear on the sector since the middle of 2002. At the beginning of this year, Shulman projected that the Morgan Stanley REIT index would hit 520 by December 31.

"We see a further 20 percent decline," Shulman says. "Stocks wouldn't be cheap at that level. They would just be at the high end of fair value. In our view REIT stocks have to get a lot lower to be cheap."

Green Street's Fosheim is more sanguine. "This has been a natural correction. I see no alarm whatsoever," he says. "At this point, even though I know there's a good chance they can still get sold down from here, the fact that I can buy them at about their net asset values is comforting."

Retail REITs had enjoyed the biggest run-up in price compared to other types of REITs before the sell-off, so they suffered the biggest relative drop. But a number of analysts now recommend the retail area, particularly shopping mall owners, over apartment and office REITs. Many retail rents are below market value and will thus increase once leases are up for renewal. Another encouraging sign: March retail sales rose 1.8 percent, exceeding Wall Street expectations of 0.7 percent.

"The retail sectors have the strongest cash flow growth in 2004 over 2003, and that growth should still look pretty good in 2005," says Timothy Pire, managing director and lead public securities portfolio manager for Heitman, a Chicago-based real estate investment management firm. "I don't think it's getting better, but it will be good. You're going to begin to see other sectors' overall growth rates start to catch up. And I think that's the tricky part -- finding those transition points."

Although apartment and office REITs will clearly benefit from an improving economy, their recoveries will probably be slow. Office landlords must contend not just with the problem of filling vacant space, but also with the fact that many office suites carry above-market rents that will likely be marked down once tenants' leases are up for renewal.

"The office market is going to be tough," says Pire. "I think you could see some pickup in occupancy rates, but I don't think that's going to turn into substantial cash flow growth, because you still see rental rates rolling down and a fair amount of capital being spent to get or retain those tenants."

Meanwhile, REIT analysts are keeping a close eye on earnings. Companies with long-term leases in their portfolios, and thus little prospect of boosting rents, may be forced to slash their dividends. "We won't see a lot of cuts," says Shulman, "but we'll see enough to remind people that the dividends aren't as safe as people perceive them to be."