The Opportunity Left in a Bid-Up REIT Sector

By JOHANNA BENNETT AIM's Paul Curbo discusses real-estate stocks that he thinks still offer value. LIKE THE FAMED war hero Audie Murphy, real-estate investment trusts, otherwise know as REITs, have been "to hell and back" over the last two years. REITs, which own and manage office buildings, shopping malls, rental apartments and other properties, have enjoyed big gains since the broader market began its rally seven months ago. The Dow Jones Equity REIT Index has almost doubled in value since early March, versus a 56% gain by the Standard & Poor's 500 index. Still, the sector faces economic headwinds. And stocks remain well off highs from early 2007 before the U.S. real-estate market collapsed and the credit crisis erupted last year. Manager's Bio Name: Paul S. Curbo Age: 38 Title: Co-manager of the AIM Real Estate Fund; the AIM Global Real Estate Fund, the AIM Select Real Estate Income Fund, the AIM V.I. Global Real Estate Fund Education: Bachelor of business administration in finance, University of Texas Hobbies: Cycling, fishing and campingWe recently asked Paul Curbo, co-manager of the AIM Real Estate Fund (ticker: IARAX), about the current environment. His $1.1 billion-asset fund, which focuses on equity REITs, is ranked by Morningstar as the third-best performing real-estate fund based on 10-year annualized returns, despite posting a 36% loss in 2008. Barrons.com: Once favored for low volatility, high dividends and stable cash flow, REITs have had quite a ride over the last two years. What has changed recently? Paul Curbo: Real estate is a capital-intensive industry. When capital is expensive or not available -- as was the case in late 2008 and early 2009 -- it's difficult to value an equity REIT. Credit markets have improved and new debt is being priced at more attractive levels. Also, equity REITs have raised roughly $16 billion in equity since the beginning of the year, improving balance sheets and providing the funds necessary to acquire more assets from property owners overloaded with debt. Q: Have fundamentals actually improved? A: Real estate in general will lag the overall economy. I don't expect improvement in funds from operations until sometime in 2010. Still, there are pockets where the environment is improving. [Editor's Note: REITs use funds from operations (FFO) to define cash flow from their operations. Sometimes quoted on a pre-share-basis, the figure is a proxy for earnings.] Q: Are debt concerns still an issue? A: Yes, because the upcoming debt maturities are so significant. Well over $1 trillion in mortgages on commercial and multifamily mortgage properties will come due between 2010 and 2013. Some of these properties will need to be recapitalized or sold. Smart companies have been raising equity and unsecured debt so they can refinance or grab new assets. Q: Do valuations sufficiently reflect these issues? A: Valuations reflect an improving credit market and improving economy. Historically, equity REITs trade at premiums to the value of their real-estate assets. The spread between cash flow yields generated by REITs and the lower yields generated by Treasuries is still pretty wide, which is normally a good indicator of future performance. REIT stocks were cheap earlier this year, and have moved closer to fair value. If the economy or the credit markets worsen, then the stocks will pull back. Q: The weak economy has dimmed demand for office and retail space, and forced landlords to cut rents. Which companies have weathered these headwinds? A: Digital Realty Trust (DLR) is a technology-focused REIT that owns data-center properties and server farms. Many companies are outsourcing data storage or face growing need to store vast amounts of data. Digital takes space intended for other uses and converts it to a data center or builds it themselves. It's a niche without a lot of competition. Digital increased rents during the downturn, which allowed profits to grow while other companies suffered declines. They are looking at acquiring properties, and recently bumped their dividend by 9%. Fund Facts AIM Real Estate Fund (IARAX) Assets: $1.1 billion Expense Ratio: 1.3% Front Load: 5.5% Annual Portfolio Turnover: 47% Yield: 2.7% Source: Morningstar.com as of Sept. 30, 2009 ____________________________________________ Top 10 Holdings (as of Aug. 31, 2009) Simon Property Group SPG Ventas VTR Boston Properties BXP Public Storage PSA Equity Residential EQR Digital Realty Trust DLR Vornado Realty Trust VNO Health Care REIT HCN Host Hotels & Resorts HST Nationwide Health Properties NHP Source: Invescoaim.com Q: Simon Property Group (SPG) is your top holding? A: They are accumulating a lot of cash and have built up quite a war chest. They have over $3 billion in cash on their balance sheet and access to a $3 billion credit line. They will generate over $700 million in free cash flow this year. Simon's biggest competitor, General Growth Properties, is in bankruptcy. And while I am not suggesting that they will buy General Growth, Simon has the capital to acquire assets from distressed property owners. Meanwhile, Simon's strong balance sheet assures prospective tenants that the company will be around for a while. Q: Retail REITs account for 18% of your fund. Yet the U.S. consumer and retailers face stiff headwinds. A: We are actually underweight retail. We don't see a robust consumption environment over the next several years and expect retrenchment in places like neighborhood shopping centers. Our retail holdings favor regional malls with longer lease terms, good operators and strong balance sheets. Q: What else looks attractive among the ruins of commercial REITs? A: SL Green Realty (SLG) is the largest office landlord in New York City. They maintained a high occupancy rate for their properties during the downturn and rents are relatively low compared to other landlords. Meanwhile, the government has focused on helping banks and improving the financial-services sector, a major tenant for office space in New York. The financial industry hasn't returned to precrisis levels, but sentiment has improved along with demand for office space. In fact, the New York market has rebounded a bit, and rents have modestly increased in some spaces, which bodes well for SL Green. At almost $44 a share, SL Green's share price has increased 400% since early March. But it fell from a high in 2007 of over $156. Q: Apartment REITs face many of the same troubles as office REITs. Yet you hold several, including AvalonBay Communities (see Barron's, "Getting in on the Ground Floor," July 27, 2009). A: New home formation drives demand for apartments. But forming your own household, for instance after graduating college, requires having a job. Employment is not growing, so don't expect strong demand for apartments over the next year. But people need a place to live, and apartment REITs can often fill their units at some price level, which isn't the case for retail REITs. Thus, apartment REITs can manage through a down cycle. We still hold AvalonBay (AVB). But there are better picks. We like Essex Property Trust (ESS) and Mid-America Apartment Communities (MAA). Equity Residential (EQR) is in our top 10. We like the markets where they own properties, and their price points are more attractive compared to AvalonBay. Q: Thank you.