Separating REITs From Residential Real Estate

Homebuilders such as Toll Brothers (NYSE: TOL  ) and WCI Communities (NYSE: WCI  ) have seen their share prices fall by 40% or more in the last year, but the blue-chip real estate investment trusts (REITs) such as Boston Properties (NYSE: BXP  ) , Kimco (NYSE: KIM  ) , and Public Storage (NYSE: PSA  ) have seen their share prices continue to increase.

Some investors are wondering what gives and have been asking this recently fashionable question: When are real estate investment trusts (REITs) are going to join the residential housing market in decline? REITs and residential properties are both real estate, but that's pretty much where the similarities end.

Apples and elephants
Despite some jawboning and a lot of speculators hoping that the housing market would remain strong, it has shown consistent signs of weakness: median sale prices continue to fall, transactions are slowing down, and inventory keeps mounting. Interest-only mortgages and option ARMs that historically played a very minor role in residential real estate became common in the recent boom, and now this creative financing is rearing its ugly head. Many of these mortgages are just now starting to roll over at higher rates, and more are expected to roll over in the next year, as well.

Commercial real estate, where REITs operate, doesn't work in the same way. REITs don't expect to buy a property and flip it in a few months; instead -- for the most part -- REITs buy a property planning to rent the space out to tenants. The revenue from the tenants is expected to cover all of the operating expenses of the building, any financing on the property, and a small portion of the company's administrative expenses, with a profit left over.

On the flip side, purchasers of homes in many East and West Coast locales within the last few years with traditional 30-year fixed mortgages would be hard-pressed to rent their homes at a rate above their mortgage payments. Part of this is because we don't buy our homes as investments or with an eye toward renting them at a profit -- we tend to buy what we can afford to live in. There's nothing wrong with that; the problems start when we go beyond what we can afford or allow creative financing to make it appear we can afford more than we can. Since REITs are businesses focused on turning a profit, this type of speculation is far less likely to occur.

That's not to say that REITs are insulated or perfect investments. REITs are exposed to overbuilding (creating too much capacity), which drives down rents and hurts profitability. Historically, this has happened from time to time in the office, apartment, and hotel sectors, but there is little sign today that overbuilding is occurring. A REIT management team might also overestimate how much a property will rent for and underestimate future increases in expenses. Still, when the starting point is earning a profit on your properties when they're not 100% occupied, it helps to keep a cap on how assets are priced.

One thing leads to another
There is, however, a case where a weak housing market can spill over and have an impact on REITs. If the housing market continues to decline and the loss of wealth -- or perceived wealth -- causes consumers to reduce spending, most REITs will feel the pinch with the rest of the economy, because as consumer spending decreases, businesses' need for space will slow or decline.

Apartment REITs, such as Avalon Bay (NYSE: AVB  ) and Archstone Smith (NYSE: ASN  ) , are benefiting from the housing decline as homeowners become renters and the supply of apartments is reduced by buildings being converted to condos. It is possible that apartment REITs might hold up well if the economy slows, but most REIT sectors would feel pain from any serious or long economic slowdown.

Foolish final thoughts
What happens with the housing market over the next couple of years is important to REITs because it is important to the economy -- not because residential and commercial real estate markets are directly linked in any way. This is something to keep in mind if REITs begin to decline or when investigating the valuation of a particular REIT.

If you're interested in learning more about REITs and other investments that carry substantial dividend yields, take a free trial of Motley Fool Income Investor. Our service is besting the market by more than six percentage points and contains a handful of REITs that make solid investment candidates.

At the time of publication, Nathan Parmelee had no financial interest in any of the companies mentioned. The Fool has a disclosure policy.


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