After a multiyear bull market, REITs have finally stumbled this year, with many highfliers like Vornado Realty Trust (NYSE:VNO), and General Growth Properties (NYSE:GGP) falling from all-time highs. As the REIT space gets more interesting, I thought it might be Foolish to see what Warren Buffett did during the last REIT downturn.

The REIT moment
It was the best of times for tech companies, and the worst of time for REITS. As "companies" like eToys and raised billions of dollars during the dot-com boom, boring "old economy" real estate investment trusts were cast aside. The Vanguard REIT Index (VGSIX) declined roughly 30% from 1998 to 2000.

When an unappreciated (yet perfectly healthy) stock falls in the forest, guys like Stock Advisor recommendation Berkshire Hathaway (NYSE:BRK-A) (NYSE:BRK-B) chairman Warren Buffett usually hear it.

Public records show that Mr. Buffett purchased roughly 7.5 million shares of HRPT Properties Trust (NYSE:HRP), an office and industrial property REIT that competes with the likes of Mack-Cali Realty (NYSE:CLI) and Maguire Properties (NYSE:MPG), for his personal account at the end of 2000. Based on HRPT's trading price in the three months leading up to the SEC filings that indicate Buffett's ownership, we can guesstimate that his average purchase price was around $6.25 per share.

Public records also show that Mr. Buffett sold most of his stake one year later, when the stock was around $8.50. Thus, Mr. Buffett probably realized around 50% appreciation on his investment (including dividends) in about one year. Let's see whether we can understand how he evaluated this opportunity.

The catalyst
First, let's look at the opportunity. HRPT had about 132 million shares outstanding at the time, which would give it a $825 million market cap, assuming a $6.25 share price. HRPT also owned 49% and 7% of Senior Housing Properties (NYSE:SNH) and Hospitality Properties Trust (NYSE:HPT), which were carried on its balance sheet at roughly $300 million.

However, Senior Housing Properties had some problems. In 2000, two of its tenants, accounting for half its rent, had gone bankrupt, causing the company to halve its dividend rate. That reduced the dividend income HRPT received, and HRPT in turn cut its dividend rate by about 40%.

The decoupling
This is the key. Shareholders own a company for a variety of reasons. However, when many shareholders own a company for very similar reasons, and that reason ceases to be true, those shareholders simultaneously rush for the exits. That can create small windows of opportunity, allowing astute investors such as Mr. Buffett to scoop up shares at huge discounts to their intrinsic values. We've seen this phenomenon before, when shareholders besotted with blue-chip stocks briefly abandoned American Express (NYSE:AXP) and Wells Fargo (NYSE:WFC).

In this case, as a REIT, HRPT's shareholders probably valued its high dividend rate and relative safety. After all, dividend investors aren't looking for home runs; they want income and principal protection. However, after the dividend rate was cut, the shrinking payout spooked those conservative folks, and suddenly a whole class of investors were no longer interested in HRPT.

Margin of safety
That said, a low share price doesn't necessarily constitute a buying opportunity. Buffett only buys low-priced shares if he knows he's getting a bargain at a margin of safety.

In this case, the lowered dividend still provided a 13% annualized yield, or more than double what 10-year Treasuries were offering at the time. In addition, the then-$825 million market cap represented about 60% of tangible book value, even after shaving off the decreased value of Senior Housing Properties and Hospitality Trust.

The dividend yield was also safe, because funds from operation (a measure of cash flow) for the first nine months of 2000 were $1.05 per share, or $1.40 annualized. In other words, HRPT's FFO represented 1.75 times its lowered annualized dividend of $0.80.

This was a more-than-adequate coverage ratio even after accounting for lower future distributions from Senior Housing Properties. Taking into account the lower distributions, HRPT would be trading at a 20% FFO yield.

Foolish final thoughts
HRPT was a classic case of a special situations investment. A lowered dividend yield created a clear catalyst for HRPT's shares to become severely undervalued. However, HRPT offered a juicy dividend yield of 13%, substantial principal protection at 60% of tangible book value and a 175% FFO dividend coverage rate, and a 20% FFO yield. It's very, very difficult not to make money in those situations. By my estimates, that's how Buffett earned half again his initial investment in a single year.

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This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.