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Reversal of REIT Fortunes?

It's been building since the Federal Reserve started hiking short-term interest rates. Now, it appears, the moment has arrived when yields on pricey REIT shares significantly trail the safe returns available on Treasury securities.

As the 10-Year Treasury Yield hit 4.99% Friday, nearing its highest level since June 2002, REIT shares began to skid. The MSCI U.S. REIT Index (RMZ) dropped 1.53% to 916.90 and, on Monday with bond yields holding steady at 4.96%, the index fell 1.08% more to as low as 907.04.

This has many REIT observers wondering if, unlike blips of the recent past, this correction has real depth. First Quarter earnings season officially begins tonight when industrial REIT AMB Property Corporation (AMB) unveils its numbers, but it will take a week or two to see a pattern in operating earnings — which could halt or deepen the correction, depending on the results.

"The REIT pullback should come as no surprise to investors, given that the sector needed to take a breather after rising 15% during Q1, along with the fact that the continued rise in long-term interest rates makes the sector's dividend yield of 4.1% less attractive," says Merrill Lynch REIT analyst Steve Sakwa. Through last Friday, the MSCI U.S. REIT Index was up 32.78% for the year.

Economic growth is cutting both ways for REIT stocks. Friday's employment report, which showed that 211,000 new jobs were created in March, helped push bond yields higher. The Wall Street consensus for job growth was roughly 190,000 going into March. Unemployment, at 4.7%, also beat analyst predictions.

Standard & Poor's warns investors that REITs could see a 5% to 15% correction through the next six months. The culprit, says S&P, is a combination of technical indicators plus inflated valuations.

"There are a number of potential catalysts for a short-term correction in the sector, including rising longer-term interest rates, and an earnings shortfall from a market leader or widespread profit taking," says Robert Hansen, head of Standard & Poor's Financial Services Group.

The scenario could follow what happened last summer. At the end of July 2005, the S&P 1500 REITs Sub-Industry Index began an 11-week tailspin that sliced 14% off the index. Hansen believes that a similar correction is likely in coming weeks, although he remains bullish on the long-term prospects for REITs.

Yesterday, S&P's Equity Research Services placed a "strong sell" recommendation on office giant Equity Office Properties Trust (EOP), citing the operating challenges that EOP faces over the next 12 months. Higher operating expenses and lower rental rates on expiring leases could hit EOP hard in coming months, according to Hansen. S&P also issued a "sell" on apartment REIT AvalonBay Communities, citing the company's valuation as a concern. Shares in AvalonBay (AVB) have nearly doubled over the past year; shares were trading at $104.19 shortly before noon today.

Ralph Block, CEO of asset-management firm Phocas Financial and author of the book Investing In REITs, is closely watching the interplay of interest rates and cap rates. "If, for some reason, the interest rate on the 10-year Treasury were to spike at 5.5 or 5.75%, you could see REITs having a significantly negative year," he warns. "If cap rates back up by 25 to 50 basis points you could see a 10% to 15% decline in NAV and the stocks would decline by a similar amount."

Stay tuned. On May 10, the Federal Open Market is expected to raise the Federal Funds target rate to 5%. Many observers expect the 10-year Treasury yield to climb above 5% before the Fed holds that meeting.

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