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Seventh Heaven For Property Trusts

The REIT market has done it again. Yesterday morning, the National Association of Real Estate Investment Trusts (NAREIT) announced that its index delivered a total return of 34.5% for 2006, outperforming all other major U.S. equity market benchmarks for the seventh consecutive year.

The NAREIT Index, which tracks the performance of all listed U.S. property trusts, exceeded the S&P 500 at 15.79%, the Dow Jones Industrials at 16.29%, the Russell 2000 at 18.37% and the NASDAQ Composite at 9.52%.

“The performance of REITs is a long-running story,” says Steven Wechsler, president and CEO of Washington, D.C.-based trade group NAREIT. “The [U.S. REIT] industry has outperformed other major benchmarks of U.S. equities for the past 35 years.”

For example, says Wechsler, $10,000 invested in the NAREIT Index in 1977 would be worth $434,815 today. The same amount invested in the S&P 500 would have returned just $339,718 during that 30-year period.

Another positive highlighted by Wechsler: Roughly two-thirds of the REIT index’s 12.72% average annual total return over the past 20 years was delivered in the form of dividends, which makes REITs attractive investments for both institutional and individual retirement portfolios. NAREIT data shows that pension funds have boosted their allocations to commercial real estate every year for the past five years, and most funds are putting money into REIT shares.

Some REIT sectors generated higher total returns than others. The office segment, which saw heavy privatization activity in 2006, delivered a 45.22% total return. Moderate economic growth also helped the office market finish 2006 with lower vacancy and higher asking rents. Meanwhile two demographic trends — an aging population combined with a growing number of space-starved big city dwellers — helped the health care and self-storage sectors earn second and third place with 44.55% and 40.95% returns respectively.

Fourth place went to the apartment market, which posted a 39.95% return last year. Apartment landlords benefited from a weak single-family housing market in 2006, plus a growing number of young tenants who have flocked to rental units.

But can the REIT market repeat this command performance in 2007? Optimists believe it’s possible provided that 2007 resembles 2006 in many ways. Banc of America Securities analyst Ross Nussbaum projects that “a perfect world” for REITs in 2007 would mean healthy gross domestic product growth, muted supply growth, cheap debt and an endless supply of real estate-hungry funds. Nussbaum, who outlined his 2007 forecast to SNL Financial last week, believes that cap rates have bottomed out.

Many analysts have made similar predictions over the past few years, but cap rates have failed to show any real sign of rising. If Nussbaum is correct, net operating income growth will become increasingly important as the year unfolds. To that end, Nussbaum believes that REITs with convincing growth plans will prevail in 2007. While cap rate compression allowed many REITs to boost share prices in 2006, he thinks that REITs with "stronger earning stories" will outperform the market.

Nussbaum favors regional malls, healthcare, self-storage and coastal office properties this year. But one cloud in Nussbaum’s forecast is new construction, which may become problematic over the next 18 months. He sees construction permits and starts ramping up over the next few months.

“With valuations at all-time highs, reduced demand for space triggered by a slowdown in economic activity, coupled with an increase in new supply, and higher interest rates would be a death blow for commercial real estate landlords,” says Nussbaum.

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