The run on residential real estate investment trusts (REITs) may be set to slow soon, despite some analysts' predictions, according to a report from Lipper of New York.

Tax advantages and regular issuance of dividends, coupled with a vigorous real estate market, have made this alternative investment popular and, in recent years, seem unstoppable.

But Lipper Analyst Andrew Clark suggests that some predictions on the high-performing real estate market may be a bit optimistic. Clark studied fundamental data of REIT indexes for various real estate categories for 47 quarters, measuring the actual growth rates dating back to 1993.

The result is that despite a general consensus among analysts that REITs' earnings per share should grow over the next decade by 5.1% for residential real estate and by 6.2% for shopping center REITs, the actual growth will be closer to between 2.4% and 2.9%.

"Now, fundamentals are only part of the price of security, sentiment being the other piece of the puzzle," according to the report.

It might be that sentiment which is driving analysts' earnings predictions up. Real estate markets across the country have grown considerably over recent years. Low interest rates, and a soft stock market have encouraged people to put their money into real property, and turned many long-term renters into first-time homeowners. Low interest rates also encouraged people to trade up, and created a construction boom for both single-family luxury homes and upscale multi-family complexes.

Adding to the optimism, perhaps, is the fact that REITs, residential REITs in particular, have delivered strong returns. The composite REIT index was up 8.54% year-to-date through February, while the S&P 500 Index was up 3.80% in that period, according to data from the National Association of Real Estate Investment Trusts (NAREIT). However, residential REITs rose 19.92% year-to-date through March and delivered returns of 13.67% in 2005, according to NAREIT.

While great for investors, such growth simply may not be sustainable, according to Clark.

That doesn't mean it's time for investors to rid their portfolios of REITs, though. "It looks like they will continue to do well for the rest of the year," Clark predicted.

But 18 months from now, it might be a different story, he said.

"There's some speculative elements," he said. "In my opinion, [analysts are] trading residential REITs purely on a 12-month basis."

The biggest danger is that the recent real estate fervor has resulted in more apartments and condominiums being built than can be sold.

"It's not a matter of Connecticut, or Colorado, or California you have to watch for. There are signs of overbuilding nationwide."

When the market is flat, REITs become especially popular, because they typically issue dividends, deliver strong returns, and often have long-term appreciation, which helps investors hedge against inflation. Furthermore, REITs help diversify portfolios, because their performance is only loosely correlated to other markets, according to a 2005 study released by New York-based Ibbotson Associates, which has since been purchased by Chicago-based Morningstar.

But REITs are subject to broad economic forces, and one working against them could be rising interest rates. First, rising rates discourage new purchases. For the week ending April 7, mortgage application rates were down about 14% compared to the same week one year earlier, according to data from the Mortgage Bankers Association of Washington. In fact, mortgage applications have been slowing for several months, according to the association, which tracks application rates on a weekly basis.

Also threatening the housing market is the fact that the number of mortgage delinquencies nationwide is creeping upward, according to the association's data. The delinquency rate for residences with between one and four units was 4.7% at the end of 2004, compared to 4.38% at the end of 2004.

"The increase in delinquencies is not surprising," said Doug Duncan, MBA's chief economist. Duncan attributed the uptick to individuals with adjusted-rate-mortgages, who have been caught off guard by increasing interest rates, as well as climbing energy prices, all of which has put pressure on Americans, who already have notoriously low personal savings rates.

These trends threaten REIT values, and therefore their ability to steadily increase their earnings-per-share. "To have a thriving condo complex, you have to have everyone paying their mortgage," Clark said.

The good news for investors is that despite all these negative forces, Clark does not expect the REIT sector to crash but, rather, to slow - considerably. "If there's one thing we've learned in the past decade or so it's that you can have bubbles, but not all bubbles burst. Some just deflate," Clark said. The financial world learned a lesson for the recession of the early 90s that burst the mortgage bank bubble and shoved properties into foreclosure, practically city blocks at a time.

The industry has also consolidated in the past decade, Clark noted. In 1995, there were 178 REITs that owned and/or managed properties publicly trading, according to NAREIT, with a market capitalization of about $57.54 billion. As of the end of March, there were 143 REITs trading, with a market capitalization of about $348.55 billion. Fewer, but bigger, companies have lent greater stability to the marketplace, Clark said.

There are only 22 residential REITs, 18 of which focus on multi-family developments, a sector where Clark says there is excess inventory. "For people investing in funds, my recommendation is to see what their exposure is to the multi-family sector." In the short term, however, residential REITs should continue delivering strong returns, Clark said.

"If you want to get into residential REITs, get into them this year, but be careful," said Clark. "They can turn on a dime."

(c) 2006 Money Management Executive and SourceMedia, Inc. All Rights Reserved.

Subscribe Now

Access to premium content including in-depth coverage of mutual funds, hedge funds, 401(K)s, 529 plans, and more.

3-Week Free Trial

Insight and analysis into the management, marketing, operations and technology of the asset management industry.