Bargain Properties

	Roger Conrad Utility Forecaster.com
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There's a profound shift happening quietly in the REIT sector. Below we reveal what we've uncovered and how to profit from this shift.

From CNBC to The Wall Street Journal, financial media are screaming real estate bubble. Even Federal Reserve Chairman Alan Greenspan has warned of the dangers, fueling a consensus on the Street that property values have reached extremes and are close to crashing.

To be sure, there are plenty of signs of exuberance, but not in the residential rental market. Even as housing values and commercial real estate have soared, apartment rents have stagnated and vacancy rates crept up, as would-be renters have used low mortgage rates to buy homes.

Poor conditions mean residential REITs are cheap, yielding nearly twice as much as their commercial retail, office and industrial cousins. That's built in protection against a potential downturn in the property market, as well as powerful returns as the sector inevitably recovers.

Below, we highlight the best and worst of eight residential REITs. Our favorite is new Income Portfolio recommendation Gables Residential. It's replacing Prologis Trust, which we sold last issue for a big gain.

Cheap Property

Real estate is enjoying its broadest bull market since the 1970s. Property values are soaring and even investors who are still scared of stocks are levering up to buy property.

Condo flipping is again the rage in hot markets like sunny Florida and New York City. Demand is soaring for alternative financing arrangements like "interest only" mortgages. And almost every newsstand is selling magazines touting the joys of a career in real estate.

Even the professionals are caught up in the frenzy. Former PF recommendation Prologis Trust, for example, is acquiring Catellus Development in a $4.9 billion merger to create the nation's largest warehouse and distribution REIT. The price tag is a whopping four times book value and nearly 20 times funds from operations (FFO).

REITs have reaped more than their fair share of spoils. The average REIT mutual fund has returned an unheard of 20 percent a year since 1999. Apartment REITS have posted some gains during that time. Most, however, have been left out of the frenzy as renters have become homebuyers.

The eight apartment REITs in the table, for example, yield 5.8 percent, sell for 2.2 times book value and 15.5 times FFO. These are far lower valuations than other REITs, even as their bull market gains have been much less.

Their underperformance may be changing, however. In the May 25 PF back page article, we contrasted the cost of renting versus buying in 14 major US property markets.

Adjusted for inflation, the cost of renting property has fallen 4 percent since 1975. In contrast, the cost of buying property is nearly 50 percent higher. The gap has become particularly acute since 2000, with rental costs dropping about 3 percent while buying costs rose 23 percent.

To deal with the exodus of renters, apartment REITs have had to play defense—keeping rents low, cutting costs, continually upgrading facilities and restricting expansion—just to maintain cash flows and dividends. The good news is those that have succeeded can keep pumping out high dividends, even if current conditions continue. That applies to all the REITs in the table, though some have measured up better than others. All of these REITs stand to be big winners.

The greatest risk of all REITs is a spike in interest rates, given their growing link as share prices have risen. Residential REITs are no exception. But their lower valuations and high yields do offer better protection than any other REIT group.

Top Picks

Gables Residential is our top choice. The REIT caters to the elite, with more than 41,000 units in 161 luxury multifamily communities located in "established premium neighborhoods" around the country. Management has deemed these high-job-growth markets resistant to economic swings.

The REIT continues to face tough market conditions, demonstrated by flat rents in the last 12 months. Nonetheless, it boosted occupancy 200 basis points to 93.8 percent and posted positive sales growth in five of its core markets, representing 77 percent of its core portfolio.

Management continues to identify new communities for development, with 10 are now underway. Acquisitions include properties in toney areas of Atlanta and Dallas last month.

Gables has one of the largest project pipelines in the industry, with current development equal to about 15.7 percent of assets. It also continues to fund growth with sales of non-core properties, holding down debt and shoring up its solid BBB (stable) credit rating.

Gables' focus on quality properties and controlling leverage are solid insurance for its generous dividend, even if the tough times continue. Any pickup to the rental market means hefty gains as well. Buy Gables up to 40.

Also attractive is Memphis-based Mid-America Apartment Communities. The REIT's focus is on middle-market properties in the Southeast and Southcentral US, with more than 38,000 apartment units either wholly or partly owned.

First quarter results demonstrate sound management in the face of tough market conditions. The REIT boosted portfolio-wide occupancy by 10 basis points to 93.6 percent and hiked rents 0.9 percent from year ago levels. That increased same-store property sales—which don't include acquisitions made since the beginning of the year—by 1.8 percent. Resident turnover fell 5.9 percent and advertising costs per lease declined as well.

All that added up to a 4 percent profit gain in the seasonally weak winter period, setting the stage for double-digit gains the rest of the year. The payout ratio of just 65.3 percent and moderate leverage of less than half capitalization safeguard the dividend of nearly 6 percent. High management ownership at 12 percent is another good reason to buy Mid-American—which trades at the lowest multiple to FFO on the list—up to 42.

Best of the Rest

The remaining six residential REITs on the list have either higher valuations or weaker fundamentals. But all save one will be huge winners if conditions in the apartment market turn.

Equity Residential and United Dominion Realty are solid but pricey. Sam Zell's Equity Residential achieved strong first quarter results by selling its stake in rent.com to eBay and replacing its older properties with newer ones. Sales excluding asset disposals rose 11 percent. Equity's BBB+ bond rating is the highest for apartment REITs. Unfortunately, its 4.8 percent yield is lowest. Buy Equity only on a dip to 35 or lower.

United Dominion posted its highest same-store sales growth in four years in the first quarter. All revenue generators are on the rise, occupancy is up to 94.4 percent and rents rose a full percent from fourth quarter 2004.

Planned asset sales in Charlotte and Dallas will shore up the BBB-rated balance sheet, and build a pool of cash for growth. Unfortunately, the REIT trades at three times book value. But United Dominion is a buy on dips to 20 or lower.

High payout ratios are the principal challenge for the other four. The most attractive is Home Properties, whose high first-quarter payout is mostly due to impairment charges. Occupancy improved and expense increases were held to their lowest level in three years.

Rent growth was among the sector's best at 2.7 percent year-over-year. The REIT also upgraded its portfolio and controlled debt. That points to better times ahead, even if the rental market stays flat. And the REIT is cheap, selling nearly 10 percent below net asset value (NAV). Home Properties is a buy up to its NAV of 45.

Less attractive is former Income Portfolio pick BRE. The REIT is up slightly from our sell recommendation two years ago. But it's paying out almost all cash flow in distributions as expenses are rising. With no margin for error, conservative investors are better off in our other picks. Sell BRE.

Junk-rated AMLI and Apartment Investment & Management may interest more aggressive investors, owing to low price-to-book value ratios. But AMLI expects to barely cover its distribution for 2005 and FFO remains pressured by falling rents (-0.5 percent) and rising operating expenses (up 4 percent).

AIV is in slightly better shape after posting 4.3 percent revenue growth and 3.1 percent same store growth in the first quarter. But until those payout ratios come down, conservative investors should steer clear.

Roger Conrad will be available to take your questions until Monday, June 27. Please use the form below to submit your questions.