THE NATIONWIDE INFATUATION with property has spilled over into the stock market, where shares of real-estate investment trusts have soared, despite spotty operating results and higher interest rates.
The run-up in REIT shares, which have doubled since early 2003, has raised concern on Wall Street that a bubble could be forming in the $300 billion sector. "Our view is that valuations are in uncharted territory, and the group is very susceptible to a correction," says Jonathan Litt, the REIT analyst at Smith Barney. What's the downside? Litt says that shares of real-estate investment trusts could fall more than 10%. This year, the major REIT indexes are up about 10% (including dividends) after 30%-plus returns in both 2003 and 2004.
Some cracks may be starting to form in the REIT sector. The group declined 2% Thursday and was down about 3% Friday., hurt by a setback in the bond market that followed the release of stronger-than-expected July employment data Friday morning.
The two-day selloff illustrates the volatility in REIT stocks. Morgan Stanley's REIT index, for instance, dropped 10% in January and had rallied 25% from late March until the middle of last week. Still, REITs often appeal to risk-averse investors who don't recognize this.
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"REITs are being priced for perfection," says Peter Siris, who heads Guerrilla Capital, a New York investment firm. "REITs have benefited because the economy has stayed strong while rates haven't gone up. But I don't think you're going to have a decent consumer economy and lower rates forever." Siris points to steady insider selling by REIT executives as a sign of the sector's overvaluation.
Andrew Bary in this weekend's Barron's wrote an excellent article Pop! The Other Real-Estate Bubble on REITS (subscription required). Much has been written about the impending bursting of the real estate bubble. This article outline clear reasons why you should be cautious about REITs. I highly recommend this article even if you are not invested in REITs because it demonstrates, once again, how easily markets can become disconnected from the underlying fundamentals. Whenever something is priced to perfection, you should be cautious because your upside is limited while your downside is substantial.
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