At the beginning of the year we wrote about the factors we felt could support Real Estate Investment Trusts (REITs) continuing to produce competitive returns in 2012, even after outperforming the broader equity markets in each calendar year since 2008. As you can see in the chart below, REITs have in fact performed well year-to-date.

REITs have outperformed the broader equity markets

This strong performance has many investors looking for signs that the REIT market has come too far too fast. We thought this would be a good time to first ask ourselves if the factors we sighted at the beginning of the year are still in place and also look at some of the potential red flags observed in the REIT market recently.

 The three key reasons we gave to remain bullish on REITs in 2012 were:

• Positive fundamentals
• Credit markets that have allowed REITs better capital access
• Slow economic growth, including low interest rates

The Fed announcement committing to a new round of bond buying can possibly be taken as a sign these factors could remain in place for some time, but the year-to-date performance of the group has some investors looking for signs that the REIT sector is overheated. Here are three topics that may be worth watching:

 1. When borrowing money becomes too easy

Historically, when real estate investors have been able to easily access borrowings at low rates, the commercial real estate market is not far from its peak. Investors are hard pressed to find lending taking place today that is anywhere near the poor underwriting standards typically in place at market peaks. Also, REITs have been very disciplined with balance sheet decisions since the last downturn, and leverage levels continue to come down as opposed to the usual leverage increase typically observed as real estate markets improve.

2. Many nontraditional real estate owners are looking at the REIT structure

Another recent headline in the REIT market that could be cause for concern is the number of non-traditional real estate companies exploring the opportunity to convert to the REIT structure. Over the past year, we have seen companies from industries like timber, cell towers, data storage and document storage either convert or express interest in converting to a REIT. Just this past month an advertising company discussed converting their billboard business to the REIT structure. Many of these management teams have given expectations of an immediate “pop” in share price due to the higher expected multiple from simply converting. We believe these statements are likely more to sell the idea to shareholders and the decisions are being based more on long-term financial factors than short-term stock price movements. While the increased popularity of the REIT structure by non-traditional real estate businesses may prove to be an indication of stretched valuations for the group, we have a bigger concern regarding the unintended attention it brings to the group regarding lower tax bills to the companies converting. In either event, this remains a topic we intend to follow very closely.

3. Valuations

With REIT outperformance in recent times, we have been receiving more questions with regards to valuations. REITs do in fact look expensive relative to stocks when comparing earnings multiples, with the current REIT multiple at a premium to the S&P 500 multiple. Keeping in mind that commercial real estate and REITs are often considered for the growing income stream the investment often produces, REITs actually look attractive when compared to fixed-income alternatives. The yield spread to the 10 Year Treasury is currently at 150 basis points, which is approximately 50 basis points above the long-term average. Additionally, REITs are trading at a slight premium to NAV, or the underlying value of the their respective portfolios, and it is not uncommon for the group to trade at a premium on this metric during times when relative earnings growth is expected to be attractive.

In summary, there is no debating that the REIT market has had a great run and that there are some early signs of overheating worth monitoring. Additionally, the relative attractiveness of the group may not be as compelling as it was at the start of the year. However, the fundamental drivers behind much of the strong performance to date are still in place, and as long as the economic back drop is for slow growth, the group should not be ignored. With that said, we remain focused on companies that have attractive growth profiles with both internal and external opportunities to generate this growth, but also companies we are confident will not overextend their balance sheets as this real estate cycle progresses.

Read the full analysis in this week’s Perspectives.

See more Market Insights from Columbia Management.

Investments in a narrowly focused sector such as real estate exhibit higher volatility than investments with broader objectives. Real-estate-related investments involve risks, which can include property value fluctuations, defaults by borrowers or tenants, market saturation, decreases in market rates for rents, and other economic, political, or regulatory occurrences affecting the real estate industry, including REITs.

The National Association of Real Estate Investment Trusts (NAREIT) Index is an index that reflects performance of all publicly traded equity REITs.

The Standard & Poor’s (S&P) 500 Index tracks the performance of 500 widely held, large-capitalization U.S. stocks.