Job growth could help REITs weather hikes in interest rates.

Shares of U.S. real estate investment trusts may rise as job growth boosts office and apartment occupancies for the first time since 2000, helping landlords weather higher interest rates.

The Morgan Stanley REIT index, which tracks 117 real estate trusts, may return up to 12 percent over the next year as vacancies drop and rents rise, said Kenneth Statz, who helps manage $4.4 billion in property stocks at Security Capital Research & Management. Shares of Corporate Office Properties Trust and AvalonBay Communities Inc., which owns 139 apartment communities, will lead the gains, he said.

"More jobs being created equals more space absorbed, and that's good for landlords," said Statz, senior market strategist at the Chicago-based firm. "The fundamentals are improving."

The Morgan Stanley index has rebounded 14 percent from its 2004 low on May 10 and has gained 5.2 percent this year. The index may outperform the Standard & Poor's 500 Index, which has climbed 2.6 percent this year, for a fifth consecutive year.

REIT stocks are less expensive than they were at the beginning of April, when the Morgan Stanley Index had its steepest monthly loss in its nine-year history, dropping 15 percent, Statz said.

Statz's U.S. Real Estate Shares fund has returned 7.4 percent this year, the second-best performance among REIT mutual funds tracked by Bloomberg.

REITs are companies that develop and own everything from warehouses in California and apartment buildings in Chicago to New York hotels. They are exempt from corporate income taxes if, among other things, they annually distribute at least 90 percent of net income to shareholders as dividends.

The companies in the Morgan Stanley REIT Index, which tracks 117 of the most actively traded property shares, have a combined market value of $213 billion. The industry accounts for 0.4 percent of the S&P 500. Standard & Poor's first added property stocks to its benchmark indexes in 2001.

Apartment vacancies will drop 0.3 percentage point and rents will grow 0.2 percentage point this year, ending three years of rising vacancies and falling rents, said Legg Mason Wood Walker analyst Rod Petrik.

"We'll have to see interest rates move up and home ownership will become more expensive," said Keith Guericke, president of Essex Property Trust Inc., which manages apartment buildings on the West Coast. "We're starting to see occupancies rise in some areas."

Office vacancies in U.S. cities dropped in the first quarter to 16.8 percent from 16.9 percent at the end of 2003, according to Reis Inc., a commercial real estate research firm in New York. Vacancies held at 16.8 percent in the second quarter. Rents fell 11 percent from June 2000 to last March as vacancies rose.

"The increase in occupancy and rents will offset higher interest rates," said Tim Pire, who oversees $2 billion in REITs at Heitman LLC in Chicago. "My biggest fear is a dramatic increase in rates, but I am less fearful now because valuations have come down."

REIT stocks sell for an average of 9.9 percent more than the value of their property minus debt, according to Green Street Advisors. That's lower than the 22.3 percent premium at the end of March and close to the 7.1 percent average since 1993.

"If rates move at a slow, gradual pace, earnings growth will pick up and REITs will do fine," said Darren Rabenou, a money manager J.P. Morgan Fleming Asset Management, meaning a rise over two years in the Fed's benchmark lending rate to about 4 percent. The New York-based firm has $1 billion in real estate stocks.

Most economists at Wall Street's largest bond-trading firms expect an increase in the overnight lending to 2 percent by year-end. The prospect of higher interest rates makes REITs unattractive, say some investors, such as Andrew Engle, co-manager of the $485 million Leuthold Core Investment Fund.

"Sentiment is working against them," said Engel, who sold all his REIT holdings in January and will wait until they sell for a discount to the value of their real estate minus debt before adding them to the fund again.

UBS AG analyst Chris Pike cut his rating to "reduce" from "neutral" on four apartment building owners, including AvalonBay and Essex Property. The shares are overvalued as "revenue growth prospects are modest" because low interest rates continue to bolster home sales, Pike wrote in a report.

Merrill Lynch & Co. analyst Steve Sakwa cut his recommendation on 25 REITs in a June 14 report, nine of them to a "sell." The Morgan Stanley index may fall to 549, a drop of 11 percent, if yields on the 10-year Treasury notes rise to 5.25 percent, he wrote. That would represent a loss of 4.3 percent including dividends.

J.P. Morgan's Rabenou said any drop in property stocks is likely to be short-lived as demand improves. The Morgan Stanley REIT index may return as much as 10 percent this year, he said.

"The office sector is stabilizing and we're starting to see tenant demand in the apartment and warehouse sector," he said. "Over the long term, the fundamentals are going to take over."

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