“I’ve always enjoyed the challenges involved in managing REIT accounts,” he says. “I totally love it.” In November 2004, Block received the NAREIT Industry Achievement Award for his contributions to the industry.

Block’s 2005 Stock Challenge portfolio included Archstone-Smith (NYSE: ASN), The Macerich Company (NYSE: MAC), SL Green Realty Corp. (NYSE: SLG), Host Marriott Corporation (NYSE: HMT), and Public Storage, Inc. (NYSE: PSA). Each pick represented a different sector.

“If they would have given me six picks, I would have also picked an industrial stock,” Block says. “I wanted to diversify my picks by sectors. I felt that this would be a year in which no one sector would scream ahead of the others.”

Within each sector, Block says he looked for proven management teams with investment savvy and companies positioned to accelerate from medium range rates of growth. The strategy proved successful. SL Green (30.54 percent total return) and Public Storage (25.10 percent) logged excellent returns on the year, and all of Block’s picks posted returns in excess of 11 percent.

Of all his selections, Block says that the hotel market, and Host Marriott, surprised him. In January 2005, the hotel industry began a new cycle. At the same time, few new hotels were being built. Block reasoned that hotels would likely have a good year, thanks to an environment that would enable owners to increase room rates and boost FFO. “In the end, though, I think hotels performed below par,” he says. Host Marriott’s total return on the year was a solid 12.16 percent.

In trying to forecast the 2005 year-end index value, Block calculated what would happen to stock prices given a dividend yield of 4.7 percent and capital appreciation of just under 4.5 percent.

“I thought that 2005 would be a weaker than average year, with cap rates remaining stable, and earnings picking up,” he says. “If that happened, I figured that NAV premiums would be compressed. All of this was just a hunch, but it led me to forecast a 9 percent total return for 2005.” The actual total return for the year was 12.25 percent.

What’s Ahead For 2006?

Now that REITs have extended their streak of outperforming the broader market to six consecutive years, what are the key issues for investors in 2006? Block says they mirror the key questions from 2005. Why are prices so high in light of poor fundamentals, like high vacancy rates? How long will the market sustain such high prices?

Certainly, the real estate market fundamentals outside of retail have been relatively weak. Nevertheless, money continues to flow into commercial real estate and REIT stocks. “People have been saying that this can’t last; that it’s crazy,” Block says.

Most analysts predicted a flat or down 2005, in part because of the impact of rising interest rates. Obviously, despite some rate increases, the roof didn’t collapse on REIT securities. The reason many investors called 2005 wrong, according to Block, is that they haven’t paid enough attention to trends in interest rates, real estate cycles, and the flow of institutional money into real estate.

After years of low long-term interest rates, investors have lowered their expectations for returns, Block says. By that comparison, real estate returns continue to look good.

Then there are the rhythms of real estate cycles and what happens to prices at the peaks and valleys. Block points to the red hot San Francisco office market in 2000 and notes that capitalization rates were not dropping below 8 percent as might be expected in a hot market. Instead, cap rates had risen to 11 percent. Why were investors only willing to pay prices that would generate 11 percent returns? “They had figured out that rents were going to come down soon,” Block says.

Today, of course, investors can be pretty sure that space rates will rise.

In addition, Block believes that institutional and individual investors have been significantly underweighted in commercial real estate and REIT stocks and that they have begun to catch up. This will help continue to sustain and drive fund flows into the market, he says.

For these reasons, contends Block, prices have been high despite lagging performance. As performance improves, the higher prices will begin to look more reasonable. At the same time, prices may continue to rise until interest rates move up and until institutions and high net worth individuals determine an appropriate level for real estate allocations.

Sector Picks

		Winning Isn’t Everything Even though Art Havener finished second in the 2005 Real Estate Portfolio Stock Challenge, his portfolio strategy is worth noting.

Given his preference for sector diversification, how does Block evaluate this year’s outlook for the various real estate sectors?

Thanks to stable consumer spending, Block says retail real estate sailed through the 2001 recession and its aftermath. However, Block suspects the party is ending.

“We’ll probably see some weakening in consumer spending this year,” he says. “Consumers will have to pay higher energy costs. As residential real estate values flatten out, they will not be able to borrow as much against home equity. Retail will still be pretty good, just not as good as it was.” However, Block expects good things from Federal Realty Investment Trust (NYSE: FRT), and as a returning participant in this year’s contest he included it in his 2006 Stock Challenge portfolio.

Block’s outlook for the office sector can be summed up in one word, steady.

“We’ve seen significant positive absorption in office space,” he says. “Vacancy rates are coming down. Landlords have found it possible to raise prices. The weakness of recent years has ended. But I don’t see a quantum leap improvement in office. Tenants still want concessions when signing a lease. Construction costs have risen. Overall, I think the office market will be steady.”

Industrial REITs have performed well in recent years and will likely continue that solid performance, Block says. Industrial owners benefit from increasing global trade, and that trend remains in place. As always, shorter-term leases give industrial landlords pricing power. ProLogis (NYSE: PLD) and AMB Property Corporation (NYSE: AMB), which Block included among his 2006 Stock Challenge picks, are strong in joint ventures and generate property management and incentive fees.

“I think the industrial sector will perform above average in 2006,” he says.

		2006 Real Estate Portfolio Stock Challenge Who is up to the challenge in 2006 to take the crown from Ralph Block? A field of six industry veterans will test their prognosticating prowess in the 2006 Real Estate Portfolio Stock Challenge.

Apartments will be contradictory in 2006, Block says. On one hand, landlords now have pricing power, and they will benefit from the topping out of the single-family housing market and rising interest rates. On the other hand, residential REITs must contend with negatives, including rising employee expenses and the difficulty of passing through utility costs. In addition, cap rates in the apartment sector have come down faster than in other sectors. From the residential sector, Block selected AvalonBay Communities, Inc. to his 2006 Stock Challenge portfolio.

“Apartment properties are priced for perfection right now,” Block says. “If there is any weakness in pricing in commercial real estate, apartment owners could be at risk.”

Also in good position for 2006 are hotel REITs, according to Block. While consumer spending may weaken, Block suspects that consumers won’t put off their vacations and will support demand for hotel rooms. In addition, Block says businesses have plenty of available cash and will be willing to spend on travel and conventions. Finally, Block points to a still low supply of new hotel rooms in the market.

“Hotel owners will be in the catbird seat in 2006,” he says. “I think the hotel sector will be one of the top performers of the year.” From the hotel sector, Block selected Sunstone Hotel Investors, Inc. (NYSE: SHO) for his 2006 portfolio.

Health care REITs ended 2005 as one of the year’s poorest performers. Block attributes that to the fact that health care REITs triple net lease their properties and are particularly sensitive to changes in interest rates. Last year, the sector ran into a headwind of rising interest rates. For 2006, however, Block predicts a change of fortune for health care REITs, especially if interest rates top out. Block tabbed Ventas, Inc. (NYSE: VTR) for his 2006 Stock Challenge portfolio.

“A health care REIT that has locked in its interest rates may be in good shape this year,” Block says. “Add to that the fact that health care REITs yield higher dividends. The average dividend yield for equity REITs today is around 4.4 percent, while most health care REITs yield dividends of 6.5 percent to 7 percent.”

Last but certainly not least, self storage turned out to be the best sector performer of 2005.

“The fundamentals of self storage have been strong,” Block says. “The biggest fundamental driver for self-storage is new supply, because it doesn’t take a lot of money to put up a new self storage property. So there can often be problems with too much supply. In 2005 and so far in 2006, though, supply has been in balance with demand.”

Equally important, continues Block, institutional investors interested in beefing up commercial real estate investments already own all the standard real estate sectors. Institutions set out to find lesser-known sectors with better returns, and self-storage REITS have benefited from that.

Michael Fickes is a regular contributor to Portfolio.