By Jada A. Graves

1. What new or ongoing trend will generate the biggest impact in 2006?
In terms of ongoing trends, technical and demographic factors will continue to drive fund flows into REITs from existing and new investor bases. This includes the aging baby boomer population, corporate 401(k) plan participation, smaller pension funds and non-dedicated (i.e., value and yield) investors. We also expect cash proceeds that investors receive in exchange for shares from public REIT mergers (or, as has been the more recent trend, from REITs that are taken private) will likely to be reinvested into the REIT market.

We see two new trends emerging. The first being the growing valuation gap in FFO multiples between more growth-oriented REITs with higher potential total returns versus REITs with more bond-like returns. With the advent of value and non-dedicated investors into the REIT arena, we see a growing tendency for investors to value REITs using broader, more objective metrics such as growth in free cash flow per share. These new investors respect traditional industry-specific metrics, like NAV, but view REITs in the context of the broader investment spectrum. Their broader perspective is unhampered by biases often found in the dedicated REIT world and, in our view, has prompted what we respectfully refer to as “separating the wheat from the chaff in REITland.”

Second, many investors are concerned about a rotation toward growth and away from more defensive investments like REITs. To mitigate this risk, investors should overweight their allocations toward REITs in the S&P 500 and S&P 600 indices. A marginal shift in investor preference toward growth also would accelerate the valuation gap we previously discussed.

2. Over the next 12 months, which real estate sector or sectors will perform the best, and why?
At BB&T Equity Research, we think 2006 will be a year for stock pickers. The past several years have provided clear signals as to which sectors would outperform the industry. Higher yields in a low interest rate environment or higher expected growth generally translated into higher total returns. This year is more difficult in that we expect most sectors to deliver average total returns clustered in the 11 percent to 12 percent range. So while we expect some sectors with higher expected growth to outperform the average, we really believe investors need to drill down to individual stocks within each asset class if they want to beat the average.

We recommend an overweight position in hotel and industrial REITs. Hotel REITs have the most positive leverage to “sentiment” of a growing economy, owing to their short lease duration, as evidenced by an expected 26 percent FFO per share growth in 2006. We favor full-service portfolios over defensive assets at this time in anticipation of an increase in business travel. We also expect continued margin improvement, given relatively low levels of new room supply coming on-line in 2006.

Industrial REITs are more steady-growth, defensive assets. Robust consumer spending propelled demand for industrial space in the past years. Going forward, however, demand will be driven by increased U.S. corporate spending and from increased global trade. Accordingly, we view industrial REITs’ expected FFO growth of 9 percent to 11 percent in 2006 to be solid and very achievable.

3. On the flip side, which sector do you think will face the biggest challenge, and why?
The only companies we recommend underweighting are triple-net REITs. In our view, these companies have the clearest line of sight of any asset class plus healthy 6.3 percent FFO growth expected in 2006. However, rising interest rates impeded sector returns in 2005, and are likely to continue hampering performance in the first quarter of 2006. That being said, the stocks represent attractive bond alternatives and are a compelling investment for investors with an investment holding period in excess of a year.

4. What is the biggest misconception investors have regarding buying REITs?
The biggest hurdle investors seem to have today is valuation. A lot of people have difficulty accepting where REITs trade on a price/FFO basis. Most of these investors are comparing today’s FFO multiples—some of which are in the high-teens—to ones that predate the inclusion of equity REITs in the S&P 500 (October 2001). In our view, REIT pricing is so much more efficient today than it was before 2002 when demand for REIT shares was circumscribed by the limited ranks of REIT-dedicated investors.

Since 2001, the market for REIT shares—the actual investor demand for REIT shares versus the publicly available float—has developed so rapidly, and a significant portion of the valuation expansion can be attributed to investors “discovering” REITs for the first time. Accordingly, we view data that predates 2002 as largely irrelevant for determining fair valuations for REITs today.

Instead, we focus on where a REIT trades relative to NAV and gcNAV (a metric we developed that stands for going concern NAV), the latter of which encompasses each stock’s potential total return in the context of the current risk free rate and CMBS spreads. We do look at FFO multiple to determine relative valuation between REITs in the same asset class. What is a stock’s historical premium to its peers, and is there a catalyst that would widen (or narrow) that gap? FFO multiples are still handy for answering these questions and also help quantify the premium investors are willing to pay for higher growth REITs that management teams with proven track records run—both at the real estate level and based on their stock’s total return.