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The commercial real estate world has at last begun to face a fact that should have been obvious long ago: The housing market debacle isn’t hurting only those involved with single-family homes. Commercial real estate, a lagging indicator of hard times, is now showing the strains of a straining economy, even though stocks in the field continue to outperform the broader indexes. Through Aug. 18 the MSCI US REIT Index, tracking real estate investment trusts, was down 4% this year, while the Dow, Nasdaq and S&P 500 had each lost 10% to 15%.

The relative strength of REITs has seemed to make sense because commercial real estate fundamentals–supply, occupancy levels and rent growth–have until very recently appeared stable, even strong. Now, though, the commercial markets are feeling shaky in ways that all seem to trace back to the evaporation of consumer credit. Localities that have been heavily dependent on financial services and the mortgage world, such as Orange County, Calif. and Tampa, Fla. are having an especially hard time. Their rental growth rates have flattened or fallen. Retail malls and strip centers are suffering from tenant bankruptcies as consumers spend less. Hotel owners, coming off of a sweet multiyear growth binge, are carrying too much new supply while occupancy dips. And industrial real estate, predominantly warehouses, depends on a robust economy to maintain the flow of goods.

What about apartment buildings? You’d think they would be benefiting from hordes of foreclosed former homeowners seeking rented shelter, but that anticipated influx hasn’t really materialized. Ultimately job creation is what fills apartments and sells homes, and today’s sickly employment scene just isn’t churning out households.

Virtually all of these negative trends are almost sure to deepen, even after the economy turns a corner; it will take time for any recovery to make itself felt in stronger leasing activity. Despite this, apartment REITs, after turning in the worst performance of any REITs in 2007–a bad year for the entire group–have had the best results so far this year, wiping out all of last year’s 15% loss.

A handful of strong performers stand out. AvalonBay Communities (98, AVB) and Essex Property Trust (119, ESS) are both profiting from good management and a history of

selecting locations that yield both rising rents and occupancy growth. AvalonBay, a savvy developer, is prudently curbing its plans for the next few quarters as financing stays tight. Essex, a West Coast-focused apartment REIT, has consistently turned in excellent year-over-year growth, and I expect it to continue doing so.

Neither of these companies is poised for a breakout–but that’s the point. Their access to steady earnings streams and their defensive stances suggest few surprises on the downside and the prospect of solid continued growth in a turbulent market.

Warehouses haven’t held up as well as apartments. Industrial REITs have lost 21% as of Aug. 18, on top of a 10% decline in 2007, pushed down by weakness in retail sales. Also, the way these companies tend to grow–developing and selling new buildings as merchants expand–spooks investors. Constructing buildings in a rising-cost, deteriorating-price environment is hardly an irresistible business model.

But that’s not all they do. They also lease existing space, and they are moving into new markets outside the U.S. The two leading industrial REITs have both been slapped down pretty hard after stints as market darlings but have been expanding their international portfolios and fund- and asset-management businesses. AMB Property Corp. (46, AMB) and ProLogis (45, LPD) both have the same smart management, access to capital and international reach they had when they were in the sun–and they’re a lot cheaper now. With global trade growth sure to continue but to remain highly fragmented, these two companies can resist market instability in any one region and outlast the current poor environment for build-to-sell. They are both yielding better than 4%. Both trade at less than 12 times funds from operations (net income plus depreciation).

Investors have backed away from every kind of real estate in the past 12 months, but the two areas that have seen the least fall-off–less than not only homes but also hotels, offices and retail–are apartments and industrial properties. Those hardworking, unsexy places will see some tough times, too, but in the end people and goods will still need buildings to sit tight in.

Peter Slatin is editor of the Forbes/Slatin Real Estate Report (see ) and editorial director of Real Capital Analystics.

Category: Credit

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