Keeping It Real

After rising 25% in 2000, and another 15% in 2001, REITs are already up another 10% in 2002. And although many experts are calling a top, I still believe real estate has room to run. The message boards are still relatively quiet. There hasn't been a flood of irrationally exuberant books about investing in REITs. Despite the fact the sector is up again this year, it's difficult to find the herd. And even though REITS were recently added to the S&P 500, the entire sector's market capitalization is only $200 billion — less than General Electric (GE), Pfizer (PFE), Exxon Mobil (XOM) or most of the jumbo names that dominate the major indexes.

So despite what Barron's and many of the pundits say, I'm of the mind that what we're seeing in real estate isn't a bubble but a bull market. Trends tend to persist longer than anyone might think, meaning that when it comes to many REITs and real-estate-oriented investments, we ain't seen nothing yet.

I first started talking about REITs last summer, when I said they were one of the most promising constituents of the quietly thriving American Stock Exchange Composite Index — which is up 6% year-to-date. A few months later, we highlighted how the sector was showing classic signs of an early bull market — mainly a psychology of doubt rather than hope. In recent months, we've talked about REITs as both tools for income and diversification. The truth is, I'm running out of new reasons to suggest why this is an appealing investment right now. As with any bull market, at some point you bite the bullet and buy XYZ simply because it's going up.

But as a market matures, it becomes more selective. And while I'm unabashedly bullish on real estate as an asset class right now, there are a few "leans" I've developed within some specific sectors worthy of consideration at current levels.

A lean is a worldview. It's your hypothesis, your expectation and your reason for making a trade in the first place. Whether it's a fundamental data point, an economic indicator or a technical trendline, we all need a lean. It's the confidence behind any trade.

Within real estate, one of my biggest leans right now is focused on prime commercial lots — the high-traffic locations that form a community's economic hub. Even within seemingly humdrum towns, the most highly trafficked areas should trade at a multiple to book value — not a discount to it, as many do right now.

One of the reasons why drugstore giant Walgreen (WAG) has solidly outpaced its competition: It has a real-estate strategy focused on high-traffic, high-visibility corner locations. Corner locations are among the most prized, because they offer twice as much "face" to the street. Even during economic malaise, they should trade at a premium. The way I see it, a high-traffic or prime corner location is like having a call option on an entire community.

Within the market, that hypothesis leads one to a number of businesses, both REIT and non-REIT, that also own prime, high-visibility lots.

For example, even the finest restaurants must offer both cuisine and convenience. As a result of healthy, unregulated competition, there's no shortage of options among local places to dine — and I wouldn't drive too far for a plate of caviar, let alone a Quarter Pounder. Restaurants are in the real-estate business. Indeed, McDonald's (MCD) isn't only the nation's largest eatery, but also its largest commercial landowner.

In addition to taking a look at restaurant stocks like Friendly Ice Cream (FRN) or Chicago Pizza and Brewery (CHGO), both of which own their locations, you might want to check out U.S. Restaurant Properties (USV), a REIT focused on restaurant, service-station and other highly trafficked properties. While there are plenty of technical reasons to be bullish on U.S. Restaurant, the hefty 9% dividend and a long list of blue-chip tenants just can't be ignored. Considering that the company owns more than 850 properties, I think the current market cap of roughly $270 million seems, well, cheap.

Where there's food, entertainment isn't usually far behind — and despite the availability of inexpensive Internet entertainment, it turns out that people still like to go out to a movie now and then. To that end, I've been buying shares of Entertainment Properties Trust (EPR), a REIT that owns movie theaters and other forms of "destination" entertainment. For the more adventurous, two microcap companies with theater holdings include Reading International (RDI.A), which owns both movie and "legit" theaters, and Trans-Lux (TLX). The oldest listed company on the American Stock Exchange, Trans-Lux owns and operates a chain of movie theaters, an asset I don't believe is currently reflected in its current valuation. The tiny company sports a 2% dividend and trades at a fraction of its book value.

Mid-Atlantic Realty Trust (MRR), Acadia Realty Trust (AKR) and IRT Property (IRT) are among the REITs that focus on high-traffic shopping malls with large anchor tenants. All three still yield more than 7% and are up sharply this year. And although I'm most interested in small-cap names, the $1 billion Realty Income (O) is worth a look at current levels. The company prides itself on regular dividends, but its stock-price appreciation has been more impressive, up almost 30% during the past 52 weeks.

Just like a Web site, a property is only as good as its traffic, and from Chicago's Sears Tower (owned by TrizecHahn (TZH)) to the Villa Linda Mall (owned by General Growth Properties (GGP)), there will always be a premium on the most central and oft-visited areas.

Jonathan Hoenig is portfolio manager at Capitalistpig Asset Management, a Chicago-based hedge fund. At the time of writing, Hoenig's fund held positions in many of the securities mentioned herein.