With the curtains drawn on a highly volatile 2011, investors across the world hope that the new year would bring an improved equity market over the next twelve months. Not that we believe that 2012 will be devoid of any equity volatility, but we do believe that we have already seen the zenith in market volatility in the third quarter of 2011 and the next few quarters are likely to exhibit the trough period.

Given the positive note in investor sentiment, a number of factors still persist as a thorn in the improved market scenario. 2012 being a presidential election year in the U.S., there is a good chance that the U.S. policymakers would refrain from making any radical change on key issues.

With political uncertainty likely to persist in the country until at least the elections are over and the lack of concrete fiscal planning, investors might play ‘wait and see’ before committing to different investment opportunities. This could, in turn, put a ceiling on equity returns in 2012.

On the hand, a sovereign debt crisis in Europe has resulted in the euro vying for its survival, and has sent ripple effects across the globe. For most of the latter half of 2011, investors have been the victims of inconsistency in the political process across Europe, ending up in market volatility.

According to data by UBS AG, about 157 billion euros ($203 billion) of debt is scheduled to mature in the 17-member Eurozone in the first three months of 2012. At present, European leaders are desperately trying to avert a euro fragmentation and are buying time to enable the Spanish and Italian governments amass resources for a successful bailout.

The strategic move to focus on austerity among the European countries is expected to impede regional economic growth. This could result in low investor confidence in the European financial and fiscal system, which could be felt for months.

In addition, economic growth in emerging markets, in particular the BRIC countries, is expected to be lesser than in the recent years due to a relative weakness in the developed world and related uncertainties in the global business climate. All these factors have cumulatively contributed to an equity market headwind in 2011, and are again expected to peg back returns in 2012 as well.

To make matters worse, we are in the midst of a secular bear market, which began in 2000. So far, the progress of the secular bear market has been tepid, with total return (including dividends reinvested) of the S&P 500 Index for the 11.75-year period from January 1, 2000 through September 30, 2011 being -4.49%. This in turn could compel investors to have a tactical investment policy, whereby they invest mostly in individual, high quality, dividend-paying and dividend-growing companies like REITs.

REITs’ Potential Role in 2012

Investors looking for high dividend yields have historically favored the REIT sector. Solid dividend payouts are arguably the biggest enticement for investors as the U.S. law requires REITs to distribute 90% of their annual taxable income in the form of dividends to shareholders.

By the end of 2011, the average dividend payout ratio for all listed REITs was 70% of FFO (funds from operations), implying that REITs are likely to maintain dividends and potentially increase them in future with further improvement in market fundamentals. Funds from operations, a widely used metric to gauge the performance of REITs, are obtained after adding depreciation and other non-cash expenses to net income.

The dividend yield for the FTSE NAREIT All REIT Index by the end of third quarter 2011 was 5.2% compared with 1.9% for the 10-year U.S. Treasury Note. The relatively low yield for the U.S. Treasury Note was fallout of a U.S. rating downgrade. In August 2011, credit rating agency S&P had downgraded the U.S. credit rating for the first time since granting it in 1917, from a AAA rating to AA-plus citing concerns about the nation’s budget deficits and burgeoning debt burden.

In order to stimulate the economy, the U.S. Federal Reserve embarked on ‘Operation Twist’ in September, under which it sold short-dated U.S. government debt and instead bought longer-dated paper. This, in turn, plummeted the yield for the U.S. 10-year bonds to as low as 1.67%, which inched up to 1.87% at year-end 2011.

Besides, among the various positives, REITs are historically considered to have a low correlation with equities, implying that they do not normally move in the same direction as equity stocks or bonds. More often than not, when stock prices are down, REITs tend to perform better, thus balancing the performance of the overall equity portfolio.

Consequently, as an asset class, REITs offer more diversification to the equity portfolio providing a competitive long-term return. Furthermore, REITs are currently trading at a discount to their Net Asset Value (NAV) and are therefore considered inexpensive. As of October 5, 2011, REITs were trading at a 12% discount to NAV.

A combination of factors has helped the listed REIT market to stand out and gain critical mass over the past 15 to 20 years. These have led to transparency and real-time price discovery for REITs, which have helped to mitigate risks. During 2007 to 2009, REITs took on far less debt than private real estate investors, and many were able to sell at the top of the market when private equity investors were still buying.

Importantly, during the downturn, REITs were able to acquire properties from highly leveraged investors at deeply discounted prices. This enabled them to add premium high-return assets to their portfolios.

Furthermore, REITs managed to raise capital to pay off debt, owing to a large inflow of funds as institutional investors allocated more ‘dry powder’ to the industry, thereby becoming increasingly attractive investment propositions. For the first nine months of 2011, REITs raised $43.4 billion in equity and was well on course to either match or surpass the $47.5 billion in equity raised in 2010.

Furthermore, according to data from NAREIT, the leverage ratio of listed REITs (total debt against market capitalization) as of September 30, 2011 was 38% – significantly lower than 51% at the end of second quarter 2008 prior to the Lehman Brothers collapse. In addition, REITs typically have a large unencumbered pool of assets, which could provide an additional avenue to raise cash during a crisis. Consequently, REITs are comparatively better equipped to continue outperforming the broader market.

As of December 30, 2011, the total return of Self-Storage REITs were 35.22% (as measured by the FTSE NAREIT Equity REIT Index), followed by Regional Malls (22.00%), Residential (15.37%), and Health Care (13.63%). As such, we remain bullish on Public Storage (PSA) – the largest owner and operator of storage facilities in the U.S.; Taubman Centers Inc. (TCO), which owns, develops and operates regional shopping centers throughout the U.S. and Asia; Simon Property Group Inc. (SPG) – a leading mall REIT; Avalonbay Communities, Inc. (AVB) – one of the best-positioned apartment REITs; UDR Inc. (UDR) – a leading multifamily REIT; Ventas Inc. (VTR) – a premier healthcare REIT; and HCP Inc. (HCP) – a leading healthcare REIT.

Moving forward, limited supply of new construction coupled with the growing demand for high-quality properties bode well for the earnings prospects of REITs, in particular those that have assets in high barriers-to-entry markets. According to reports, new construction is currently averaging 390 million square feet per year, compared to 1 billion square feet per year in the decade prior to the global financial crisis. As a result, REITs are now heavily dependent on inorganic growth to fuel their expansion drive. This could also help the overall industry with significant market consolidation.

To sum up, we firmly believe that despite a few pitfalls, REITs still make a worthy investment proposition in 2012.

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Zacks Investment Research