1-26-05                                                                                           Vol. 8: No. 1 RealtyStocks' Observer If you're not receiving this free monthly e-newsletter, please register. Monthly Feature: Stocks Start 2005 with a Hangover REITs Repeat of a Strong 2004 Performance will be Difficult A. Out like a Lion, In Like a Lamb chop B. Privatization of Social Security C. Difficulties for A REIT Repeat of 2004 D. Equity REIT Performance E. Large Cap REIT Performance F. Mortgage REIT Performance G. Realty Corporations H. Real Estate Mutual Funds (REMFs) A. OUT LIKE A LION, IN LIKE A LAMB CHOP The stock market rally at the end of 2004, boosted by the November elections and the end of year "Santa Claus" purchasing, helped major indices reach highs not seen since three years ago. This late year rally allowed the Dow Jones to jump into positive returns with an overall gain of approximately 3%, the S&P 500 to return over 9% and some other broad based indices to achieve even better returns. In particular, some sectors, like transportation and REITs, had exceptionally strong returns of around 25%, depending upon the reference source, thus creating a strong ending to 2004. Even the bond market performed relatively well in 2004, despite a strong negative consensus for this group by nearly all leading economists at the beginning of last year. A year ago, all 50 leading economists predicted the dryer treasury yield would increase and be nearly 5% or more. In actuality, the yield finished a slight bit under the prior year and was around 4.2%. In contrast, during the first three weeks of this year, the major indices have declined weekly. This has not occurred since 1982. Though last week showed positive returns, the slow start for this year, in part, may be attributed to a change in institutional purchases that are now increasing at the end of the year rather than the beginning of the following year. However, most explanations for the equity doldrums include the same issues that held the market back for most of 2004. Job growth reported at the start of this year again disappointed and was less than forecasted, waning consumer confidence. Though oil prices abated at year end, they have since crept up again due to continued uncertainties abroad and colder weather in much of the country. Productivity gains appear to be slowing to a level that could encourage inflation, the pace of corporate earnings increases is slowing, and the deficit is widening. Another factor that has been well known, but that could still be causing concerns, is the continued insurgency in Iraq, despite an apparent strong election turnout. This could exacerbate the problems in that country and create greater pressure on the U.S. military there. Domestic unrest over the Iraq war, as evident by numerous demonstrations during the President's Inauguration, is growing. In order for President Bush to achieve success with his agenda during the next term, it may require more progress with the Iraq situation over the next couple of years. The largest items on Bush's agenda may well concern health care costs and the privatization of Social Security.   Top B. PRIVATIZATION OF SOCIAL SECURITY COULD IMPACT REITs A principal issue in the debate about Social Security, is whether private investment accounts will be able to maintain acceptable returns as realized during our current lifetime; or, if we may be entering a period of equity returns that will be less than inflation, which occurred several decades ago. Minimizing the risk of such accounts, to prevent an overexposure to those investments with employees from such firms as Enron, Global Crossing and Worldcom, is also of great concern. It has been proposed that these private accounts should be some mix between some broad stock indices and bonds, with the mix increasing towards bonds as people age. Another proposal is to limit these accounts to government securities that would be indexed to inflation. Financial institutions could be great beneficiaries from this proposal, which will place great scrutiny on their involvement. There are several other issues on this topic, such as the decline in tax revenues the federal government will receive and the cut off and transition period of people to receive the current type of social security benefits. A main issue about privatization of Social Security, is it's possible benefits upon equity investments. After all, if trillions of dollars will be flowing into equities, it could result in a long term stock market rally. However, what happens to smaller market cap stocks that are likely to be excluded? This may be a major issue to watch during the discussion of Social Security reform, especially as it pertains to REITs. Relatively speaking, REITs have relatively low market caps, most are under $3 Billion; only a few are over several billion and these are the only ones included in the S&P 500. Hence, could the enormous flow of investment dollars flowing into equities due to the privatization of social security exclude some 95% of all publicly traded REITs? This is an issue we will begin to closely monitor, and we welcome any insight from our readers.   Top C. DIFFICULTIES FOR A REIT REPEAT Despite modest returns for most broad-based equity indices in 2004, there were some very positive developments. In particular, employment gains were over 2 million and the highest in five years. Interest rates were stable and inflation was low, especially if oil increases were excluded. One of the brightest investment sectors of the year continued to be real estate. The real estate sector and real estate mutual funds posted overall returns again in excess of 20% in 2004, but what is most noteworthy, it that it has had a similar average return for the past five years. This places real estate in the top 10th percentile of all sectors and handily beats the broader indices that have been much lower. However, as anyone in real estate and investments knows, these types of returns are not sustainable for extended periods. The cyclical nature of equities and real estate point to a coming change for REITs. We have continued to espouse that real estate was likely to perform well, as long as rates stayed stable and the economy showed improvement. We began to become more pessimistic on the REIT performance at the beginning of last year, when it appeared likely that both long and short term rates would increase. At a Real Estate Forecast in Los Angeles in early 2004 with an attendance of over 1,000, from a hand count of those who thought rates would not increase last year, there was not one fully raised hand. When economic growth became robust and rates surged in April 2004, this consensus seemed on track. The affect knocked down REITs with a double digit percentage dive in less than a month. However, by late summer oil prices surged, economic growth sputtered, and domestic terrorism became a concern, as many investors were leery of a possible Kerry election, which would be less friendly to investors. This formed an environment for lower interest rates, which were favorable towards real estate. This year we are sanguine about prospects for a hot economy in the near term, believing that mixed economic results will persist in the coming year. As a result, the sweet spot that is necessary for good real estate performance, low long term rates and an improving economy, could still continue. However, we do believe that cracks in real estate equity will start to form. During the past two years, none of the REIT property type groups declined, but in 2002 nearly half of these groups declined in price. We believe the ones that were strongest the year before in 2001, such as Health Care, Specialty and Regional Malls and most Mortgage REITs, may struggle to be positive this year, especially if mid and long term rates rise. The recent consolidation of major retailers, such as K-Mart and Sears, as well as Federated and May DNF place more pressure on regional mall REITs, and could stunt their returns this year. At the opposite end, certain REIT groups that underperformed in recent years, like Hotels, Apartments and even Offices - could continue to outperform their counter parts. Sub-groups related to REITs (Real Estate Co's.), particularly Home Builders whose stocks have often doubled in just two years, should start to cool with rising rates. As a result, we see more of a dichotomy in real estate stock performance, which should cause greater variance in the performance of mutual fund managers for the coming year.   Top D. EQUITY REIT PERFORMANCE Equity REITs finished the year with a respectable 2.24% in December, but off their stellar gain of 5.94% in November. All but one REIT group was positive in December, compared to unanimous increases across all groups the month before. After posting a major loss in April, REITs have responded with eight consecutive monthly increases. Their overall price appreciation for the year was 20.06%, a bit short from the 33.25% surge from the prior year. The best group for December was Hotels with 7.39%, about the same as their performance the prior month. However, the best performers the prior month were Retail Malls & Centers at 11.73% followed by Factory Outlets up 8%. The best price performances in the year 2004 were in the Retail Groups with Factory Outlets up 47% and Regional Malls up 39%. The worst performers for the year were MH Parks and Specialty, with scant gains of only 1.12% and 2.5%, but none were negative. (Please see Equity Gainers and Losers.).   Top E. LARGE CAP REIT PERFORMANCE Finally, this was the year Large Cap REITs outperformed the broader Equity REIT gains in over four years, posting a gain of 26.9%. December and November were both positive months, slightly ahead of Equity REITs, with gains of 3.4% and 6.3%, respectively. The best large cap performer for the December was St. Joe (JOE), jumping 16.6%, which outperformed the monthly star from the prior month, Crescent Real Estate Equities (CEI), up 13.8%. The worst performer for the month, only off -2.7%, was Duke Realty (DRE) and the worst gainer from the month before was Health Care Property (HCP), off -1.8%. For the 2004 year, the best performers were St. Joe leaping 70%, followed by Avalon Bay (AVB) up 57.6%. The worst performers for the year were Equity Office (EOP) and Crescent with minor increases of 1.6% and 6.6%. Please see Large Cap REITs.)   Top F. MORTGAGE REIT PERFORMANCE This sector recovered from a decline in October, with a gain of 3.18% in November, before slipping -.07% in December. For the last three years Mortgage REITs significantly outperformed Equity REITs, with a gain of only 4.55%, was much different. Of the three groups in this sector, Commercial Mortgages has struggled the most with a gain of -1.35% in December and Residential group was the best with a 2.85%. The prior month the mixed group was the best performer, up 5.31%. (Please see Mortgage Gainers and Losers.)   Top G. REALTY CORPORATIONS After a disappointing performance of -4.83% in 2003, Realty Corps bounced back with a gain of 38.6% in 2004 and exceeded REITs for the first time over the last few years. Property Services and Constr./Engr. firms posted the highest gains a little over 60% with the only negative group, Tech & Net, falling -18.6%. In December, Home Builders came back to lead all groups gaining 16.4%. The only negative performer for both December and November was OnSite Tech with losses of -5.8% and -4.6%. It is important to keep in mind, however, that some of these groups have just a few stocks with prices under a few dollars a share. Therefore a rise of a couple dollars for just one stock can produce strong price gains for its group. (Please see Realty Corp. Gainers and Losers.)   Top Stock Changes. None. Note: In reporting group percentage changes, if a stock is under $2 for more than two months, it is subject to removal from our coverage. All gains or losses regarding Realty Stocks are price changes only; dividends are excluded, and are calculated as of the end of each month. Disclaimer: The material provided herein should not be taken as endorsements or recommendations to invest in a stock, fund, a group of stocks or other securities. No guarantee can be made as to the expected performance of such investments. Investors should consult all available information, including data external to RealtyStocks and associated Web sites, and exercise own best judgment before making any investment decisions. The author may have equity positions in some of the companies covered in RealtyStocks, which may change from time to time, and will divulge such information upon request.   Top InRealty Sponsors Inquire about our special advertising banner promotions! E-MAIL: stocks@inrealty.com Copyright ©2004, WebVisers Inc. All rights reserved .