7-21-06                                                                                           Vol. 9: No. 3 RealtyStocks' Observer If you're not receiving this free monthly e-newsletter, please register. Monthly Feature: Concerns for Inflation and Rising Rates Cause REITs to Decline in Q2 of 2006. A. Weakness in Real Estate May Dampen the Economy B. A Potentially Volatile Second Half C. Larger and Fewer REITs D. Equity REIT Performance E. Large Cap REIT Performance F. Mortgage REIT Performance G. Realty Corporations H. Real Estate Mutual Funds A. WEAKNESS IN REAL ESTATE & CONSTRUCTION MAY DAMPEN THE ECONOMY The home building and real estate services industries, including brokerage and mortgage lending, have been responsible for approximately 40% of all new jobs within the last few years. However, with home prices doubling in many areas over this period and interest rates increasing to nearly 7% for 30-year fixed rates and doubling for 1-year adjustable rates, (now over 5%), these industries are slowing. Residential sales are declining, inventories are increasing and layoffs are beginning to occur in these industries. Even though few areas of the country are reporting declining home prices so far, it's clear that residential markets are weakening in the U.S. Certain condominium markets in Florida and Las Vegas seem particularly overbuilt, with builders now needing to offer incentives, price reductions or conversions to rentals. Still, the much ballyhooed prospects of a potential real estate bubble, which has plastered papers for a couple of years, is not viewed to be likely in the immediate future by most experts. We concur with this view, as long as interest rates don't increase by a couple more points anytime soon. However, as we mentioned before, if we become mired in an environment of relatively stable, but higher rates, we may see relatively flat to gradually declining home markets for several years. With adjustable rate mortgages coming due in the next one to four years, home foreclosures will certainly accelerate if interest rates rise another point or more. As a result, without an increase in home equity and if an increase in wages doesn't materialize, consumer expenditures could ultimately fall. Of course, if wages and prices escalate, the Federal Reserve will raise interest rates more in an attempt to curb inflation. Our economy is therefore reaching a very pivotal and delicate point, which is even causing the sentiment on some indicators that were previously positive to turn negative. For example, for a couple of years, the consensus was that the larger the monthly job growth numbers, the better the economy - resulting in rising equity markets. To just stay at static employment levels due to retirements, etc., it is believed that the monthly job growth needs to be about 135,000; numbers above 200,000 were treated enthusiastically. Now with so much trepidation about rising rates hurting corporate earnings and economic growth, there is fear that job growth approaching 200,000 or more will be viewed by the Feds as inflationary, causing rates to rise. Therefore, job growth needs to remain in a relatively narrow range as to not invoke a negative reaction. Last month a job growth of 175,000 was expected, and the number released was 135,000, which was received rather well. However, there are other concerns that can affect the economy, which are mounting.   Top B. A POTENTIALLY VOLATILE SECOND HALF Violence between Hezbollah and Israel has escalated and is taking its toll on innocent civilians, especially in Lebanon. Additional violence is also occurring in the Gaza strip, as well as Nigeria, and a terrorist bombing in India has left hundreds dead. The recent launching of missiles in North Korea, and events in Iran, have heightened concerns over nuclear weapons in these countries, which could ultimately result in some military action. Investors seem to have developed a thicker skin towards violence abroad, but some worry that increased violence abroad, will cause a greater likelihood of domestic terrorism. The U.S. stock of oil supplies is less than expected as we enter a more active summer period during hurricane season, and violence in the mid-east may cause oil supply disruptions. The noted events have pushed oil prices to their all time highs over $77/barrel, causing more concern over price increases and inflation. A much expected pause in the rise of the discount rate is expected in August, but if higher oil and consumer prices persist, it could result in another increase, which would be very bearish for financial markets. The growing size of hedge funds is also exacerbating a broader spectrum of markets, including oil, metals, international currencies, foreign equity and debt markets, real estate and more. Elections in November could well change the balance of power in Congress, creating more political uncertainty. The increase of rates in other countries could make many currencies more attractive than the U.S. Dollar and, as noted in a prior newsletter, should foreign investors leave our debt and equity markets, it could cause rates to rise significantly. The good news in the coming weeks is that quarterly earnings are generally expected to be positive, with an overall increase in the low double digits, though there will undoubtedly be some upside and downside surprises. The trade deficit, though still quite high, was less than the prior month. Consumer sentiment is also fairly strong. Many investors are averse to risk, especially among the aging "boomers" who are seeking more secure and better returns as they enter retirement. With short term rates now over 5%, and major stock indexes declining several percent in the last couple of months, many "boomer" investors view short term CD's and money markets as an alternative to equity investments. There is already a growing trend for investors to seek large, blue chip companies that may offer safer and better returns than more speculative issues, which may be yet another foreboding sign for equities. The clamor for investments abroad is also declining, as various foreign markets, particularly in Asia and India, have fallen in the past few weeks and large mutual fund inflows into these markets have turned negative. Top C. LARGER AND FEWER PUBLIC REITs To some extent, we believe that REITs can be viewed in line with the trend to find more conservative investments, yet also with attractive yields. In a previous newsletter, we discussed how several REITs amounting to over $20 billion, were acquired as investment platforms by value oriented investors in the past couple of years. Additionally, merger and acquisition activity is occurring, further reducing the number of larger public REITs (over a couple billion dollars). Most recently, Trizec Properties (TRZ) announced it is being acquired as did Pan Pacific (PNP) and Heritage Properties (HTG) at respective values amounting to $7.8 billion, $4 billion and $3.2 billion. REIT acquisitions amounted to over $20 billion in 2005 and may well be breaking that amount this year. Even though most of the acquisitions are a few billion or less, there is some speculation that one of the largest REITS may be acquired in a private deal within the coming months. We view the reduction in the number of REITs, as generally positive. First, the M&A activity is causing some REITs to become larger. Theoretically, this should result in greater management efficiencies and along with broader geographic diversity, less location risk. Second, the larger size of some REITs increase their chance of inclusion in some of the larger indices which makes them more desirable as a main stream investment, instead of just a niche play. Third, the reduced supply in both the number and capitalized value of REITs may create a more favorable supply and demand relationship for REITs. Finally, investors may become more comfortable with REITs, as some property sectors now only have a couple or a few major companies, and there are now only about a dozen REITs that are much larger than most others (with market caps around $10 billion or more), as discussed in Large Caps, below.   Top D. EQUITY REIT PERFORMANCE Equity REITs had a robust gain, in the first quarter of 2006, of 11.25% with all property type groups positive. However, all sectors were negative the following two months and even though most groups were positive in June, the second quarter performance fell by several percent. Still, year-to-date (YTD), all but two property type groups (Retail Malls/Centers & Specialty) are positive and Equity REITs have gained 7.38%. The best performers YTD are Offices (up 19.11%) followed by Apartments (up 16.92%). The best performer for the second quarter and only group with a slight positive return was Hotels. The worst performers for this period were Self Storage and Retail Factory Outlets. (Please see Equity Gainers and Losers.)   Top E. LARGE CAP REIT PERFORMANCE Large Cap REITs finished the second quarter stronger than the broader REIT market each of the last three months and actually ended slightly positive for the quarter. Out of 25 Large Cap stocks, nearly all were negative in the first two months of the quarter, but all were positive in June. The best Large Cap REIT in the quarter was Trizec Properties (TRZ) with a gain of over 21% alone in June due to its acquisition announced by Brookfield (BPO) and the Blackstone Group. The worst performing Large Cap for the Q2 was Crescent (CEI). YTD, the leaders are SL Green, leaping 44.7%, Avalon Bay, up 25.7% and Trizec, up 25%. The only two negative performing REITs YTD are Plum Creek Timber (PCL) and General Growth (GGP). Please see Large Cap REITs.)   Top Please note that we are revising the Large Cap REIT list, mostly due to changes in the market capitalization values (Market Caps). It is interesting to note that the largest REIT is now Simon Debartolo (SPG) with a Market Cap of over $18 billion, followed by Vornado Realty (VNO) with over $14 billion. Equity Office (EOP) and Equity Residential (EQR) were surpassed in size by these REITs, but are still over $13 billion each and are the next largest REITs. The top 10 REITs in size currently all exceed about $10 billion. To become one of the 25 largest REITs now requires nearly $4 billion. As the market values of many companies in recent years have declined, especially those in technology, it is interesting to note that many REITs have increased substantially in size. F. MORTGAGE REIT PERFORMANCE Mortgage REITs underperformed Equity REITs in a rising market during the first quarter with a gain of only 4.18% vs. 11.28%. However, in the second quarter, Mortgage REITs declined slightly less and posted a slight negative return, which was better than Equity REITs. Still, YTD, Mortgage REITs have a gain of 4.67%, which is below Equity REITs returns by nearly 3%. The best performing group for the quarter and YTD was Commercial Mortgages. (Please see Mortgage Gainers and Losers.)   Top G. REALTY CORPORATIONS Realty Co's. underperformed REITs in the first quarter, but were similar in their performance for the second quarter. YTD, Realty Co's. are trailing REITS with a gain of only 2.52%. Most of this loss, however, is due to only two industries, Home Builders and Timberland, which are down -22.31 and -10.25% YTD. The best performing REIT for the second quarter is Tech and the worst is Home Builders. (Please see Realty Corp. Gainers and Losers.)   Top H. REAL ESTATE MUTUAL FUNDS (REMFs) REMFs performed well in June with an average overall return of 4.02%, which still exceeds the gains on the broader REITs after the affect of dividends are considered. The best performing REMFs for June were ProFunds Ultra Sector with a return of 5.71%, followed by Seligman LaSalle, up nearly 5% for the month. For the first half of the year, out of 284 funds, the average REMF has had an overall return of 14.11%. The top two funds YTD were ProFunds Ultra Sector and JPMorgan U.S. with overall returns of 19.95% and 18.19%, respectively. In comparison to our broader REIT index, including an average dividend gain of about 2.5%, our overall return is estimated to be slightly under 10% for the first half of the year, but if only Large Caps were considered, the overall return would be about 13%. Therefore, REMFs are performing very similar to Large Caps, but are out performing the broader index by a few percent. We believe the explanation for this is not particularly because of specific stock picking skills. Instead, it seems that most REMFs are 1) avoiding the smaller REITs, which have generally underperformed, 2) concentrating primarily on the core property types of Offices and Apartments, which have gained about 19% and 17% this year - without dividend contributions, and 3) for the most part, are avoiding Home Builders and the non-core property groups, e.g. HeatlhCare and Specialty properties. (Please see REMFs.)   Top Stock Changes: CarrAmerica was privately acquired by the Blackstone group and is no longer traded. From the Large Cap list, Hospitality Properties Trust (HPT), Health Care Properties (HCP), Crescent (CEI) and St. Joe (JOE) were dropped and replaced by Developers Diversified (DDR), SL Green (SLG), Macerich (MAC), Regency Centers (REG) and Federal Realty (FRT) - because the latter group had higher Market Caps. Note: In reporting group percentage changes, stocks that were under $1 are excluded from our calculations. If a stock is under $1 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 ©2006, WebVisers Inc. All rights reserved .