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NEW YORK-Smith Barney downgraded a dozen companies in the REIT sector late last week, hanging the “sell” sign on nine of them. The report by analyst Jonathan Litt, which forecasts a near-term drop-off in share prices, sparked a sell-off that pulled REIT share prices down between 1% and 4% on Thursday. After trading Monday, all involved had fallen further.

“[REIT] Fundamentals continue to improve but valuations are ahead of themselves,” says Litt in the report, explaining that REITs are up about 16% year-to-date, and with dividends they are on track to deliver 17.4% total return in 2004. “We believe the group is…due for a pause in total returns as earnings catch up with extended valuations.”

The report details two possible scenarios. The first, a “Goldilocks” economy for REITs–where the economy muddles along with modest job, inflation and GDP growth–may provide upside to the group. The second, an “End of the REIT Bull Market” economy, is where investors will be attracted to other sectors of the stock market that promise big total returns as a result of the strong economy.

“We view the likelihood of an ‘End of the REIT Bull Market’ economy more likely than the ‘Goldilocks’ economy,” says Litt. “As a result we believe the REITs can suffer a sell off of 10-15% in the next 12 months, but will likely end the period flat, with share prices being down 5% or so.”

The report came out early Thursday. By the end of the day, the Dow Jones Equity REIT Index had fallen 3.65 points to 202.90, the Morgan Stanley REIT Index had tumbled 11.79 points to 677.96. And shares of individual REIT stocks, many trading at near 52-week highs, were off between 1% and 4%.

The retail REITs were hit the hardest. Macerich Co. shares dropped $2.19, or 3.9%, to $53.60. Mills Corp. lost $1.62, or 3.1%, to close at $50.98. Pan Pacific Retail Properties Inc. fell $1.59, or 2.9%, to $52.81. Acadia Realty Trust dipped 42 cents, or 2.8%, to $14.46. The office REIT Alexandria Real Estate Equities Inc. lost $2.40, or 3.6%, to close at $63.95, while PS Business Parks Inc. dropped 37 cents, or about 1%, to $40.68. The apartment REIT Camden Property Trust was off $1.29, or 2.7%, to $46.45., while AvalonBay Communities Inc. fell $1.64, or 2.6%, to $60.46. Industrial REIT Catellus Development Corp. dropped 60 cents, or 2.2%, to $27.20, while AMB Property Corp. ended the day down 48 cents, or 1.3%, at $37.08.

After trading Monday, all had fallen further. Macerich, having lost another $0.30, stood at $53.30. Pan Pacific was down to $52.30, Mills to $50.10, and Acadia to $14.35. Alexandria lost another $0.50 to close Monday at $63.45, Avalon Bay fell to $60.07, Camden to $45.55, AMB to $36.74, PS Business Parks to $40.30 and Catellus to $27. The two indexes also continued their fall. The Dow Jones Equity REIT Index finished Monday at 201.48 and the Morgan Stanley REIT Index fell another 14.52 points to close at 663.44.

With regard to valuation, Litt says one of the more disconcerting statistics is that the spread between the REIT dividend yield and the 10-year Treasury yields is now 93 basis points, which is well below the historical average of 128 basis points. “If the 10-year Treasury yield increased by 100 bps over the next 12 months, REIT share prices would have to decline by 16% for the REIT dividend yield to increase by 100 bps…[and] maintain the current 90 bps spread between REIT dividend yields and Treasuries.”

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