By John Spence

A DOW JONES COLUMN

Merger talk centered on real estate investment trusts pushed exchange-traded funds tied to the sector to fresh recovery highs, shaking off most concerns that commercial real estate could be the next shoe to drop after the credit crunch.

SPDR Dow Jones REIT ETF (RWR) registered a 52-week high last week after ProLogis (PLD) and AMB Property Corp. (AMB) confirmed media reports they are in merger negotiations. (The companies announced the merger early Monday morning).

The ETF rose to a one-year high of $63.55 a share Friday before tumbling along with stocks as escalating protests in Egypt unnerved markets. The fund has recouped about half the losses it suffered in the 2008 financial meltdown.

"In the near term, we expect acquisitions will be the primary growth vehicle for many REITs," analysts at Keefe, Bruyette & Woods said in a Jan. 24 note.

REITs scaling a new recovery high has been lost in the shuffle with popular stock benchmarks such as the S&P 500 Index and Dow Jones Industrial Average recently touching key hurdles of 1300 and 12000, respectively.

The quarterly reporting season for REITs is getting into full swing. Deutsche Bank said REIT valuations "appear relatively full" in a sector earnings outlook.

"However, with fundamentals on the mend, commercial real estate debt markets continuing to open and the potential for dividend increases to broaden, we remain positive," Deutsche Bank analysts wrote. "In 2011, REITs could benefit from a stronger-than-expected deployment of capital by investors and a more robust economic recovery."

Investors' hunger for income and their struggles with low bond yields may be driving some of the interest in REITs, which are required to pay out most of their profit as dividends to qualify for tax breaks. Subsectors include apartments, offices, malls and self-storage.

Vanguard REIT ETF (VNQ) is the largest exchange-traded product by assets for real estate. The Vanguard fund was up 37.9% for the year ended Jan. 26, outperforming the S&P 500 by nearly 17 percentage points, according to investment researcher Morningstar Inc.

Other popular options include iShares Dow Jones U.S. Real Estate Index Fund (IYR) and iShares Cohen & Steers Realty Majors Index Fund (ICF), which yields 3%, according to manager BlackRock Inc. (BLK).

"The market pendulum is constantly shifting from the desire for capital appreciation, to an income focus," said Michael Gayed, chief investment strategist at Pension Partners LLC.

"If bonds rally in the near-term, then you'll likely to see leadership in income-oriented areas of the stock market" such as utilities and REITs, which can cause the sectors to hold up even in a market correction, he said.

Shaky Ground

Other analysts say REITs could cool somewhat in 2011 after their solid run.

Following two consecutive years of returns in excess of 20%, the sector "will take a breather" and "will come down back to earth" this year, Jefferies & Co. analysts wrote in their outlook. They're estimating a return of about 6% for the REITs they cover.

"We also expect capital markets to remain receptive to REITs," Jefferies added. "That said, rising interest rates will be a headwind."

Indeed, hundreds of billions of dollars of commercial real estate mortgages need to be refinanced in coming years. Default rates have been rising after the credit crunch, while occupancies have fallen. Some bears are predicting a looming shakeout similar to the housing bust on the residential side.

"During the past decade, REITs benefited from increasing leverage, lower borrowing rates, rising property values, and strong growth in demand for properties," Timothy Strauts at Morningstar said in a recent analyst profile on Vanguard REIT ETF.

"Looking forward, it is unlikely REITs will enjoy so many positive trends at the same time," he wrote. "And while interest rates remain low at this time, rates will eventually rise, and this will increase REITs' cost of capital, pressure asset values and reduce cash flow."

(John Spence is a writer for MarketWatch. He can be reached at 415-439-6400 or via email at AskNewswires@dowjones.com)