The gloom has lifted from Reitville. By August the NAREIT Equity Index had chalked up a 22.4 percent total return. But, it would be dangerous to overestimate the extent to which the perception of REITs has changed from last year. There's still a great deal of caution out there, as not everyone regards REIT stocks as stable and reliable investments. The Bear has extracted his pound of flesh, and deep wounds heal slowly.

Even dedicated REIT investors are looking over their shoulders in fear of an ill-conceived equity offering or a dumb acquisition. Furthermore, much of the REIT price rebound could merely reflect the need for a temporary refuge from the extreme volatility in the equities markets; the S&P Utility index was up even more than REIT stocks during the first half of this year.

Thus I don't believe that investors' total return requirements on their REIT investments have changed much from last year; REITs' long-term cost of capital has not declined. What follows from this, or course, is that REIT organizations must continue to generate some pretty high returns on invested capital if they are to keep shareholders happy. It also means that, as I noted in my last column in Portfolio, very few REITs can justify raising fresh equity capital, even assuming it's there for the plucking. Most real estate markets are in equilibrium, and we may see modestly increasing vacancy rates if the economy slows; opportunities to generate rates of return comfortably above long-term capital costs are scarce—especially if we factor in realistic estimates of recurring cap ex and tenant improvement costs.

Proper Use of Retained Earnings

Retained earnings are liquid assets and must either be deployed at the high returns demanded by today's avaricious REIT investors or be returned to them in the form of stock repurchases or—gasp!—higher dividend payout ratios. REIT organizations have done an outstanding job over the past few years of increasing their retained earnings. Lower payout ratios improve corporate flexibility and liquidity, while bolstering the sustainability of dividends. But perhaps REITs' high cost of capital, coupled with the scarcity of mid-teen return possibilities today, should goad REIT boards of directors to consider allowing payout ratios to rise.

A significant number of REIT stocks now yield less than 7 percent, which doesn't compare well with cap rates available today on some pretty fair real estate. Might REIT organizations be shooting themselves in the foot—and discouraging interest from new investors—by retaining the maximum amount of earnings possible and keeping their dividend payout ratios puny, all with the objective of squeezing out another 1 percent of FFO growth annually? After all, most REIT stocks are bought for their real estate and their stable and rising dividend streams; there's still no shortage of growth stock choices today, from pharmaceuticals to dotcoms.

Each REIT's board of directors would do well to take a very close look at the internal rates of return which can be generated today on new investments. Can they comfortably exceed 11 percent—which is my estimate of the weighted average cost of capital today for the typical REIT? If not, one of the best uses of the company's resources might be increased dividend generosity.