A dramatic rally in bonds of U.S. real estate investment trusts may not be sustainable as the sector faces a protracted slump in property values, low occupancy rates, and weakened credit markets.

Rebounding from their worst year ever, high-grade REIT bonds have rallied 36 percent this year, including a 22 percent gain in the second quarter alone, according to Bank of America Merrill Lynch data. Bond prices shot up after a number of REITs, companies that own commercial property, retired debt ahead of schedule and regained access to the bond and stock markets to shore up cash.

Despite recent gains, banks are still cautious on the sector and the bond market remains inhospitable for many REITs, limiting sources of capital.

REITs also face about $16 billion in unsecured debt that either matures or may be put back to the issuers in 2011, according to Fitch Ratings. As a result, more companies are likely to face liquidity shortfalls over the coming quarters and possibly rating downgrades, according to Fitch.

It's the most critical risk in this environment because it's the one that we see that could most dramatically change ratings, Fitch analyst Steven Marks said.

The credit crisis last year was especially hard on REITs, which depend on capital markets to fund investments in apartments, office buildings and other properties. Investment-grade REIT bonds tumbled 28 percent in 2008, according to Bank of America Merrill Lynch data.

TALF MAY BROADEN FUNDING

REIT bonds rebounded this year as investors bet the selling was overdone and as access to the capital markets reopened. In recent months, REITs have shored up their balance sheets by issuing about $13 billion in equity and reduced debt by buying it back at steep discounts.

Even so, Gimme Credit analyst Kathleen Shanley recently assigned underperform ratings to three REITs and said the rally may have gotten ahead of itself.

Certainly it is reasonable for bond investors to be reassured by the success REITs have had in tapping the equity markets over the past few months, since equity financing provides a cushion for bondholders and eases fears of near-term liquidity issues, Shanley said.

But the fundamentals remain weak for employment, retail sales and commercial real estate sales trends, so some caution is warranted, she said.

Some strategists expect REITs to get a boost this summer by tapping the governments Term Asset-Backed Securities Loan Facility, or TALF program, to fund commercial mortgage-backed deals. Under a revamped TALF, government loans can be used to buy top-rated CMBS, a move that would broaden lending options for REITs. Developers Diversified Realty (DDR.N) for example, is planning CMBS deals that would be eligible, while Simon Property Group (SPG.N) has said it is evaluating options with bankers. For details click on [ID:nN16308358].

BONDS STILL CHEAP

JPMorgan Chase analyst Mark Streeter has an overweight on the REIT sector, noting that it remains the cheapest investment-grade industry sector in his firm's corporate bond index. Despite weak commercial property fundamentals, supply remains in check and demand is expected to eventually return, Streeter said in a recent report.

Tight credit for commercial property remains a concern, however. Fitch analyst Steven Marks estimates that REIT's revolving credit lines may be cut by about a third when they come up for renewal as banks trim exposure to the sector. Bond sales, meanwhile, remain expensive for many

REITs as a financing option.REITs also face a long slog before commercial property recovers, according to CreditSights.

Commercial real estate fundamentals are still deteriorating and they will continue to deteriorate because it's a lagging economic indicator, said CreditSights analyst Craig Guttenplan. In the office sector, for example, demand will not recover until well after hiring has picked up.

If REITs continue to raise more equity, that would probably be very good for their credit profiles, but issuance has stalled since the beginning of June, Guttenplan said. For REIT bondholders, I think we're probably close to a holding pattern for now, he said.

(Reporting by Dena Aubin; additional reporting by Al Yoon)

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