Though markets continue to show signs of improvement, real estate investment trusts (REITs) still face headwinds. Unemployment remains elevated and occupancy rates are generally on the decline. But as both real estate markets and the economy continue to recover, now is the time to add high-quality REITs to your portfolio.

The credit crunch has hit real estate investment trusts hard, and economic weakness has weighed on occupancy rates. The group has rallied sharply in recent months, as access to credit has eased–though terms have been less favorable than at the height of the credit boom. But retail, office and other commercial real estate REITs aren’t out of the woods yet: Analysts regard commercial real estate as the proverbial next shoe to drop.

That being said, shifting demographic trends bode well for multifamily REITs. Over the next several years the portion of the population between the ages of 25 and 43, which is most likely to rent than buy a home, is expected to swell to more than 4 million. And tighter lending standards suggest that the US homeownership gradually decline toward 60 percent over the next decade.

AvalonBay Communities (NYSE: AVB), a multifamily REIT which focuses on the higher end of the rental market, should thrive in this environment. AvalonBay currently owns or has stakes in 164 apartment communities that comprise over 45,000 rental units in ten states and the District of Columbia.

By virtue of its up-market focus, Avalon faces near-term headwinds from elevated unemployment, and competition from the high volume of single-family homes for sale and rent. Nevertheless, Avalon offers several distinct advantages over the long haul.

First off, the REIT focuses on markets with high barriers to entry such as New York City and Washington, DC. In these markets the cost of owning is still high compared to the cost of renting, despite the decline in home prices. And given the limited space available in the heavily urbanized markets, it’s extremely difficult for competitors to eat AvalonBay’s lunch. This strategy, coupled with the geographic diversity of the REIT’s portfolio, has enabled it to weather the recent storm. AvalonBay’s occupancy rates generally have remained above 95 percent.

AvalonBay also has handled its debt situation prudently. Already one of the least levered multi-family REITs going into the crisis, Avalon has kept a lid on borrowing, drawing down less than 4 percent of its available lines of credit. The REIT also has just over $700 million of debt maturities coming due through 2011, giving it a coverage ratio of 1.9 when liquidity and revenues are taken into account.

Over the past two years AvalonBay has been a net seller of properties, a strategy that enabled it to amass a sizable cash position. With the recent improvement in real estate markets, the REIT is in a position to make favorable acquisitions in key markets.

In 2009 full-year revenues were flat compared to 2008, with forecasts calling for a $90 million fall this year. But those estimates appear to be based on a worst-case scenario that appears to be overly pessimistic given the improvements in the economy.

Now is an excellent time to buy AvalonBay Communities and take advantage of what should be a stronger-than-anticipated improvement in 2010. And the REIT pays a secure dividend of 89 cents per share; investors enjoy a better than 4 percent yield while they wait.

WHY TO BUY
AVALONBAY COMMUNITIES (NYSE: AVB, $75.38)
• Strong position in markets with high barriers to entry
• Shifting demographics will add 250,000 rents per year over the next decade
• Market-beating yield that’s well covered by cash flows