Behind the Rebound in Commercial REITs
(Updates in 5th paragraph to include Nov. 4 report from TrimTabs.)
The U.S. commercial real estate market has so far averted the catastrophe that many strategists were predicting last year. While the residential sector faces the threat of further home-price declines, analysts see commercial real estate values stabilizing. (In the residential sector, the cumulative 17.3 percent rise in sales of existing homes in August and September didn't even halve the cumulative 36.6 percent drop from May through July.)
Vacancies for apartment buildings, office complexes, retail malls, and self-storage facilities are no longer rising meaningfully, rents are no longer falling, and many real estate investment trusts, the main vehicle for individual investors to participate in the sector, continue to reduce their debt loads.
Equity investors have taken notice: FTSE Nareit's All-REIT index, comprising 148 publicly traded REITs, was up 23.9 percent year-to-date as of Oct. 29 while the Standard & Poor's 500-stock index was up 7.84 percent. Publicly traded REITs represent 15 percent of the total U.S. commercial real estate market.
Equally striking is how much more confidence investors have put in U.S. mutual funds and exchange-traded funds that focus on real estate assets than they have in equity funds in general. Year-to-date through October, $2.35 billion flowed into U.S. real estate mutual funds and ETFs, while $54.4 billion flowed out of U.S. equity funds and ETFs, according to fund research firm TrimTabs.
However, the popularity of real estate funds is worrisome, says TrimTabs. "When big investment inflows coincide with lots of equity issuance, it is often a sign of trouble ahead," says a Nov. 4 report from the firm. New equity offerings for REITs already total $2.0 billion in the fourth quarter, putting it on track to be the highest since the second quarter of 2009, TrimTabs warned. Normally, such oversupply would mean stock prices are near a peak, but the Federal Reserve's encouragement to buy assets could delay a pullback, TrimTabs chief executive Charles Biderman told Bloomberg Businessweek.
The 20 best-performing commercial REITS from the start of January through Oct. 29, according to Bloomberg Rankings, included a handful of highly leveraged companies whose stock prices were hammered in 2009, when prospects for refinancing maturing loans amid frozen credit markets looked especially grim. Take Glimcher Realty Trust (GRT), which owns and operates regional malls and community shopping centers and was first in the Bloomberg rankings with a total return of 183.4 percent through Oct. 29.
"[Glimcher's] balance sheet was challenged in 2009, but they have worked through their maturities," says R.J. Milligan, an analyst at Raymond James. "Now in 2010, the risk that people associated with the stock, given its balance sheet, has been relatively taken out of the stock price. Now they're going to be able to manage their maturities."
The quest for income and higher yields than can be found in U.S. Treasury bonds is the main reason investors have flocked to REITs in 2010. The ongoing rally in U.S. REITs can also be attributed to much improved credit markets, which have enabled the trusts to refinance debt and issue equity that can be used to pay down debt early or buy more properties, CreditSights' lead REIT analyst Craig Guttenplan said in an e-mail.
Effect of Lower Interest Rates
Deutsche Bank Securities said in an Oct. 15 research note that negative economic news has helped strengthen REIT markets, which have been anticipating a second round of quantitative easing by the Federal Reserve to stimulate economic growth. (The Fed said on Nov. 2 it would purchase a further $600 billion of longer-term Treasury securities by mid-2011 to help boost the recovery.) The lower interest rates that would result would make people more willing to pay higher prices for commercial properties.
From a fixed-income perspective, equity REITs may well be trading at fair value, when you measure their 3.6 percent dividend yield against a 2.8 percent yield for 10-year Treasury bonds, says John Wenker, co-manager of the $2.25 billion First American Real Estate Securities Fund (FREAX). They look fairly expensive, though, from an equity standpoint, trading at 21 times adjusted funds from operations (FFO), compared with the historical average of 14 times adjusted FFO, he says.
Still, Wenker believes there's perceived value in REITs "if you're of the mind that the eventual economic recovery will lead to increased occupancy and higher rental rates."
Impact of Momentum
While REITs with better-quality properties and stronger balance sheets continue to trade at the highest multiples, investors may start to shift from sectors and stocks that have done quite well to others whose fundamentals are improving but that have more attractive valuations, says Paul Adornato, an analyst at BMO Capital Markets. Or, if this fourth quarter mirrors some in the past, "the winners keep on winning and losers keep on losing into yearend, because there's less concern with valuation and more attention paid to momentum [stocks]," he says.
Dave Rodgers, a REIT analyst at RBC Capital Markets, expects commercial real estate prices to continue to climb, in part because the Fed's commitment to keeping interest rates low will make higher-priced properties more affordable. Any further depreciation in the value of the U.S. dollar against foreign currencies will likely continue to attract foreign buyers for high-quality properties, especially in central business districts of the biggest U.S. cities, he says. In general, Rodgers sees "more capital chasing higher priced properties."
Still, plenty of commercial real estate loans are in default. In an Aug. 20 report, Fitch Ratings said that 14 percent of the 158 loans in commercial mortgage-backed securities set to mature in November—representing $1.6 billion in face value—are either delinquent or in foreclosure. (Commercial mortgage-backed securities are pools of loans that were bundled and sold to investors in tranches rated for their level of risk of default.)
Gap Between Distressed and High Quality
There are early signs that banks' willingness to give commercial property owners more time to repay maturing loans—to avoid having to foreclose on them and put them on the books at sharply marked-down prices—may be coming to an end. A handful of retail REITs "that have been on the sidelines waiting for the day when banks will stop 'extend and pretend' are starting to believe that transactions may start to come their way" as early as the first quarter of 2011, says BMO's Adornato.
But Milligan at Raymond James says he doesn't expect properties to flood the market as a result. He cites a big gap between distressed properties, whose prices have continued to decline, and top-quality properties, whose desirable locations in densely populated areas have helped push prices back up to peak levels. Well-capitalized REITs will be able to get discounts on the distressed properties but not on the high-quality ones, he points out.
Increased competition for more desirable properties, particularly from institutional investors often willing to accept lower returns on investment, is forcing REITs to pay more for these properties, says Milligan. He points to the decline in net operating income yields on the purchase price, commonly called cap rates: That decline indicates buyers are willing to pay more for the same amount of operating revenue—which means the buyers would take longer to recoup their investment.
Playing Bonds Instead of Stocks
In reporting third-quarter earnings, most REITs on CreditSights' coverage list reaffirmed or boosted their full-year forecasts for FFO, according to Guttenplan. CreditSights continues to recommend an overweight position in REITs' credit, such as unsecured bonds. "Despite being the best-performing sector year-to-date, REIT spreads [vs. Treasuries of comparable maturities] are still the widest of the investment-grade sectors and should continue to benefit from the ongoing reach for yield," Guttenplan said in his e-mail. On Nov. 1, Simon Property Group (SPG) raised its full-year forecast for funds from operations to $5.90 to $5.95 per share from an earlier estimate of no more than $5.87 per share. The company also increased the dividend it will pay in the fourth quarter by 33 percent, to 80¢ per share from 60¢.
Rodgers at RBC Capital sees liquidity as a more important factor for REIT investors to watch than outstanding debt, because liquidity determines how much capital a company can afford to spend on acquisitions. An attractive balance sheet doesn't necessarily mean strong liquidity, he says. Warehouse REIT ProLogis (PLD) bolstered its liquidity by issuing 80 million shares at $12.30 each on Oct. 26. "That gives them more [options] about what they want to do—more development, pay off debt early," he says. At the Nov. 3 close, the stock was up 8.3 percent since its equity offering.
Boston Properties (BXP) used $2.5 billion in investment capacity, including untapped credit lines, to buy "high-quality trophy buildings," such as the John Hancock Tower in Boston and 510 Madison Avenue in New York, "so liquidity has helped," says Rodgers. The $275 million acquisition of 510 Madison was completed on Sept. 24 and the $930 million purchase of the Hancock Tower, the tallest building in New England, is expected to close by the end of 2010.
Equity Residential (EQR), SL Green (SLG), and Simon Property Group have been the biggest acquirers so far, according to CreditSights. Brandywine Realty Trust (BDN) is buying office buildings in downtown Philadelphia, and Kilroy Realty (KRC) is acquiring properties on the West Coast,
The Yield Advantage
REITs have a permanent place in the investment portfolios that Palisades Hudson Asset Management, in Scarsdale, N.Y., manages for its clients because of the higher yields they offer vs. government bonds. On Oct. 29, the yield on the FTSE Nareit Equity REIT index was 3.61 percent, compared with 2.80 percent for the 10-year Treasury bond. "You can't fake dividends," says Jonathan Bergman, chief investment officer at Palisades Hudson. His firm uses mutual funds with a focus on developed economies, such as the Morgan Stanley Institutional U.S. Real Estate Fund (MSUSX) and the Morgan Stanley International Real Estate Fund (MSUAX), to invest in REITs.
The best REITs to own if the economy continues to recover aren't necessarily ones with higher-quality properties in their portfolios, says Milligan at Raymond James. He cites as an example the self-storage sector, which is recovering more quickly than expected. "We currently have Extra Space Storage (EXR) and U-Store-It Trust (YSI) rated buy, both of which lost more occupancy in the recession than Public Storage (PSA) and therefore are more sensitive to an economic rebound, he says.
BMO's Adornato advises individual investors to make sure a REIT is flexible enough to be able to make money whether the economy is slow or growing. "I still see a very slow, unsteady recovery under way," he says. "Companies in the office, and industrial, and even the retail segments are looking to fill existing vacancies as a way to grow cash flow" by offering discounted rents.