Six Predictions for '06
[January/February 2006]
By Ralph Block
As Warren Buffett has wisely noted, “Forecasts usually tell us more of the forecaster than of the future.” That being acknowledged, here are six predictions for '06. But first a caveat: We generally assume that existing trends will continue, but they eventually change—usually when we least expect it.
1. REIT stocks will return 10 percent in 2006. REIT stocks were hit hard in October [when this column was written]; the average REIT stock now trades at a significant NAV discount, perhaps reflecting fears of declining real estate values. While we should not ignore this prospect, the inflation ogre will tire soon, long-term interest rates will moderate and cap rates will flatten. The resolution of these uncertainties will result in10 percent total returns in 2006.
2. Joint venture activity will accelerate. REITs are unable to create value via bidding contests. But those who have strong relationships with institutional investors can create significant value through joint ventures. The institutional investors get professional management, an alignment of interests, experienced developers and deep market knowledge. The REIT gets a stable income stream with prospects for incentive compensation, and is able to retain tenant relationships. These are “win-win” arrangements, and we'll see more of them this year.
3. Lodging stocks will outperform. These Rodney Dangerfields get no respect. They outperformed marginally in 2004, but significantly underperformed from 2001 through 2003, and were underperformers again in 2005. But their performance will revert to the mean. An increasing number of baby boomers will spend big bucks on travel and leisure; furthermore, assuming no recession this year, business travel will continue to grow. New hotel supply is muted. Cash flow and operating margins will improve further in '06, and hotel stock prices will, finally, perform well.
4. Real estate values and NAVs will rise modestly. Everyone worries about real estate bubbles, and “hedgies” are convinced that commercial real estate prices, like those of condos, must decline. While it's fair to question the valuation of single-family dwellings in some markets, commercial real estate is not overpriced today—certainly in relation to its prospective risk-adjusted returns vis-à-vis other asset classes. Rising interest rates remain a concern, but they will abate over the next few quarters and cap rates will remain flat. Meanwhile, continued improvements in the space markets will boost owners' net operating income, driving property values modestly higher.
5. M&A activity will heat up. We've seen increasing M&A activity over the past year, and this trend will accelerate. As long as differences of opinion exist among seasoned real estate players concerning the intermediate-term valuations of real estate, the number of deals will increase. Those REIT executives who see real estate prices on the cusp of a decline—will be anxious sellers to the large pool of institutional investors who continue to haunt the capital markets. And the latter will be happy to buy entire REIT portfolios, paying only modest premiums. Most '06 acquirers will be private real estate investment groups, not REITs.
6. New REIT-forms. REIT investors will be able to invest in one or two entirely new property types, due to new IPOs in 2006. Recent years have seen a proliferation of new REIT choices, including student housing, telecommunications towers and timberland. Why not amusement parks, private colleges or refined product storage tanks? If lessees can make money operating in a type of property, we shouldn't be surprised to see the business separated from the real estate, with the latter owned and managed by a REIT.
Ralph Block is senior portfolio manager with Phocas Financial.
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