Participants (l to r) Christopher Haley, Steven Marks, T. Ritson Ferguson, Ralph Block (moderator), Ken Rosen, and Jeff Horowitz

Looking ahead with investment pros

By Erin Corcoran

One can never predict the motion of the market, and the past year proved true to form. After outpacing the broader market for seven consecutive years, REITs fell back in 2007. As the new year begins, questions about fundamentals, the credit marketplace and deal flow abound. What is in store for 2008?

To get a sense of what’s in store for 2008, Ralph Block, veteran REIT investor and author of “Investing in REITs” and “The Essential REIT” newsletter, led a discussion with five leading industry professionals. Participants included: Christopher Haley, managing director, Wachovia Securities; Jeff Horowitz, co-head of global real estate investment banking, Merrill Lynch; T. Ritson Ferguson, CIO and managing director, ING Clarion Real Estate Securities; Steven Marks, managing director, Fitch Ratings; and Ken Rosen, chairman, Rosen Real Estate Securities.

Ralph Block: In recent months, the REIT privatization trend came to an abrupt halt, and the real estate industry began to suffer from credit market dislocations, including widening credit spreads and rising cap rates. Given the shifts, what are the main themes for REIT and real estate investors in 2008?

T. Ritson Ferguson: Investors are going to look for reasonable returns with fairly stable or declining capital values in 2008. There's going to be the added complexity of dealing with an economic situation that's not as robust as it has been in recent years.

Right now, we are anticipating cash flow growth of 8 percent next year. Expectations for 2008 are likely to be based on an environment of slower economic growth, if not a recession.

THE YEAR’S FOCUS WILL BE BACK ON THE FUNDAMENTALS, SUCH AS EARNINGS. THERE WILL BE A DISCUSSION OF RELATIVE VALUE OF REITS VERSUS STOCKS AND BONDS IN 2008. KEN ROSEN ROSEN REAL ESTATE SECURITIES

Ken Rosen: I would agree with Ritson. The year's focus will be back on the fundamentals, such as earnings. There will be a discussion of relative value of REITs versus stocks and bonds in 2008. REIT cash flow yields are low relative to the S&P and bonds. Additionally, I would not be surprised to see several large privatizations of REITs by the private equity community in 2008.

Block: What are the biggest questions for 2008?

Jeff Horowitz: Here are three thoughts. First, REIT investors will focus on earnings and operating results, given the economic backdrop. Second, attention will be paid to determine whether real estate pricing levels are cyclical or secular. Third, for certain companies, the likelihood of private market take-out bids will become paramount.

Also, REITs' cost of capital and their availability and access to capital will change from the past, particularly for non-investment grade companies. Finally, many companies that would have been expected to buy back stock will become hesitant to do so, given the economic uncertainty and market instability.

Block: Now, I'd like to turn to challenges that U.S. REITs may face in accessing the debt markets. Are we going to see some kind of easing of the financial markets in 2008?

Steven Marks: Both the unsecured and secured debt markets are open but at spreads that are demonstrably higher than six months ago. The biggest challenge the REIT industry may face is transitioning from denial to acceptance that the debt markets have re-priced. The ability for even the best REITs to execute no-covenant deals in the unsecured debt markets is remote. Unsecured debt offerings will need some degree of financial covenants. The secured debt markets are open but at lower loan-to-values and higher spreads, primarily driven by the liquidity stress in the commercial mortgage-backed securities (CMBS) market.

INVESTORS ARE GOING TO LOOK FOR REASONABLE RETURNS WITH FAIRLY STABLE OR DECLINING CAPITAL VALUES IN 2008. T. RITSON FERGUSON ING CLARION

Block: There has been some indication that cap rates have begun to move higher, perhaps due to the widening of spreads in the debt markets and the prospects of a slower growing U.S. economy. What's your outlook on prices for commercial real estate and cap rates?

Ferguson: While it is hard to infer from current activity that there has been a change in cap rates, it is clear that they are on their way up. We've gone through an exercise of revising NAV estimates based on the presumption that cap rates will be moving up between 25 and 50 basis points, depending on the quality and the property type. We are working under the presumption that required rates of return have moved up to an average of approximately 8 percent, having been as low as 7 percent within the last year.

Horowitz: Our view is that cap rates are likely to move up 50 to 100 basis points, given the increased cost of debt. Additionally, we think the spread of cap rates between higher and lower quality assets will widen; as well as between primary and secondary markets.

Block: Which real estate sectors are most exposed to rising cap rates?

Rosen: Apartments, in part because condominium development activities have ended. The cap rates may be considered low compared to other property types and therefore may be more susceptible to an increase. Additionally, hotels have had a big supply increase in the low-to-middle hotel sector, and so they may see a pullback in occupancy and revenue per available room (RevPAR) growth.

Horowitz: To answer the question, we need to distinguish between asset type, quality and market. During the last few years, buyers and lenders have been less discriminating; we think that the disconnect in pricing will increase.

REITS NEED TO UNDERSTAND THAT OPERATING IN VARIOUS TIME ZONES AND NEW JURISDICTIONS IS VERY CHALLENGING AND REQUIRES THE RIGHT PERSONNEL. JEFF HOROWITZ MERRILL LYNCH

Chris Haley: Just as we have seen additional pressures to chase yield often into secondary or tertiary property type and locations, we think that even core property types that also were exposed to higher level buyers similarly have more risk to the upside, with respect to cap rates movement or downside in terms of value per foot.

Block: Several investors were surprised and negatively impacted by downgrades on residential debt securities. Will this phenomenon extend now to REITs, most of which participate in the commercial real estate credit markets?

Marks: The issues that have affected residential real estate and residential mortgage-backed securities (RMBS) transactions have not yet directly touched commercial real estate. Fundamentals do remain solid across property types, and managements have remained disciplined in maintaining conservative balance sheets with sizeable unencumbered portfolios. Most REITs in our coverage universe have ample liquidity and demonstrated access to multiple forms of capital. Our outlook for equity REITs remains positive.

Block: We have seen a U-turn in transaction volume for privatizations and buyouts for REITs. How should investors look at this sudden shut-down in buy-out activity? Does it have anything to do with decline in the value of REITs or commercial real estate, or is it simply a phenomenon of the capital markets?

Horowitz: From an equity investor perspective, there is no question that the leveraged buyer/buyout created a floor under REIT pricing. In addition, the success of the industry also drove non-dedicated money to invest in REIT stocks. Today, there is almost no debt available for large scale buy-out transactions. This may change over time, but we will see fewer and smaller transactions and a greater potential to see strategic mergers among REITs.

MOST REITS IN OUR COVERAGE UNIVERSE HAVE AMPLE LIQUIDITY AND DEMONSTRATED ACCESS TO MULTIPLE FORMS OF CAPITAL. OUR OUTLOOK FOR EQUITY REITS REMAINS POSITIVE. STEVEN MARKS FITCH RATINGS

Rosen: I would emphasize that the financial engineering-type transactions that we saw in 2007 will not be prevalent. As Jeff said, there will be strategic mergers, and we may see some pension funds that want to increase real estate in their portfolio. This can be done through advisers such as Morgan Stanley and ING.

Horowitz: We will also likely see a difference in the way the REIT sale process occurs. As opposed to an auction process, companies will more likely engage in a negotiated transaction, with a low breakup fee. In this manner, a floor in pricing will be established and there will be greater certainty of execution.

Block: If privatization does come back, which sectors are most likely to participate?

Rosen: It will be office and apartment sectors. The office sector because there are a number of portfolios with mark-to-market rents that are undervalued. Additionally, apartments are underweighted by most pension funds.

Ferguson: The shopping center sector is of great interest to some of the private equity buyers. However, many of the better quality shopping center companies are trading at premiums, so they might not represent attractive targets at this point in time.

Block: Let's move on to globalization and investing internationally. How should U.S. REIT investors think about this, and how should the typical U.S. investor allocate capital between U.S. and international real estate?

THE KEY GOING INTO 2008 WILL BE THE DEMAND RESPONSE AND THE POTENTIAL REBOUND IN THE PRIMARY PROPERTY TYPES, SUCH AS OFFICE AND INDUSTRIAL. CHRISTOPHER HALEY WACHOVIA SECURITIES

Ferguson: For investors who don't look strictly at the U.S., it's logical for many reasons to take a global perspective for their real estate allocations. First and foremost, you triple the size of the universe of public real estate companies when you take a global view. The U.S. has about 35 percent of the global universe of real estate companies.

Block: How should REIT investors look at U.S. REITs that invest abroad?

Horowitz: From our vantage point, the estate estate business lends itself only in certain circumstances to international investing. First, the REIT must have certain operational efficiencies and an appropriate cost of capital to compete in the various markets. Second, REITs need to understand the tax, currency and hedging issues. Additionally, REITs need to understand that operating in various time zones and new jurisdictions is very challenging and requires the right personnel.

Ferguson: There are exceptional global companies that prove a global approach can be implemented. However, those companies are often exceptions, rather than the rule. Investors should be wary of companies going abroad simply for the sake of diversification.

Haley: We try to look closely at companies that are initiating a non-domestic strategy from the perspective of risk mitigation. We assume that returns are generally higher and the return on investment (ROI) is higher abroad than domestically. The domestic market is more mature, and some of these other markets provide substantial development and investment opportunities.

Rosen: There's a bit of a rosy-eye view of globalization. You are not necessarily going to get higher returns, but you are getting diversification of the return stream. You can get higher returns in some developing countries, but in places like Japan, Germany and England, we think you can actually have lower returns because of the maturity of the markets.

Block: The relative performance of specific sectors within the REIT industry can be volatile from year to year, but many REIT investors like to overweight or underweight specific sectors. What sectors would you recommend investors overweight in 2008?

Haley: We attempt to provide sector overweight and underweight recommendations in a short time period. The key going into 2008 will be the demand response and the potential rebound in the primary property types, such as office and industrial. There is potential for a slow down in retail but supply in those sectors provides opportunities.

We have less conviction that supply will recede in most property types for 2008, but demand stability should be best in industrial. That will be followed by health care, which is a relatively small sector. Fundamentally, we're bullish on the office sector, given that the supply response to improved market conditions hasn't been high. We do think that we will get a demand rebound in 2008.