Block

By Ralph Block

I’m not a meteorologist, and I don’t know if the storm in which we find ourselves is “perfect” or otherwise. However, it’s clear that tumbling home prices, high energy costs, soft consumer spending, falling employment and—scariest of all—a jolting credit crunch have combined to create some very heavy weather for investors. Whether some arcane group of economists places the “R” word on the U.S. economy is less important than whether we can muddle through.

The depth and duration of the current weakness, as well as the shape of the eventual recovery, is unknowable. Yale’s Robert Shiller believes that GDP growth will be very slow for the next several years. All that we really know is that today’s investors are risk-averse, focusing on capital preservation—perhaps for good reason. Being frightened is sometimes rational.

So how do REIT investors want their REITs to comport themselves in this tricky and difficult environment? A strong balance sheet is absolutely essential. We are all hopeful that the credit crunch will abate soon, but history has shown that broken credit markets are often not quickly repaired. Investors today are re-learning that high debt leverage can extract a very costly penalty when credit and space markets become difficult.

The best-situated REITs will be highly liquid; investors are placing a steely eye on free cash flow and available credit lines, as well as debt maturities and development commitments. Bolstering the balance sheet and augmenting liquidity is probably a REIT management team’s single most important task today.

Improving cash flow stability—perhaps by aggressively leasing vacant space and renewing leases early (albeit at a cost)—will also be important. Additionally, smart management teams will focus on cost control. Investors are more concerned with preservation of cash flows than how rapidly they will grow this year.

In this environment, capital allocation is as important as balance sheet strength. With both debt and equity less available and more expensive, REIT investors will be judging REITs by how they deploy precious capital. Free cash flow is never free—especially now.

The REIT industry has impressed the skeptics in recent years by becoming well-disciplined on the acquisition front; many REITs have been net sellers. Although attractive acquisition opportunities may open up over the next 12 months, perhaps in response to property debt that can’t be rolled over, most investors want REIT management teams to remain highly disciplined.

Stock buybacks provide a good opportunity to increase equity values in this environment, and with little risk. However, a decision to allocate capital to buybacks should be made only after weighing all variables, including the size of the stock’s NAV discount, the expected direction of cap rates and prices, balance sheet strength and liquidity, and the prospective risk-adjusted returns from other opportunities.

Many REITs have created shareholder value through a well-conceived development strategy. However, given the REITs’ increased cost of capital and the heightened risks in development today, every project should be examined with the care that my dog Sammy uses when approaching an unknown pit bull. Will investment returns comfortably exceed the REIT’s increased capital costs? Is there enough of a profit margin to justify the project, particularly when compared with less risky uses of capital?

Every sector of REITdom is different, and so are the business strategies and skill-sets of each REIT. However, investors will be much more inclined to add to their investments in REITs that “get it” and are responsive to today’s particular challenges—and are likely to sell the shares of REITs that don’t. F