REITs begin to separate from financials

By Allen Kenney

Outward perceptions often mask inner realities. For example, at the beginning of the 2007 NFL season, the New York Giants looked like a team on the verge of disaster.

After decisive losses in the first two games of the year, coach Tom Coughlin's job was hanging by a thread, and fans were booing quarterback Eli Manning. Five months later, however, the once left-for-dead Giants were crowned Super Bowl champions in February 2008, following a historic upset of the heavily favored New England Patriots.

The Giants' story might feel familiar to today's most faithful REIT investors. It's no secret that REIT stock prices have declined since reaching an all-time high in February 2007, a downturn aggravated by a major pullback in the credit market and a weakening overall economic outlook. In the one-year period ending February 2008, the FTSE NAREIT Equity REIT Index saw a 24 percent decline in total return.

Coming off the first quarter 2008 of outperforming the broader markets, however, it could be that REITs are turning a corner, even if it involves an occasional step back after taking a few forward.

"In these uncertain times, investors are looking for businesses with relatively stable earnings and current income, and we believe REITs fit this bill," says REIT analyst Shawn Barnes of Edward Jones. "The short term may see further headwinds, but we think the long-term story remains intact."

After all, business performance among REITs has remained strong throughout the correction. Meanwhile, industry leaders and observers seem to be gaining confidence that the investing public will catch on to the value opportunity presented by REITs sooner or later.

Don't Believe Everything That You Read

Take Hamid Moghadam, chairman and chief executive officer of industrial REIT AMB Property Corporation (NYSE: AMB), for example. He doesn't seem particularly worried by downturns in the REIT market. Even though AMB's stock price had fallen approximately 20 percent between mid-February 2007 and March 2008, Moghadam says market tempestuousness is nothing that he and other real estate veterans haven't seen before.

"I've been through four of these cycles, and every one is different. When everybody says the sky is falling, that normally means that it's a good time to get in the sector," Moghadam says. "Wall Street doesn't always get valuations right."

AMB, which owns a portfolio totaling 150.2 million square feet of industrial property worldwide, has seen the highest growth period in company history during the last two years. In April, the company reported 14 percent year-over-year FFO per share growth. Like many other industry leaders and observers, Moghadam contends that the fundamentals of his company and the market in general remain strong, despite the recent flood of bad news.

"The underlying business environment is surprisingly strong, given what you read in the newspaper," Moghadam says.

Hamid Moghadam

I’ve been through four of these cycles, and every one is different. When everybody says the sky is falling, that normally means that it’s a good time to get in the sector. AMB Property Corporation

Constance B. Moore, president and CEO of apartment REIT BRE Properties (NYSE: BRE), takes a similar view of her company's prospects. She notes that BRE saw core earnings growth of 16 percent in 2007, and the company is forecasting increased earnings this year as well. The company's stock, however, was trading at a discount of approximately 40 percent to its net asset value as of late March.

"There's clearly a disconnect between fundamentals and stock price," Moore says. "On the ground, we still have pricing power."

William Hauser, who recently joined the global securities team at the real estate investment arm of Prudential Financial, PREI®, also contends that the general market instability actually has had a "muted" impact on the REIT sector so far. He notes that fourth quarter earnings from 2007 generally met or exceeded expectations.

Going forward, Hauser says he expects "relative stability of REIT earnings versus the broader market." He points out that while analysts' estimates for REIT earnings have trended lower since the beginning of 2008, the downward revisions have been less dramatic than those seen in the general market. Additionally, REITs' earnings guidance has been "more upbeat than less-sanguine analyst expectations."

What Happened in 2007?

So what created these "less-sanguine" expectations and investors' skittishness about REITs? Experts have posited a host of factors, many of which are outside of the industry's control.

Jonathan Litt, former senior REIT analyst for Citigroup Investment Research who left the company in April to form real estate securities management firm Land & Buildings Investment Management LLC, attributes part of the REIT industry's 2007 performance to the public's questionable perception of REITs as financial services companies. Litt maintains that the hybrid nature of REITs, which take on characteristics of both real estate and more traditional equities, means that investors sometimes group REITs with the financial services sector. That sector has been battered by woes in the subprime mortgage market since last summer.

"The bank indexes and the REIT indexes stayed pretty well correlated" throughout 2007, says Richard Moore, who heads RBC Capital Markets' REITs research team. Moore said the trend in 2007 had been puzzling, as banks' fundamentals were deteriorating, while those of REITs held firm.

Hauser notes, however, that the market began to punish REIT share prices before concerns about the subprime market and general economic conditions had even started to surface, suggesting that those factors exacerbated a downturn that was already in motion. Ironically, Hauser credits the beginning of the decline to the REIT industry's previously strong performance.

Bill Hauser

Success begets success. Put differently, successive years of outperformance by REITs draw in trend-chasing capital, which, in turn, stretched valuations. Prudential Financial

"Success begets success," he says. "Put differently, successive years of outperformance by REITs attracted trend-chasing capital, which, in turn, stretched valuations."

Ken Rosen, founder of real estate investment firm Rosen Consulting Group, estimates that REITs were overvalued by 30 percent to 40 percent relative to stocks and bonds by early 2007. He contends that generous lenders helped fuel the run-up, thanks to easy credit and frenetic privatization activity.

"Credit was so easy that people could do privatization transactions and buy real estate at very high valuations," he says. "The downturn in stock prices occurred because we were overly valued in 2006 and the early part of 2007."

Moghadam notes that a prolonged bull run in any sector is bound to precipitate an eventual decline. He ascribes part of the quick sell-off in REITs to the same phenomenon that helped produce the sector's dramatic rise.

"At the first sign of trouble on the horizon, there are a lot of impatient sellers," he says. "Everybody has been trigger happy."

In other words, the same alpha seeking that accompanies a bull run can have an inverse effect when the tide turns. Performance-chasers start to head elsewhere when high-flying sectors start to dip, which only feeds the downward momentum. For example, after REIT-dedicated mutual funds posted positive inflows for the first three months of 2007, they saw outflows for the remainder of the year. When all was said and done, approximately $9 billion had been shifted away from REIT funds.

"After fund flows began to reverse course, the additional headlines related to residential real estate and a slowing economy caused further deterioration in share prices," Hauser says.

The dramatic slowdown in lending that persisted throughout the second half of 2007 and into the middle of 2008 has done little to ease the downward pressure on share prices, according to Litt. He pinpoints The Blackstone Group's purchase of Equity Office Properties in early 2007 as the last great moment of the previous upswing, which was characterized by an "incredible amount of easy debt." Investors began to jump back from REITs as the rapid developments in the financial markets that began in mid-2007 caused the debt markets to dry up, according to Litt.

A Good Deal

Total returns for the FTSE NAREIT All REIT Index stayed relatively flat during the first three months of 2008, declining just 0.42 percent. The industry's performance was bolstered by a strong March, in which the index's total returns climbed 3.88 percent. Conversely, the S&P 500, Russell 2000 and NASDAQ Composite all declined between 9.44 percent and 14.07 percent for the first quarter of 2008.

Moore notes that REITs and the financial services sector "decoupled" in the first quarter. "It could be that investors have finally taken some note that the REIT fundamentals are better than the banks'," he says.

The analysts all hesitated to predict smooth sailing for the remainder of the year, though. Rosen, for example contends that REITs "aren't out of the woods," given the looming specter of recession. A deep recession could impact REITs' net operating income, and a weak income streak could yield further contraction in stock prices.

"The main issue going forward is, is income going to hold up," he says. "How bad is the recession going to be?"

Moore cautions that he still expects 2008 to be a "choppy" year for REITs, despite the first quarter's improvement. External conditions in the credit markets and broader equities could continue to weigh on the industry for the rest of the year, he says.

"It may just be a temporary thing," Moore says. "REIT fundamentals have been fine, but fundamentals don't seem to be what investors are paying attention to these days. They're more interested in the debt and equity markets."

Litt Leaves Citi Still Loving REITs Noted REIT analyst Jonathan Litt left Citigroup Research Investment in April to form his own real estate securities management team, Land & Buildings Investment Management LLC. After years spent researching and analyzing the REIT industry, current market conditions have Litt ready to strike out on his own. “It’s starting to feel like we’re getting toward the bottom of this cycle—if we haven’t already seen the bottom,” he says. “Frankly, the downturn was a big factor in my decision to start my own company. As a research analyst, my bias tends to be value-oriented. The idea of starting a real estate securities management company at peak levels wasn’t comfortable.” Portfolio caught up with Litt to discuss his reflections on his tenure at Citigroup and his thoughts on the future of the REIT industry. Portfolio: Looking back on your experience as a REIT analyst, what have been some of the more exciting developments during that period? Litt: I got into the business in 1992 when the U.S. REIT industry was valued at $15 billion. Today, that figure stands at $600 billion. REITs began to appear globally in 1995, and now there is a $1 trillion market worldwide. I think this just goes to show the acceptance by investors of real estate in the publicly traded form. The alignment of management teams with shareholders through some of the modifications to REIT laws has created a very viable vehicle for all types of investors to get exposure to real estate. That really ushered in the current global REIT era that we have today. Portfolio: Do you have any predictions or thoughts on where the industry is headed in the next five to 10 years? Any ideas what kind of trends we might see developing? Litt: The industry will likely continue to grow, and I suspect we’re going to see a lot of public offerings over the next three years. I think we’re going to see a couple of hundred billion-dollar REITs emerge. The U.S. market will likely grow to over $1 trillion. Expectations of a 10 percent to 12 percent return on REITs over the next five or10 years are realistic, and it’s what investors should expect. I also think that what we’ll see happen is dependent upon the cost of capital. We’ll see cycles of REITs using public capital versus private investment. We will continue to see an ebb and flow of that current trend.

The silver lining of this latest down cycle, however, is that it has left prudent investors awash in REIT bargains.

Hauser and Rosen point out that the deflation in REIT share prices has alleviated the overvaluation that was likely present in the market earlier. Additionally, investors new to the REIT market are facing a safer entry point than they did in early 2007, Rosen says.

"REITs are now fairly valued, while they were overvalued for the last year-and-a-half," Rosen says. Possibly "25 percent of the REIT industry is undervalued relative to their assets."

Industry observers also note that just as the frenetic investors pushed REIT share prices to the extreme during the last upswing, the subsequent downturn has probably been exaggerated as well. For example, the fact that implied cap rates on REIT shares have risen "farther and faster" than those of real rates for direct property indicates that there has likely been some overreaction on the market's part, according to Hauser. Additionally, while REITs have historically traded at prices near par, the companies' net asset values reflect a 15 percent discount today.

"It does seem as though there's a lot of cushion, given the size of the discount," Litt says. He speculates that the general REIT market decline has likely seen its end, even if the industry continues to "bounce along the bottom" for a short period of time. As a result, Litt foresees a narrowing of REITs' stock prices and NAVs in the near-term. In fact, Litt says that the attractive valuations now available in the market actually prompted his move to start his own real estate securities management shop.

"We're starting to see light at the end of the tunnel, and rationality is starting to return," he says. "I think we may have seen the bottom."

NAREIT research also suggests that REITs likely offer solid value buys for investors. The FTSE NAREIT Equity REIT Index's negative 24 percent total return as of February 29 matches the declines seen in the two most recent down cycles. Furthermore, REITs typically precede direct real estate on the way down and on the way back up, and a new transaction-based index report from the MIT Center for Real Estate shows the value of commercial properties owned by large pension funds declined 5 percent in 2007's fourth quarter.

While Hauser always encourages investors to maintain a consistent REIT allocation in their portfolios, he says REITs now offer especially appealing buying opportunities. For example, a downturn is likely to benefit what Hauser calls the "best-in-class" REITs with top management and strong balance sheets.

"Most of these companies will be in better position to fund transactions than many private market buyers," he says.

Faithful Giants fans who stuck with their team despite all the early season naysaying were rewarded for their patience with a world championship in 2008. AMB is looking for a more lucrative reward for keeping the faith. While the company's operating performance has remained strong, the drop in AMB's stock price spurred management to authorize a share buyback in the latter half of 2007

"REITs are a pretty good bargain right now," Moghadam says. "When the market behaves irrationally, we try to take advantage of that."

Investors are likely to follow suit soon, according to Moore.

"People aren't taking the time to understand the story of our company and the story of the whole REIT industry," she says. "When people start to see the relative strength of earnings and dividends, there will be a flight back to REITs."