Real Estate Investment Trust Outlook - July 2010 - Zacks Analyst Interviews

The U.S. Real Estate Investment Trust (REIT) industry that witnessed two strong back-to-back performances in first quarter 2010 and fourth quarter 2009 somewhat lost its momentum in its fiscal 2010 second quarter. The FTSE NAREIT Equity REIT Index reported total returns of negative 3.05% in the second quarter, vs. a 12.5% and a 10.6% loss for the S&P 500 and the Dow Jones Industrials, respectively.

Although total returns as measured by the FTSE NAREIT Equity REIT Index remained well above the S&P 500 and the Dow Jones Industrials, it declined drastically from 10.0% in the first quarter of 2010 and 9.4% in the fourth quarter of 2009.

The lackluster performance of the FTSE NAREIT Equity Index is primarily attributable to broader stock-market concerns fueled by the European debt crisis, which prompted investors to cut back their holdings. With the falling euro and strengthening dollar prices, speculations were rife about possible increases in cost of borrowings around the world that could destabilize global currency markets.

However, the quarterly REIT results have been quite good, reflecting the stabilization of market fundamentals, as well as low interest rates and government policies, including low mortgage rates, tax credits, increased FHA (Federal Housing Administration) lending and a government-sponsored slowdown in distressed liquidations.

Earlier in 2009, REITs and REOCs (Real Estate Operating Companies) raised nearly $38 billion in an industry-wide push to recapitalize balance sheets, and over 90 secondary equity offerings were issued in addition to 37 unsecured debt offerings. However, once the economy showed positive signs of revival, REITs are leading on the way back up. With gradual stability in the overall industry, sector dynamics and individual companies’ strategies are currently receiving greater attention to capitalize on future growth potential.

The standout performance in the industry during the second quarter was that of the apartment REITs (a total return of 7.3% as measured by the FTSE NAREIT Equity REIT Index). The underperforming sectors were industrial REITs (-14.2%), followed by shopping-center REITs (-8.5%), lodging/resorts (-8.2%), office sector (-6.5%), regional malls (-2.1%) and healthcare REITs (-1.5%).  

OPPORTUNITIES

Many REITs are still trading at discounts to NAV (net asset value), traditionally a good "buy" signal. Over the past 7 or so years, REITs had traded near or in excess of NAV.

With dividend cuts and share price gains, the average yield for equity REITs during second quarter 2010 was 4.1%, compared to 3.0% for the 10-year Treasury, as most companies have been raising cash through asset sales and equity financing to pay down debt.

The credit freeze will have a positive effect on commercial real estate down the road; new office, apartment and retail construction has slowed considerably, which will benefit owners in a couple of years. Many companies that we cover have stopped all-new construction.

In this environment, we remain bullish on UDR Inc. (UDR), one of the best-positioned apartment REITs in the U.S., with the majority of its portfolio located in California, Florida and on the Atlantic Coast. These are areas where housing costs have soared in the past few years, and despite the drop in home values, the rent vs. own spread still remains high.

The housing meltdown will continue to help apartment REITs and we expect this sector to remain comparatively stable in the coming quarters. In addition, UDR’s properties are geographically diversified that increases investment opportunity and decreases the risk associated with cyclical local real estate markets and economies, thereby increasing the stability and predictability of earnings. Furthermore, UDR has continuously upgraded the overall quality of its portfolio by selling smaller market, older properties and replacing them with newer assets in better long-term markets.

We also like well-capitalized companies that have adequate liquidity and manageable near-term debt maturities. Currently, we are bullish on American Capital Agency Corp. (AGNC), a mortgage REIT that invests exclusively in agency securities for which the principal and interest payments are guaranteed by U.S. government agencies like Ginnie Mae, Fannie Mae (FNM) and Freddie Mac (FRE). The company has a conservative balance sheet and maintains adequate liquidity sufficient to continue operations under potentially adverse circumstances. Furthermore, American Capital is one of only a few companies to have increased its dividend during the economic downturn.

Another stock worth mentioning is Simon Property Group Inc. (SPG), the largest publicly traded retail real estate company in North America, with assets in almost all retail distribution channels. The geographic and product diversity of the company insulates it from market volatility to a great extent and provides a steady source of income. Furthermore, Simon Property’s international presence gives it a more sustainable long-term growth story than its domestically focused peers.

WEAKNESSES

REITs still depend on access to capital to fund growth, and with the credit markets still not fully back to normal, it is difficult to raise money for new developments/acquisitions. In this scenario, most REITs are raising capital through property level debt, dividend reductions and equity offerings.

Although both debt and equity financings provide the much-needed cash infusion, they could potentially burden an already leveraged balance sheet and dilute earnings. Property level debt is also harder to obtain and more expensive as commercial real estate prices remain under pressure.

Fundamentals are declining in many suburban office markets as corporate expansion continues to slow. More and more corporations are putting off leasing decisions until the economy recovers. Recent employment trends are also not encouraging as the U.S. economy continues to shed jobs at a rapid pace.

Year-to-date, the U.S. has lost over 8.4 million jobs since the start of recession in December 2007. The national unemployment rate has also remained relatively high at 9.7%. As the U.S. economy struggles with the economic downturn, REITs will have trouble holding tenants and leasing new space.

Given the market uncertainties, we are bearish on ProLogis (PLD), an industrial REIT that leases industrial facilities to manufacturers, retailers, transportation companies, third-party logistics providers and other enterprises with large-scale distribution needs. The continued troubles in the residential sector are weighing on commercial property operations.

The credit crunch has also widened the bid-ask spread between buyers and sellers of commercial real estate, which has caused deal volumes to fall dramatically. In addition, market vacancy increases will mitigate ProLogis’ ability to push through rental rate increases. This has significantly affected the top-line growth of the company.

We would also avoid The Macerich Company (MAC), a shopping-center REIT. Macerich has an active development pipeline, which increases operational risks in the current credit-constrained market, exposing it to rising construction costs, entitlement delays and lease-up risk.

In addition, the prolonged recession has led to increased tenant bankruptcies, which in turn have resulted in a decline in occupancy and an increase in vacancy rates. This has affected the top-line growth of the company and puts considerable pressure on maintaining its profitability through stringent cost-cutting measures.Zacks Investment Research