REITs Are Down, but for How Long?

THE enduring rally in real estate investment trusts finally ended this year as turbulence in the credit markets rattled the confidence of commercial investors and effectively halted the frenetic pace of REIT privatizations.

Now the question on some people’s minds is whether the downturn means that a lingering bear market is looming.

For more than seven years — from November 1999 through January 2007 — REIT shares soared in value, providing investors with average annualized returns of 23.6 percent. In 2006 alone, REITs climbed by an average of 34.4 percent.

But the market is poised to finish 2007 sharply lower. This year through Thursday, the REIT composite index compiled by the trade association had a negative return of 11.39 percent. The index of equity REITs, which own commercial property and constitute the bulk of the market, has fallen 8.63 percent.

Meanwhile, losses for mortgage REITs, which originate loans and invest in mortgage-backed securities, were a staggering 43.5 percent, on average. By contrast, the Standard & Poor’s 500-stock index is up around 6.4 percent so far in 2007.

“It’s been a very ugly year,” said Mike Kirby, a principal of Green Street Advisors, a real estate research company in Newport Beach, Calif., echoing the sentiment of many others. “It’s one of the worst performances we’ve seen in REIT land in a long time.”

Industry analysts and money managers, though, had been predicting for a while that the REIT market would run out of steam.

Fortunes reversed, they say, just as a giant private equity firm, the Blackstone Group, was completing its $36 billion acquisition of Equity Office Properties Trust, the nation’s largest office landlord. “That was when the market peaked,” Mr. Kirby said.

Indeed, part of the reason for the REIT run-up was the record number of mergers and acquisitions, about half of which involved leveraged-buyout deals by private firms with voracious appetites for commercial property. As investors tried to predict which REIT companies, or sectors, might be singled out next, share prices surged.

Last year, there were 23 announced transactions totaling $106.15 billion, including the assumption of debt. But so far this year there have been only 18 transactions totaling $68.69 billion. Only one deal has been announced since July 25.

Analysts attribute the falloff to a reluctance among financial institutions to provide loans for buyouts in light of the credit squeeze that swept through the subprime mortgage market as the housing market softened.

Because REITs themselves typically have only moderate levels of debt, they have generally fared well in the credit crisis; the noted exception, of course, has been mortgage REITs.

Nonetheless, concern has grown that the credit problems may eventually weaken the economy and therefore hurt demand for commercial space.

Real estate fundamentals are still in pretty good shape by historic standards. Occupancy is in the low- to mid-90 percent range across the board by geographic and property types, and there’s positive rental rate growth.

But even though these business fundamentals are relatively strong, securities prices have dropped. REIT performance, Mr. Kirby noted, “had been pretty decent at the operating level and poor at the share level.”

Whether REIT shares stay depressed is open for debate. The last bear market, in which annualized losses averaged 13.18 percent, lingered for 23 months until November 1999. The one before that lasted 14 months, from August 1989 to October 1990, average annual returns during that market were a negative 20.86 percent.

“REITs have been in a bear market pretty much all year,” said Ralph L. Block, the author of “Investing in REITs” (Bloomberg Press, 2006) and the publisher of The Essential REIT, a newsletter. “I think the key to forecasting what REIT stocks do in 2008 is determining whether the U.S. is going into a recession.”

Our good friend Paul E. Adornato, a senior REIT analyst at BMO Capital Markets, agreed. “This is the key uncertainty going into 2008,” he said, adding that investors “will be focusing on the macroeconomic issues — rather than real estate fundamentals — such as job growth.”

But we also think that investors must overcome a perception problem. I call it a perceptual connection. Investors are hearing that real estate is softening, so they think that that must mean all real estate is bad. They don’t stop to think that the value of their homes in which they live and the office buildings in which they work are two very separate markets.

At the same time, REITs seem to be lumped in with all financial stocks right now, noting that shares of financial services companies have been beaten down because of losses in their mortgage-backed securities businesses.

Still, we maintain that REITs have a lower correlation with most other stocks and bonds — in other words, they tend not to move in tandem with them — and that this makes them good portfolio diversifiers. Although we have seen the group get hurt when the general market goes down.

Now may be a good time to buy, citing industrywide data that shows REITs over all trading at a significant discount to asset value. According to Mr. Kirby of Green Street Advisors, the current average discount to net asset value is around 20 percent. For a long period of time they were trading at a premium. Let us hope this is not a value trap...

We ususally focus on the larger, so-called blue-chip REITs with excellent management, strong balance sheets and good business models. They also pay out regular dividends.

We particularly favor the REITs in the industrial sector — one of the stronger performers, with an average return of 9.13 percent so far this year — which invest in warehouses and distribution centers. This sector includes companies like ProLogis Trust. Prologis is rapidly expanding into Europe, China and India. Their global exposure will insulate them to some degree to the economic softness domestically.

We are less enthusiastic about the office sector, which has posted losses of 14.52 percent, on average, so far this year, and the apartments sector, which has had negative returns of 18.69 percent. Multifamily housing will continue to face head winds based on the oversupply of single-family homes for sale. Landlords have less pricing power. Although there are some office REITs that should be more resiliant to the slow down despite their stock price dropping dramatically. Stocks such as Corporate Office Properties for example. With a high percentage of their portfolio leased to government security agencies, an economic slowdown should not hurt them.

There are other REITs that we like that have come down in price. Call us if you want to discuss them...