In the real estate investment trust world, the motto right now is "Build, baby, build"-not skyscrapers. Not malls. Not green bungalows on Park Place.

No, right now REITs have to build capital. And fast.

Empty skyscrapers dotting the landscape have always offered the most piquant symbol of economic collapse. After it was finally finished in the early 1930s, the Empire State Building became a half-empty sentinel standing over Manhattan, a reminder of the hubris of the long-gone economic boom of the 1920s (a project redeemed at first only by its observation deck tours and its featured role in King Kong). Later, there was the "Intel Shell," a half-finished Intel building in Austin, Texas. When the tech bubble burst, the company halted production in 2001, but the five-story building continued to blight the city skyline until early 2007, its rebar tentacles waving in the air, until it was finally dynamited while crowds cheered on.

It wasn't supposed to happen this time. Putting aside for a moment the overheated housing market, the bull years of the mid-2000s were not so much characterized by the rampant overbuilding of new malls, hotels, office parks and skyscrapers, say portfolio managers. Because supply was in check, some believe REITs should have been in a better position to weather a downturn.

But then came 2008. Not only were REITs slaughtered like everything else, but they dipped even farther and faster than the S&P by some measures. The SPDR Dow Jones Wilshire REIT ETF fell 42% for the year. Those declines quickly wiped out much of the breathtaking 328% returns the sector experienced from Jan. 1, 2000, to the end of 2006. From that peak in February of 2007, the index had lost 60% of its value by the end of 2008.

As it turns out, the cheap debt that has undone other sectors of the economy has stained the hands of REIT owners as well, and the sector is awash in leverage these companies are now struggling to cover at the same time the economy sours and rents plummet.

A case in point is the stunning crash of General Growth Properties, one of the largest mall owners in the country with more than 200 shopping centers. The company declared bankruptcy in April after its stock price dived by a vertiginous 97% in 2008. The reason for its Chapter 11 filing was not that it lacked cash flows, say portfolio managers, but that it had so laden itself with debt it could no longer refinance it all.
Southern California office space owner Maguire Properties is another company facing enormous debt maturities in 2009, enough that Morningstar has given both it and GGP zero fair-value estimates.

"General Growth is basically one of the worst, if not the worst, in this space," says Morningstar equity analyst Joel Bloomer. "Their issue was
being overleveraged and having a lot of debt come due at the worst possible time. Maguire is very similar to General Growth. They just way over-levered kind of at the peak of the bubble, and they paid too high of a price with a huge amount of debt for properties they acquired."

Other REITs, using the lubrication of easy lending terms to pursue growth, are now going to have to spend time bulldozing the bad stuff off their books-at a time when banks have frozen lending and are not as liable to refinance.  

Meanwhile, the bad economy has crimped need for retail space, hotel space, and office space, making for scarcer occupants, pruned rental income and diminishing real estate value. Thus REITs have been whipsawed, finding themselves having to go out and find more loans when the value of their collateral has fallen. The regular method of rebuilding capital-dumping property-is hard to do when everyone's got buildings on the block.

Investors might think now would be a good time to go in and find good deals-great buildings unfairly valued in the economic malaise. Indeed, Bloomer recently wrote in a Morningstar report that the firm's universe of REITs is 26% undervalued (with a 74% price to fair value). But the outlook for these companies is so uncertain that his group now says it wouldn't recommend purchasing a REIT stock unless the discount was 50%. Bankruptcies are likely, says the report.

"The whole space is exposed to the lending environment," says Bloomer, "and until that improves, most REITs are at risk. We think the space as a whole is cheap, but we're not really recommending very many until we get more clarity."

Another attractive REIT feature that should be tantalizing investors is the rising dividend yield. REITs are particularly juicy income investments, since they are required to pay out 90% of taxable income every year as dividends.

But even that has become a phantom feature, less tantalizing now when downward rent pressure and more desperate capital needs have forced many companies to cut or suspend their payouts. The yields may be at historic highs, but poor cash flow makes a lot of those dividends untenable. "We own some [REITs] but not very many because we like dividends and we're concerned that so many of them have reduced or had to eliminate dividends," says financial advisor Bob Haley, president of Advanced Wealth Management in Portland, Ore.

In their rush to recapitalize, many REITs have begun bringing new shares to market. Some analysts look askance at that, suggesting that it dilutes existing share prices. Cash-poor companies are also paying out dividends with more stock-a surefire way to anger investors who had come to the party for income.  

One REIT offering shares for dividends, says Bloomer, is Simon Property Group, an industry leader that will likely prompt others to follow the same strategy.

Good News?
To the extent that there's any good news in this space, Paul Curbo, a manager at the AIM Select Real Estate Income Fund, says it is that the sector is indeed poised for a good recovery when the economy heals itself. Although he concedes that the industry is going to be smarting for a while, that's mainly because of what's happening in the broader economy with the financial and liquidity crisis-and it has less to do with the inherent weakness of the asset class. The fundamentals of the companies themselves are fairly good, he says.

"Roughly in the last 30 days [ending April 27, 2009], REITs have raised roughly $6.8 billion of new equity capital," he says. "So I think that that's a good indication that investors are supportive of the asset class, supportive of the companies that have those good fundamental characteristics from a real estate perspective, and that companies are able to raise capital and move forward."

Those that are going to be the most successful, he says, are the ones taking a multipronged approach to refinance their debt maturities-by selling assets, delaying or reducing capital expenditures or raising new equity. He likes it when these companies bring new issues to market.
"I think the market has responded positively to it because it just shows that that source of capital is open to them," he says. "I don't think it's a cure-all, and I think the company management teams have been pretty forthright about indicating that they realize that there are a lot of different things that they can do in terms of reducing development, selling assets and refinancing debt. It can't just be equity offerings."

Curbo says his fund, which is rated five stars by Morningstar, has tried to shore up performance by focusing somewhat on the debt side of the equation-buying highly rated mortgage-backed securities and certain REIT corporate debt issues. "The idea being that until the credit markets stabilize and until the legacy paper begins to normalize in terms of its spread, the equity market is going to experience continued volatility and is going to have a tough time having a sustained rally until the debt markets are operating in a little more normal manner," he explains.

Bloomer says that as long as capital remains tight and banks aren't willing to refinance debt that's coming due, we're going to see more stress in the space. "As things are right now the pain is definitely not over," he says. "If lending does return in a short amount of time, things will improve. But the problem is we're not overly optimistic that that's going to happen yet.

"Dividend cuts will probably become more common," he adds, "and they're not going to return until that capital picture improves and they know they can rely on the banks to roll over their debt on reasonable terms. And it's very hard to predict but all indications now are that we're still at least year or two away from that."