When the Federal Reserve cut interest rates on September 18, there was one immediate and inexorable effect: REIT prices popped up like a line of Mexican jumping beans on a griddle, some of the most notable ones posting between 3.5% to 7.5% gains.
The Fed's interest rate cuts gave a momentary boost to a sector that had been having a miserable year-and which was said to have wandered into bear country for the first time in a decade. Saving them from the mauling, at least for now, was the Fed, since lower interest rates (i.e. credit to borrow and develop) usually equal happiness in the real estate world.
Still, it seems to most observers that maybe the great REIT run had finally ran out of gas this year. Whether it was their worries about inflation, worries about people spending less money at malls, fears of embattled Wall Street firms ditching office space, clammy hands at the persistent threats of higher interest rates-or even terror that circling private equity sharks ravenous for cash-rich companies were driving up the prices too high-it didn't matter. REIT investors finally got vertigo in February and started to sell. Share prices plunged, reaching a negative 15% this year at their lowest in July. With wind from the Fed at their back, however, they nicely rebounded to just a squeak above positive with a 0.62% total return as of October 8, according to Bloomberg.
Before the turmoil of 2007, REITs had enjoyed amazing success for the past seven years. From January 1, 2000, through December 31, 2006, the S&P 500 index's cumulative return was 8.15%. The Dow Jones Wilshire REIT Index's cumulative return, meanwhile, was 328%, according to Morningstar, and the MSCI U.S. REIT index had a 306% cumulative return. (The Lehman Brothers Aggregate bond index was 54.93%.)
When REIT prices started to fall, it made some wonder whether now might be the time to start looking for buying opportunities and bulking up on the asset class in portfolios. And for some planners, the answer is still a resounding "no." Just look, they say, at those still-nosebleed prices.
"We're not seeing valuations right now anywhere close to what we saw 10 years ago when we were pounding the table for REITs," says financial advisor Stephen Barnes, at Barnes Investment Advisory in Phoenix. "Back before this whole bull-market run in REITs, we were carrying 10% weight in client portfolios. We're probably at 1% [now] and have been for quite some time for the last couple of years."
Louis Stanasolovich, who heads Legend Financial Advisors Inc. in Pittsburgh, also says he thinks that publicly traded domestic REITs across the board are priced too high, and that it will take at least a couple of years, amid decent single-digit earnings growth, for the prices to readjust. Part of that is the worry that the denominator in this equation-the underlying value of the real estate-will also fall.
"One of the things you have to remember is that the underlying real estate itself is high as well because interest rates have been so low," Stanasolovich says. "Real estate of all sorts has been purchased at 4% and 5% cap rates," he says, referring to the rate achieved by taking a building's net operating income and dividing it by its purchase price. "Which means you're investing to get a 4% to 5% return. That is a ridiculously low return for an illiquid investment."
He suggests that a two-year period is needed to sniff around the market. "I think it's a two-part adjustment," he says. "REITs will get cheaper because earnings will be decent, growing earnings and dividends at 7% to 8%. On a total return basis, I would expect domestic REITs to lose 5% to 10% over the next couple of years from this point forward."
Bob Haley, president with Advanced Wealth Management in Portland, Ore., says that despite the Fed's short-term moves, other factors affecting REITs make him wary in the intermediate term, such as inflation, which he thinks is worse than the government is letting on, and means rising interest rates that will indeed hamstring the real estate market. He also thinks that after the seven-year run-up, Wall Street money has simply decided to cycle out of the asset class for now, and that this ebb tide is one of the many things hurting the share prices.
However, he stresses that he is bullish on REITs in the long term. "While on its face this might look like an attractive time to be an aggressive buyer of REITs, that will only prove to be true in the short run if the asset values do not decline as rapidly as the stock prices have declined," Haley says. "I am still strongly of the opinion that a three- to five-year time frame, especially five years and longer, is an excellent time to buy as long as you can be patient and as long as you can use the cash flow."
Cash flow is the big selling point. Planners like REITs for several reasons. Because they must pay out so much of their income (90%) to investors, these securities make a great source of yield for those in need of steady liquid cash. Because they are based on real estate, they are not correlated with stocks (though some see the two asset classes chasing each other). Furthermore, because they are traded like stocks, their cash flows are very transparent. Even better is the fact that this cash is coming from rents, which tend to keep going up over time, not down. And earnings are expected to keep growing in this landlord's market.
A Good Foundation?
The thing that no one can agree on, however, is whether REITs are currently a decent value. And that's where the art comes into it.
With prices on REITs down this year, they have begun trading at a discount to net asset value. (According to Green Street Advisors, they were trading at a 15.7% discount to net asset value as of September 4, 2007, before the interest rate cut.)
However, others are more bearish on the earnings multiples (price to adjusted funds from operations) which they say are still too high compared with the overall stock market. Meanwhile, some look at cap rates and say those are too low, while still others counter that cap rates are just one data point, one that can be declining on a company that still offers attractive overall returns and embedded growth.
"Cap rates are actually only a good indication of cash flow in year one," says Joel S. Beam, a portfolio manager with Kensington Funds in Orinda, Calif. "Cap rates generally reflect growth expectations for any given asset-a low-cap rate doesn't tell you anything in and of itself because you don't know what the growth profile is behind those assets."
Though analysts concede that this year has been rough for REITs, they say the underlying reasons are more complicated than first meets the eye, and a lot of them have to do with credit. "REITs have been underperforming this year for a variety of reasons," says Heather Smith, the head of the REIT team at Morningstar in Chicago. "There has been some concern about the fact that we have rising interest rates. That's expensive for REITs, which have large development pipelines with large floating-rate debt."
The subprime mortgage debacle has also played a part, but not for the reasons one would think. After all, commercial REITs mostly have nothing to do with residential home lending. But indirectly, the fear in the credit markets has made new pricing for all new debt a bit of a wild card, and indirectly led to fear that developers would not get their hands on the easy capital they need to develop and acquire.
"A lot of what drives these REITs and their growth is the ability to develop properties," says Barnes, "And what I'm hearing from a lot of the commercial guys is that everybody's afraid to do anything right now because nobody knows how far the problems extend."
Says Michael Grupe, the executive vice president at NAREIT: "The lesson that the REIT industry has taught the investment world is that the way to solve that [credit] problem is not to use too much leverage. And rather than financing a property with 90%-95% debt, the REIT industry finances with 40%-45% debt."
Another wild card is that REITs this year became victims of their own success and attracted the private equity mob-firms seeking cash-rich companies that would help them pay off the heavy leverage in their deals. The REIT success story of the year, of course, and in many ways the culmination of the bull market, was the monster buyout, in February, of Equity Office Properties Trust by Blackstone Group LP for a reported $39 billion, the largest reported privatization of a publicly traded real estate company. On the heels of that came a deal in May for Archstone-Smith Trust by a partnership sponsored by affiliates of Tishman Speyer and Lehman Brothers Holdings Inc. in a transaction valued at approximately $22.2 billion, the second-largest such deal, according to reports.
One of the reasons that prices fell this year, according to Tom Bohjalian, senior vice president and portfolio manager at Cohen & Steers, is that the share prices had gotten ahead of themselves after the sale of Equity Office, which sent a lot of cash recycling back into the market. "The Equity Office transaction drove up a lot of prices because it was a cash transaction and money got recycled back into REITs and drove prices higher," he says. In addition, the price tag on Equity Office made some of the stocks trade higher than they probably would have given their "a bit more modest" growth profiles, he says-causing them to trade at NAV premiums instead of discounts.
Without all the smoke and mirrors and mania, Bohjalian says that his firm right now views REITs as relatively cheap and says that they can still deliver mid-to-high single-digit earnings growth. "We think there will be a little deceleration in the growth in 2008, and some of the effects of the slower economy will filter through the fundamentals of real estate, but then there should be a re-acceleration as we go into 2009."
On a price multiple basis, he says that the stocks are indeed trading above historical earnings levels: "about 15x versus 12x historically." But he also thinks that the growth rate today and over the next several years will also be above the historical growth rate. "Just like with any other stock, you're willing to pay a higher price for that higher growth. Where you have to be careful is where you have massive deceleration in growth, and that is where you're willing to pay less of a multiple for that growth."
Beam believes, as does Bohjalian, that evaluating REITs demands looking beyond the simple liquidation value of the assets and cap rates. He says looking at the price based on net asset value alone doesn't take into account the management expertise of these companies and the ability of their boards to squeeze a dollar from a dime.
"Many of the valuations that are done, including our own, can be conservative," says Beam. "They often don't attribute any franchise value, any kind of premium for a going concern value. They don't consider how somebody would pay a premium for a portfolio of assets that would take a career to assemble. ... But I do think that [REITs are] not the kind of deep-value, pound-the-table value they were at in '98. I mean, it was a bloodbath in '98. We had great companies paying out 70% of free cash flow and the yield on that was 8%."
Values To Be Found
Says Beam: "We think the home run model for REITs is to grow cash flow over time, grow NAV and grow a dividend rate that's lower than cash-flow growth. We want companies that will grow at 5%-7% a year. If they can grow that dividend at a 4% yield level above a 3% inflationary environment, we think that's a home run value proposition."
Like many others, his portfolio owns office REITs Vornado Realty Trust (a one-time bidder for Equity Office) and SL Green Realty Corp., both of which were off their February 8 highs of this year, the former by 18% and the latter by 26.9% as of September 24. "Look at a company like Vornado," Beam says. "The way they add value is really over time through land acquisitions, entitlement and development-all the classic ways of growing value in real estate. It's off ... its highs in February, even though they probably have one of the most enviable long-term track records in the business. We don't advocate market-timing, but it's down considerably from its highs. You can't put spot-NAV on this company to be fair because it is up-zoning the entire area around Penn Station. That provides value that's difficult to quantify."
Like Kensington, Cohen & Steers also owns Vornado and SL Green. Bohjalian says Cohen & Steers right now sees value in office REITs. Though he concedes there's a perception that New York City real estate, for instance, will be hurt by what will happen in an economic downturn on Wall Street, he believes that even if there is some loss in financial jobs, it wouldn't affect the office market overall because of the underlying dynamics of the market.
"If you've got to lay off 500 out of 25,000, it doesn't change space requirements," he says. "And the other thing about this cycle that's different from 2001-in the early part of the decade companies were stockpiling space for growth, so they were taking more space than was actually needed, and that's why we had an environment where the economy really slowed. There was extra space. As we sit here today, they haven't taken more space than they need. We're using the space we have today."
Indeed, while he understands why REIT prices dropped this year, he says they overshot in the other direction because there hasn't been the kind of overbuilding that has resulted from past booms. "Typically, real estate fundamentals get in trouble when there is a lot of new supply and you can't meet that supply with demand," he says. "In this cycle we have had very little supply. That's part of the reason we've had such good real estate fundamentals-greater supply is less than demand and this is what we believe is a midcycle slowdown versus a recession."