Wave of privatizations suggests market still has legs.

    Poet Robert Frost famously wrote he had "miles to go before I sleep." The same thought might apply to REITs today. These recent stalwarts of the financial markets are holding their ground nicely-so far. Seven years of market-busting returns has barely dented their armor.
    But there are a few cracks starting to appear. If your REIT owns distribution centers, warehouses, regional malls or shopping centers, you will likely be pretty well insulated from the slowing housing market. But if it's a mortgage REIT you own, or it has residential-related properties, you may be subject to more risk and volatility. So just because you hear so much about a slowing real estate market, or real estate "bubble," does not necessarily mean your clients' REITs will all be impacted negatively by the residential slowdown and rise in interest rates.
    Still, REITs as an asset class have seen substantial appreciation over the past seven years, dividend growth has outpaced inflation during the past decade, and now may be a good time to lock in some of those profits. "Remember, you never go broke taking a profit," says Robert K. Doyle, a wealth manager in St. Petersburg, Fla. "A lot of money has left the financial markets over the past three years to go into residential, often speculative real estate. I am starting to see that trend reversed."
    It's not a slam-dunk, however. Some advisors like Doyle suggest taking profits. Other industry experts say it's too early-the market still has legs. Meanwhile, there's plenty of "hot money" entering real estate today, especially on the commercial side, much of it from institutional sources. So that's a vote of confidence.
    But there's no mistaking some cold winds are apparently gusting through the housing market today. As a financial advisor, just how do you evaluate individual REITs of your clients?
    In evaluating current real estate, it is important to note that there is limited correlation between the commercial and residential sectors. The strength of the commercial segment is driven more by an expanding economy, job growth, and the health of industries specific to the subject area. By contrast, residential sales are influenced more by interest rates, demographics (i.e., a large baby boomer population that's equity-rich and focused on family and home), job stability, immigration and other factors that are emotional in nature.
    Historically, commercial markets have been strong in weak residential markets, and vice versa, although a weak housing market can boost the residential apartment market, which is happening today, notes Pamela O'Connor, CEO and president of Leading Real Estate Companies of the World, a nationwide network of independent residential real estate firms.
    After September 11, 2001, housing benefited from low interest rates, which were driven down to 1%. There was tremendous availability of credit for home purchases, which resulted in appreciating values and further encouraged people to borrow against the value of their home. Now the rate cycle has reversed, interest rates are rising in the U.S. and there's a lag in the residential market.
    This is affecting the residential side of the REIT market. If you have clients in residential mortgage REITs, for example, they are probably hurting. Total returns on residential mortgage REITs have been volatile of late. They were up 42.73% in 2003 and posted a negative 25.95% in 2005. As of May 31, 2006, they were up 9.23%, according to the National Association of Real Estate Investment Trusts, or NAREIT. Moreover, there have been consolidation and conversions in this segment, further evidence of its troubles.
    But mortgage REITs are by no means the whole story in residential REITs. Residential properties-particularly rental units and retail units-appear to be holding their own, and there are indications of further strengthening in this segment. "What we're seeing in the rental apartment market, which had fallen sharply in terms of units being produced and increases in vacancies, is a tightening up, and we would expect to see increases in rents and production," notes Michael Carlinger, an economist at the National Association of Home Builders.
    Valuations in this segment appear high, however. The multifamily housing segment of REITs has delivered total returns of nearly 110% over the past three years relative to private residential housing and other REIT sectors, according to SNL Financial LC, a Charlottesville, Va.-based research company that supplies data to the industry. "REITs have outpaced the market for seven years now. In the reversion to the mean, the sector at some point has to underperform the broader market, and it may be time to take profits," says Glenn Doggett, assistant director of real estate for SNL Financial. "On the other hand, considering premiums paid in privatization transactions, there are still growth opportunities when looking at the market value of real estate owned by REITs."
    Indeed, a wave of privatizations has hit the REIT market recently with no end in sight. Private equity firms, along with hedge funds, pension funds and endowments, are looking for a slice of the pie-and finding it. Enamored by the large cash flow REITs generate from collecting rent and selling properties, these private investors are buying REITs and taking them out of public play. Figures from NAREIT show 17 transactions disclosed so far in 2006 worth an estimated $35.26 billion, fueled by the tremendous liquidity in real estate today to finance deals.
    What this suggests to some insiders is that certain segments of the REIT market are undervalued, and there is still some upside potential left in REITs.
    At a recent NAREIT conference in New York, considerable discussion centered on the large number of privatizations and their meaning to the REIT market. In a panel on the topic Paul Ingrassia, director and head of North American real estate at Citigroup, noted that from an average $12 billion in transactions annually between 2000 and 2003, the market quadrupled to transactions worth $50 billion in 2005, and the pace in 2006 remains strong. The activity is being driven by four factors, he said: equity flows, debt flows, management receptivity and the perceived spread between public and private valuations.
    Observers noted that Blackstone Group LP, the private equity firm, alone has been involved in seven such REIT transactions recently. The latest was a joint venture with Brookfield Properties Corp., a real estate operating company with offices in New York and Toronto, to acquire both Trizek Properties Inc., a Chicago-based REIT, and Trizek Canada Inc. in a transaction valued at $8.9 billion, including $4.1 billion in debt. In March, Blackstone bought out REIT Carr America Realty Corp. for $2.8 billion.
    In an interview following his presentation, Stephen Furnary, chairman and CEO of ING Clarion Partners LLC, a real estate management advisor, took a somewhat different view. "We're making a little bigger deal about this than it really deserves. There are many reasons why companies, whether they're private or public, step up and sell; it's really just relating to the life cycle of the investment. Many of the (deals) that have been done in the last year have had an arbitrage between the public and private, but that's essentially over since pricing in both ownership vehicles is relatively the same. It's not a phenomenon that's scary.
    "There are other reasons people are stepping up to the harvest," he said. "Prices are high right now, and it's a good time to sell. It's just that simple. Investors are harvesting investment gains, and there are buyers anxious to buy, particularly on the private side today. On the personal side, there are also management teams who might prefer a subsequent career on the private side."
    Mitchell Hersh, president and CEO of Mack-Cali Realty Corp., a REIT in Cranford, N.J., managing in excess of 34 million square feet of office buildings, primarily in the Northeast corridor, cites a "wall of capital" entering the real estate sector because: (1) There is a disparity between public and private market valuations; (2) real estate has proven very predictable and reliable through various economic cycles; and (3) the private markets can employ higher levels of leverage and can thereby generate outsized returns.
    "Depending on the sector," says Hersh, "I think we're in the relatively early part of an economic recovery that's going to foster job growth, which will benefit the office sector in particular. I also think the residential sector in apartment REITs will benefit from rising interest rates and the cooling housing sector. A significant amount of capital remains in the public real estate markets due to the liquidity and current cash dividends paid."
So given this mix of good and bad news-the notion of plenty of liquidity sloshing around in the market versus perceived overvaluations in some sectors-what do you tell your clients? Stand pat, take profits or boost REIT holdings?
    Advisor Doyle says he is currently taking profits and reducing his clients' exposure to REITs as an asset class. "All of our portfolios have a target asset allocation, with many having an allocation to REITs. What we are doing now by taking profits is simply reducing our REIT allocation to our target level, which varies by client."
    Ross Marino, a CFP with Raymond James Financial in Wilmington, Del., says he is also taking profits. He rebalances his REIT allocations yearly, he says, with target allocations ranging from 5% to 10%, depending on the client. "At this stage in the cycle, I would prefer more diversification for my clients in real estate in general."
    Marino especially favors REOCs (real estate operating companies), saying, "They are a much broader asset class than REITs. The big difference is that REITs have to pass along 90% of their net investment income to shareholders, whereas REOCs can reinvest their net income back into the business."
    Perhaps Furnary of ING Clarion Partners, sums up the current state of the market best: "People are scared that something that's been good this long can't last forever. But that doesn't make for a bubble. In real estate it will likely lead to more modest returns going forward for a while."

Bruce W. Fraser is a frequent contributor to Financial Advisor magazine. You can reach him at [email protected].