REITs: Impressive Long-Term Record

By Anthony La Malfa, CPA
The culmination of five years of steadily rising prices for U.S. REIT shares reached a climax of sorts in November with the purchase of Equity Office Properties (EOP) for $36 billion, by the Blackstone Group, a private equity fund. Blackstone had previously purchased two other office REITs-Trizec Properties Inc. and Carr-America. The series of purchases clearly indicates Blackstone's belief that the recovery in the office building market has some way to go and that the U.S. economy continues to be in an expansion phase.

The trend toward "privatization" of public REITs reflects the underlying assumption that public real estate, notwithstanding the strong price gains in recent years, is undervalued in comparison with private ownership. There are several possible reasons for this. One reason is that publicly-owned REITs normally limit the percentage of debt to 40-plus percent in order to reduce the possibility of significant price declines if interest rates rise-a situation that caused a significant REIT price decline in the mid-1990s. Private owners, on the other hand, often utilize a much higher debt-to-equity ratio in order to increase returns, accepting the risk of higher interest rates.

A second reason why REITs are attractive to private buyers is that private firms are not under pressure to pay high dividends as are public REITs, thus making cash available for additional acquisitions. Finally, firms acquiring public REITs may be anticipating selling off properties at a fairly early date in the future if prices continue to rise.

Overall Outlook
In its October 2006 industry study of U.S. REITs, Moody's Investors Service said it maintains a stable rating outlook on 92 percent of the companies, with only 2 percent having a negative rating and six percent subject to review for downgrades. Overall, the firms are viewed as being prudently managed, with leverage and secured debt levels flat to up modestly and with increasing fixed charge coverage and operating margins.

Separately, Prudential Real Estate Investors (PREI), in its third quarter 2006 Market Perspective, says it expects the Property Index of the National Council of Real Estate Investment Funds (NCREIF) to show a total return in the 15 percent range. Next year, total return is projected to be between 12 and 15 percent, subject however to two conditions: no sudden weakness in the economy and interest rates remaining close to the 4.5 - 5.25 percent range existing in 2006.

MENU TOP

Apartment Sector
The apartment sector in 2006 enjoyed its most successful year since 2000 and according to some commentators now offers good investment opportunities. A key reason is that land and construction costs remain at high levels, making new development unattractive. As a result, apartment REITs are able to maintain solid cash flows and high dividend payments. In many cases, apartment occupancies are 95 percent or above, giving landlords pricing power and virtually eliminating the need for any concessions.

One shadow on the horizon is the weakness in condominium markets due to overbuilding, with sales plummeting in some key cities. This is likely to result in buildings converted to rental use, possibly creating an oversupply of apartments in some markets. Over the longer term, however, prospects for the apartment sector seem strong since the two major groups who favor apartments-the 19-25 age group and new immigrants to the U.S.-are increasing in numbers.

One caveat for apartment investors at this time is the narrow spread between primary and secondary markets and between Class A, B and C properties. If and when demand for apartments declines, the spreads among these apartment types is likely to widen, meaning lower prices for the less desirable B and C properties.

Retail Sector
Retail properties have been very stable over the past few years as rents have continued to grow. Nevertheless, investor demand has been diminishing for the past several quarters as investors have concentrated on other property types that have been seeing more rapid growth. As a result, retail has been the only property type where sales in most of 2006 have declined from last year. The result is that some attractive buying opportunities may arise for long-term investors. The best opportunities should be in markets where residential development has been expanding rapidly and where retail supply has not kept pace. The rating outlook of Moody's Investors Service for retail REITs remains stable, a reflection of continued consumer spending. The risk levels are highest for B and C regional malls and for community centers with weak grocery and/or discount anchors; and anchor sites that are too small.

Major trends in the retail sector include consolidation of REITs and retailers, retail expansion, property redevelopment and international expansion. Consolidation of ownership can be positive if it creates a more geographically and tenant diverse company. However, consolidation can increase risk if it is debt financed.

Several new trends can provide additional support for retail valuations. These include the use of new concepts in sales as well as new companies to fill niches or to market to specific age groups. These often result in meta-credit ratings as they utilize space vacated by anchor consolidation and tenant downsizing.

Office Sector
Capital continues to flow to the office sector, reflecting an ongoing recovery and strong market fundamentals. In the third quarter of 2006, indications were that the average vacancy rate in a 56-market universe declined to just under 13 percent, the lowest level since 2001. In downtown markets, vacancy rates declined to just under 11 percent, while in suburban markets, vacancies averaged about 14 percent.

The improvement in the office sector essentially reflects job growth. While growth in 2006 has been slower than expected, year-over-year growth has been much healthier than might appear. On the positive side, sharply higher construction costs discourage new supply. However, if employment does not continue to increase, further improvement in the office sector is not likely. While Moody's rating outlook for office REITs is stable, it expects employment growth to slow over the next few years, which should slow the pace of improvement over many markets.

Industrial Sector
Moody's rating outlook for industrial REITs is stable, reflecting improving economic fundamentals and operating performance. The industrial property cycle appears to be on an upswing because the manufacturing economy is expanding. Manufacturing output is a key leading indication of absorption in the industrial property markets, and this should lead to some measure of pricing power for industrial property rents in the next year or two. Another positive feature for the sector is the growing reliance by industrial REITs on fees and gains generated through joint ventures and real estate fund structures as well international investments.

Anthony La Malfa is a manager in the Real Estate & Hospitality Services Group in the New York Office of BDO Seidman, LLP. He can be reached at (212) 885-8140.

Continue Reading - Development: Joint Ventures With Investors

MENU TOP

Inquiries about material in the Monitor should be directed to
Alvin L. Arnold at (212) 885-8235.