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Even if rates hadn't risen, according to the Deutsche Bank analysts, REITs were headed for a fall. They had gone too far too fast, went the reasoning. For example, the Vanguard REIT Index Fund (VGSIX) returned 36% last year after averaging gains of 15% annually from the start of 2000 to the end of 2002. When interest rates rise, bad things can happen to real estate. First, REITs themselves borrow money to buy property, and the interest rates on some of that debt will increase, cutting into profits. Consider Rouse. Rouse has $4.5 billion in debt and pays $223 million in interest on those loans. If the rate on Rouse's overall debt rises half a percentage point, that's $22 million in additional expenses, a big number for a company whose net profit in 2003 was $140 million. The second problem with higher rates is that the companies and people who rent the properties that REITs own may become strapped for cash themselves as their borrowing costs rise. And the third problem: When five-year Treasury notes shot up from 2.8% to 3.5%, Rouse's dividend yield, which in fact was 3.5% on April 1, lost some of its luster. So Rouse's stock fell, and its dividend yield is now 4.3%. On the other hand, maybe the three negatives are outweighed by a single positive. As the Deutsche Bank analysts put it, "Rising interest rates imply a stronger economy which would benefit all property types." In other words, rates rise because business is booming, companies are earning higher profits and more people are employed at higher salaries. As a result, the properties that REITs own can boost their rents a lot more easily than in a sluggish economy when it's tough enough just to sign leases. The Deutsche Bank analysis, which I find convincing, points out that, when interest rates start rising, the yield on 10-year Treasurys typically increases 2 to 3 percentage points over 12 to 18 months. So expect T-bond rates of 6% or so by the end of 2005. NOTE: Every time I have checked these stats, I have changed them - so it is probably not error free and not ready for publication. Let us calculate - March's 3.8% yield plus 2.5 percentage points expect yield movement in the 10 yr Treasury = 6.3% for the 10-yr and probably a 7.8% required yield for REITs. At a 6% yield, every 1 dollar in dividends would generate a $16.66 price. My $16.66 buys me one share in a stock yielding one dollar a year. Let's accept the presumtion of a 4% annual rise in yields. So in 18 months my $1.04 in annual dividends at a 7.8% yield would generate a price of $13.33. But in 18 months my one share would also gain $1.52 in dividends - leaving me with $14.85. I have lost $1.81 before taxes on my dividends. Let us re-calculate using bullish assumptions - March's 3.8% yield plus a much smaller 2.0 percentage points expected yield movement in the 10 yr Treasury = 5.8% for the 10-yr and probably a 7.3% required yield for REITs. Let's speculate that our growth REIT can raise dividends at 5% per year - thus a 7.625% rise over an 18 month period [1.00 times 1.05 times 1.025]. So in 18 months my $1.07625 in dividends at a 7.3% yield would generate a price of $14.74. But in 18 months my one share would also gain $1.525 in dividends [1.00 for the first year plus half of 1.05 for the second year] - leaving my with $16.26525. I have lost 40.475 cents before taxes on my dividends. Let us re-calculate using the same bullish assumptions but this time waiting for a further REIT correction - March's 3.8% yield plus a much smaller 2.0 percentage points expected yield movement in the 10 yr Treasury = 5.8% for the 10-yr and probably a 7.3% required yield for REITs. Let's speculate that our growth REIT can raise dividends at 5% per year - thus a 7.625% rise over an 18 month period. But this time we have waited for a further REIT correction to a current yield of 6.50%. So I start with paying $15.38 for my $1.00 in dividends. In 18 months my $1.07625 in dividends at a 7.3% yield would generate a price of $14.74 - still losing money on the stock. But in 18 months my one share would also gain $1.525 in dividends [1.00 for the first year plus half of 1.05 for the second year] - leaving me with $16.26525. I have made 88.525 cents before taxes on my dividends. My effective yield over that period has been cut by 42% assuming I sell at that point. But I have caught the falling knife without too much injury. Keeping the same assumptions as above but changing the falling point to a 6.3% yield and paying $15.87 for the dollar div, the fall to $14.74 [7.3% yield] plus the $1.525 div leaves me with 16.2625 and a 39 cent gain. At a 6.2% yield and paying $16.13 for the dollar div, the fall to $14.74 [7.3% yield] plus the $1.525 div leaves me with 16.2625 and a 13 cent gain. Keeping the same assumptions as above and keeping the falling point at a 6.3% yield and paying $15.87 for the dollar div, the fall to a [changed and lower] 7.4% yield on the 1.07625 dividend generates a new and lower price of $14.54 - plus the $1.525 dividend leaves me with $16.06 and a 13 cent gain. At a 6.3% yield and paying $15.87 for the dollar dividend, the fall to $14.35 [the price at a 7.5% yield of a $1.07625] plus the $1.525 dividend leaves me with $15.87 and break even. The average yield for the 155 REITs that make up the Bloomberg REIT index - which includes every REIT with a market cap of at least $15 million - was 5.95% on Tuesday. But with REITs, unlike with bonds, investors have growth on their side. Deutsche Bank expects earnings and dividends to rise between 5% and 8% a year. Value Line projects 7.5% annual dividend growth for Rouse over the next six years. Is this a good time for investors to add REITs to their portfolios? My own view is that market timing is as senseless for REITs as for other investments. Don't guess about the direction of prices or interest rates. If you don't own REITs, get some - maybe 5% to 10% of your stock holdings. They'll add ballast to your portfolio, and you'll reap nice dividends along the way.
A big part of retailers' strategy has been differentiating themselves from one another - shoppers are less likely this season to find the same Liz Claiborne or Tommy Hilfiger fashions in every department store in every mall. And stores are relying more on their own exclusive private labels. For the first three months of the year, the department-store sector averaged a sales increase of 5.4%, compared with a 4.9% decline in the year-ago period, according to the International Council of Shopping Centers-UBS sales tally. The tally is based on same-store sales. Overall, retailers' same-store sales so far this year are up 6.5%, with discounters' sales up 5.9% and mall-based apparel store sales up 8.1%. The biggest sales growth has come from upscale department stores such as Neiman Marcus and Nordstrom, the first beneficiaries of the economic recovery, having enjoyed double-digit sales increases. But midtier department stores owned by Federated Department Stores and May Department Stores have seen some solid improvements.
Elsewhere in the multifamily sector, Banc of America said its two "Top Picks" are Equity Residential (EQR) and United Dominion (UDR), both of which are rated "neutral." Banc of America's two "Least Favorite" stocks in the group are Gables (GBP) and Summit (SMT).
In a better economy, demand for space in offices, apartments and strip malls rises, and these companies can raise rents. That makes REITs more economically sensitive, like cyclicals, than rate-sensitive, like bonds. These businesses have tons of operating leverage, which means that when occupancy rates rise, earnings will move up faster than revenues because they have high fixed costs. Paul Gray, portfolio manager at Kensington Strategic Realty Fund (KSRAX), says, 'We actually want job growth and inflation! These companies have as much pricing power as any strong business. A booming economy is good for real estate.' Gray said much of the problem for the group in recent weeks was related more to its recent manic run-up than to rate fears. REITs as a group were up 37% in 2003 and an additional 12% in the first quarter, pushing valuations to extremes. March was the 14th straight month that the sector was up. More money was put to work in REITs in the first three months of 2004, in fact, than in many of the previous entire years. Much of the latter boost, Gray said, came from momentum-chasing investors who didn’t understand the fundamentals of the business and dumped shares at the first whiff of perceived danger. 'There was a massive exodus of people who thought REITs were bond alternatives,' he said. 'But they don’t seem to understand that these companies can raise their dividends while bonds cannot.' A few names that are worth considering at this time, according to Gray: Macerich - Gray says the company has strong management, a predictable earnings outlook for this year and next due to its long-term leases, and a tidy dividend of 5.1%. Boston Properties - Has a great management team, a stable portfolio of buildings in places where few new ones are being built and lots of operating leverage. The portfolio manager estimates the stock is now trading for a 10% discount to the value of Boston’s properties. Koger Equity - A small cap, is a suburban office-building specialist in Florida that pays a 6.2% dividend. Gray says the company has strong management, good assets that could withstand a rise in rents, and a stock that is trading at a 5% discount to its properties’ value. Barry Vinocur, editor of Realty Stock Review, believes the best values are the ones with strong earnings growth and a history of big dividend increases. Here are the three at the top of his list: Chelsea Property Group - Earnings are growing at a compound annual rate of 15%, dividend growth is in the low double digits, and management is first-rate. Ventas - Vinocur says CEO Debra Cafaro developed 'a dynamite business plan' that has generated much more top-line growth than Wall Street believed possible. The stock was up 105% last year and 114% in 2001, and is still up 6% this year even after taking the hit. Vornodo - Vinocur said he believes many of Vornado’s properties in Manhattan and Washington D.C. are renting below market and can easily be boosted if economic growth continues. Management is excellent, the valuation is good, the yield is 5.3% and there is plenty of room for further earnings and dividend growth. The stock has risen 19% compounded annually for the past 10 years - including a 57% move up last year, but after the recent slide is flat for 2004.
One hallmark of the 1994 markets was higher interest rates. The area that typically suffers adverse reactions due to fears of rising interest rates is the financial sector. This fear has led me to look for value in the REIT sector, as the consensus believes that share prices of REITs will suffer in a rising rate environment. My research has led me to believe this fear is unfounded for two reasons: The stocks are fairly inexpensive based on historical yield spreads. And REITs have been historically less sensitive to interest rate movements than one might expect. Over the past few weeks, REITs have been hit hard, falling more than 10% as the 10-year Treasury yield has risen from about 3.75% to 4.35%. Coincidently, the 10-year Treasury is at about the level where it began 2004 and below levels it traded through most of 2003. During recent weeks, there has been an estimated $700 million in outflows from real estate mutual funds, which may be contributing to the weak stock performance of REITs. Now, let's examine the NAREIT Composite Index from 1994-2003. The index's average annual return for that period was 11.96%, outstripping the S&P 500, the Dow, the Russell 2000 and the Nasdaq during that time frame. The 10-year U.S. Treasury note (constant maturity) during that same time had an average annual yield change of -16 basis points. In four of those 10 years, yields rose, while the NAREIT index was negative in only two of those years (1998 and 1999 - not 1994). Interestingly, the worst performance year for the NAREIT index was 1998 (-18.82%), when the yield on the U.S. Treasury 10-year (constant maturity) actually fell 110 basis points. In more recent history, the 10-year T-note went from a yield of 3.07% to 4.67% (+160 basis points), while REITs rose over 1%. In the past 30 days, the 10-year T-note went from 3.65% to 4.04% (+39 basis points) as REITs fell nearly 15%. These movements would confirm some studies that show that REITs have a low correlation to the fixed-income markets, and that their highest correlation is to the Russell 2000 index. The historical yield spread between REITs and the 10-year Treasury note has been about 150-260 basis points. The current spread is about 190 basis points: not table-pounding cheap, but certainly offering good value. However, as the current economic cycle unfolds, not all REIT sectors are expected to flourish. Generally, I remain positive on the Health Care [example: HCP], Mall [CBL and MAC] and Industrial [FR] sectors. These positions [in the stocks just mentioned] were lately trading at an average yield of 6.34%, about 199 basis points over the 10-year. Treasury.
The Inland Empire led Southern California, which held four of the five top spots on the list of greatest year-over-year increases in the mostly higher-end rental market. San Diego experienced a 4% increase to $1,187, LA rose 3.9% to $1,355, and Orange County was up 3.2% to $1,284. People moving from neighboring counties to the Inland Empire "has been a trend for the last two or three years," said Quintana, who used to manage a property in Rancho Santa Margarita. Her complex is getting a more upscale clientele. The inflow of renters to the Inland Empire has pushed up the region's occupancy rate to 95.3%, the highest of any of the 25 Western locales surveyed. Meanwhile, the Northern California cities of Oakland, San Jose and San Francisco saw some of the biggest declines during the first quarter compared with a year ago. The prices, which artificially inflated as competition for the units surged during the dot-com boom, had nowhere to go but down. San Jose saw the biggest year-over-year decline in rent - a 5.4% drop to $1,278. The occupancy rate was 93.5%, a drop of 0.7% from a year ago. In Oakland, rents dropped 2.4% to $1,178. San Francisco's rental prices fell 1.6% to $1,538. "San Francisco has had high vacancy rates" concentrated in the high-end apartments, said Carlton. But in the lower and moderate price apartment complexes, "there's not enough of those to go around." California remains home to the most expensive apartments in the West. The top eight most expensive markets included in the data are all in California. Despite the high rents, filling apartments in these locales hasn't been a problem. In the eight California markets, occupancy rates ranged from 92% to 96%. RealFacts surveyed 3,625 properties housing 746,405 units.
Mike Mueller, Tony Paolone and the team of real estate analysts at J.P. Morgan are linking better returns to a REIT's ability to grow retained cash flow. "Historically, REITs that have been able to generate superior retained cash flow (RCF) have also produced better earnings growth, dividend growth and higher total returns to investors," Mueller and his group noted in a recent analysis. "We thus believe that a REIT's ability to generate growth from RCF is a useful tool in stock selection." That is especially true now, given that, as a group, REITs have seen FFO growth as a result of retained cash flow decline to about 1% from 2.5% in 2000, largely because of lackluster earnings and an increase in capital expenditures. Any REIT that has been able to control rent erosion and capital expenses - such as improvements and concessions offered to entice new tenants - during the recent economic weakness should have better retained cash flow, and intuitively, it should outperform its peers. Mueller argued "By reinvesting cash flow into acquisitions, developments or debt reduction, FFO growth is naturally boosted. Thus, companies with low dividend payouts often retain more cash flow and drive higher earnings growth - a key metric in terms of stock performance." From a broader perspective, Mueller found that REITs with the highest RCF growth in the past three years have significantly outperformed those with only lackluster growth. "Average total return (on a compound annual growth rate) to shareholders for the 'top 20' REITs was 30.9% over the last three years, compared with 15.6% for the 'bottom 20,'" Mueller noted. "Further, the top 20 had average annual FFO growth of 6.7% and dividend growth of 9.3% over the past three years. In contrast, the bottom 20 saw average annual decreases in both FFO and dividends to the tune of 5.2% and 1.7%, respectively, over the last three years." Given that track record, it helps to have a better understanding of how property sectors rank in retained cash flow. "In terms of the property types, defensive REITs like retail and triple-net lease, whose fundamentals have held up better during the downturn, are seeing greater FFO growth from RCF this year than offensive REITs like office and multifamily," Mueller said. "Occupancy levels have held steady in defensive property types, protecting RCF. Additionally, companies in these subsectors have generally been more acquisitive, leading to higher earnings growth. Net-net, today, REITs in defensive property types are retaining more cash, which is in turn boosting today's FFO growth rates." The top REITs, ranked by growth from retained cash flow, are generally retail companies. Retailers on Mueller's list include Ramco Gershenson (RPT), General Growth Properties (GGP), Rouse (RSE) and Chelsea (CPG). All of these retailers should be able to use RCF to grow FFO by more than 2.5%, more than two times the REIT average. PS Business Parks also makes Mueller's list; his analysis suggests that this industrial and office REIT should be able to use retained cash flow to grow FFO by more than 3% in 2004. Also included is Alexandria (ARE), an office REIT that specializes in medical technology space. Mueller and his colleagues estimate that retained cash flow will help Alexandria grow FFO in 2004 by 2.8%. At the other end of the spectrum, a number of companies appear likely to have negative or neutral retained cash flow. Not surprisingly, all are either office or apartment REITs. Here are a few of the names on Mueller's list of RCF-challenged companies: Crescent (CEI), Post Properties (PPS) , Equity Office (EOP), Arden (ARI) and AIMCo (AIV). Mueller opines that retained RCF improvement will most likely come from the sectors at the bottom of the current list. "We calculate that RCF levels are translating into virtually no FFO growth for these property types now, leaving room for improvement over the next few years as market fundamentals improve," he said. But how soon will that happen? Although there are signs of economic improvement, property fundamentals tend to lag behind economic growth by months. With continued challenges on the labor front, an impending office recovery, especially in overbuilt markets such as Northern California, suburban Washington, D.C., and many southeastern and southwestern metropolitan areas, doesn't appear to be under way yet. As we enter a period when the markets are focused on growth, it may pay for REIT investors who are focused on total return to give up a little current yield in exchange for more FFO growth. If history repeats itself, as Mueller's data show, you'll come out ahead.
Analysts said general economic growth has come faster in New York, while companies in Washington have been slower to expand. Government agencies, major drivers of office-space stability in Washington, have not sought new space because of budget constraints. But analysts said investors should not worry. The total return on office space in Washington is still more than twice the national average of 5.67%, and Washington still boasts one of the lowest office vacancy rates in the country. Furthermore, analysts said the average return on office space in the Washington area is skewed by the suburbs, some of which still have high vacancy rates as a result of the technology collapse of the late 1990s. Downtown Washington alone boasts a 13.33% rate of return - more than a point higher than New York's. "While Washington remains very strong, they lost ground to New York as well as the national average," real-estate services firm Delta Associates said. "This trend bears watching, although we expect Washington to remain among the premier investment markets in the nation through 2004 and beyond."
The worsening numbers, especially in malls, came as a number of major retailers shuttered or announced they would close a large number of stores. KB Toys began closing 375 stores in January after it filed for bankruptcy-law protection and will close as many as 115 more, according to a statement from the toy retailer. Shoe retailer Footstar is closing about 165 stores after filing for bankruptcy-law protection in February, and Gadzooks, a girls' apparel retailer, is closing 127 of its stores, also after filing in February. Several other major retailers have closed large numbers of stores in the past three months. In the strip-mall sector, vacancies edged up to 7% in Q1, from 6.9% in Q4. But asking rents rose 0.5% to $17.43 per square foot. Absorption was 2.3 million square feet, the lowest number in two years, and less than half the 5.5 million square feet absorbed in Q1-03.
In Marina del Rey, on the west side of Los Angeles, Costco bowed to community demands and installed lush landscaping, including palm trees, around the perimeter of its normally barren 139,850 square-foot building. The community also wanted more windows and doors to break up the building's fortress-like facade. The company put in windows - but then had to add shades so the neighbors wouldn't complain about the lights shining through at night. While Costco makes design changes only if asked or if necessary, the increasingly embattled Wal-Mart has started offering communities a menu of styles from the outset and actively seeking out neighborhood groups and city planners early on. In Chicago, Wal-Mart has agreed to blanket a portion of the store's roof with soil and low-maintenance greenery, part of Mayor Richard M. Daley efforts to reduce temperatures from so much concrete by planting "green roofs." In the Riverside area of Fort Worth, Wal-Mart's designers modeled the building after the old neighborhood high school, a local landmark, incorporating arched windows, brick facade and a terra-cotta tiled roof.
What to Capitalize In simpler days, "income" referred to net operating income or NOI. This was generally regarded as Effective Gross Income (Potential Gross Income from all sources less a vacancy and credit loss allowance), less all Operating Expenses (including the property management fee, real estate taxes and insurance). Specifically excluded from the calculation were a reserve for replacements, tenant improvement costs, and leasing commissions. The theory behind these exclusions was their tendency to distort NOI in a given year when substantial one-time capital repairs were required, or significant amounts of space were rolling over, necessitating large amounts of re-leasing costs that distorted that year's income. Reflective of the current confusion in the market, one widely read investor survey currently describes NOI as either income after capital reserves but before tenant improvements and leasing commissions; or before all capital reserves, tenant improvements, and leasing commissions; or after all capital reserves, tenant improvements, and leasing commissions. And a publicly traded REIT investing in multifamily properties defines income as NOI (after payment of a property management fee) less a stabilized reserve per unit, for the first 12 months following the date of the valuation. While it has certainly become increasingly common to base a capitalization rate on anticipated income, in the bear market of the early 1990s, the convention was to capitalize income in place (existing income), and pay an additional sum to the seller if property performance improved, known as an earn-out. Most of the capitalization rate inconsistencies are applicable to the office and retail sectors. (As industrial buildings are typically net leased, there is less uncertainty associated with estimating income.) For apartment properties, the most common approach is to deduct only a replacement reserve (usually $250-$400 per unit) from NOI to arrive at an agreed upon income amount. Reis defines capitalization rates as income after capital reserves but before tenant improvements and leasing commissions. This is consistent with our observed macro trend towards inclusion of a deduction for a replacement reserve, despite the fact that we've yet to meet an office building or shopping center owner that actually sets aside money each year. Recent Cap Rate Trends Whether it is the supply-constrained nature of the Washington, DC office market, or the perceived long-term allure of Manhattan, these two office markets typically command capitalization rates at the low end of the spectrum of office buildings in the United States. Office buildings in the suburban markets, characterized by a higher availability of space, frequently trade for a higher capitalization rate than their more urbanized counterparts. Multifamily apartment complexes nationwide tend to sell at cap rates lower than for most office buildings, possibly reflective of the theoretical ability to raise rents annually as leases expire, as well as an expected increase in interest rates which will benefit rental apartment building owners by making single-family home ownership less affordable. Why Small Changes in Cap Rates Matter A building with $4 million in income capitalized at 8.0% yields a price of $50 million; at 7.0%, the price for the same building is in excess of $57 million, an increase of 14%.
For industrial, companies continue to improve the ways in which they store and distribute information, a trend that is igniting demand for state-of-the-art facilities. "Some companies can justify investment in (these types of buildings) during an economic downturn if that improves their productivity and saves money," Bach added. Growing confidence in the asset class is visible in the increased number of hard hats. Construction in the industrial sector is up 10 million square feet over the same period last year, Bach noted. Year-over-year office construction activity is flat.
Many on Wall Street shrug off those worries. They believe REITs and other rate-sensitive investments already have over-reacted. Merrill Lynch, for example, published a report last week urging investors to use sharp declines as an opportunity to buy REITs that specialize in health-care properties such as nursing homes. REIT fans point out that the Federal Reserve isn't likely to raise interest rates all that rapidly, meaning that REIT dividends could remain much higher than market yields for some time. But there is a second problem, and it has to do with the size of the overall REIT market. In a U.S. stock market whose current value is more than $13 trillion, REITs taken together have a market value of around $210 billion, says David Shulman, senior REIT analyst at New York brokerage firm Lehman Brothers. That is less than 2% of the stock market. It is less than the market value of General Electric alone -- or Microsoft or Exxon Mobil. So when investors began chasing REITs a few years ago, there were a limited number of REITs to chase. As investors' dollars poured in, REIT values soared to records, leading people like Mr. Ablin and Mr. Shulman to begin warning of a bubble. REITs were trading at 135% of net asset value, based on the overall appraised value of the assets that they own. Their prices were 13 times their income from operations, also a record, he says. Prices got so high that their average yield - their dividend divided by their price - fell below 6%. When an asset is that stretched, it takes only a small blemish to cause a problem for marginal investors. That is why REITs fell so sharply at the start of last week, on the fear that market yields are due to rise now. Investors generally don't wait and react after a problem blossoms; they react as soon as they get a whiff. That helps explain not only why people have begun moving out of REITs, but also why there has been erosion in junk bonds and in the stocks of companies such as banks, brokerage firms and money-management firms that have used the carry trade. For REITs and similar investments, the question now is how badly overvalued they became during the period of extremely low rates, and whether last week's pullback was enough of a decline to correct the problem. Many investors think that some REITs, at least, are due to rebound. "I think REITs have a lot of room to go up, especially if the economy improves," says Michael Cuggino, president of Permanent Portfolio Funds, which manages $250 million in San Francisco and invests in a number of REITs. Higher rates could push individuals to rent apartments rather than buy homes, he says, meaning "apartment REITs are an area that could do well." That is especially true if employment continues to pick up. Office REITs also could benefit from a strengthening economy, as demand for office space improves, he says. "If the long [30-year Treasury] bond is yielding about 5%, you have to go up another point or point and a half before you start to challenge REITs on a yield-only basis. And I think the outlook for REITs will improve as the economy improves," he says.
"People are scratching their heads a little bit thinking that Rouse paid an aggressive price for that property," said Rick Latella, managing director of the retail industry group at Cushman & Wakefield. "Then again, that market probably has a lot of opportunity for upside." While Providence, Birmingham and Baton Rouge have not been the most favorable markets in the past, even institutional investors and REITs are now broadening their geographic horizons. Moreover, buyers are chasing after B quality product given the five to eight year lead time required to develop regional malls and the dearth of class A properties. "The A assets in the top 25 MSAs aren't available," said Latella. "Now investors are competing with traditional B players, and you’re seeing lots of price inflation in that segment."
From Shelia Muto, RealEstateJournal 4-21: Retail REITs "have gone from pooh-poohing lifestyle centers, to incorporating lifestyle wings in their existing malls, to developing lifestyle centers from the ground up," according to a report issued earlier this month by Green Street Advisors. Now that lifestyle centers have become popular among shoppers, mall REITs are "piling on," most notably CBL, GGP and Simon, the report says. Based on expected job and income growth, which, in turn, lead to growth in retail sales, the report suggests that "sustainable" retail-sales growth is about 3% annually, down from the 6% to 8% pace of retail-sales growth of late. Given that, the supply of mall space expected to emerge by 2006 "seems on the high side," the report says. On the other hand, a report by Banc of America Securities LLC asserts that shopping-mall properties "have the most attractive financial attributes of the major real-estate property types," given that retailer demand for space is increasing and a limited supply of new malls is expected this year. Banc of America Securities analysts expect the supply of retail space will increase by 22 million square feet, or 0.8%, this year. The analysts included in the calculation only retail space at shopping malls that are 400,000 square feet or larger. Demand from tenants for retail space in terms of square footage is expected to grow 3.4% this year, according to the report.
The survey, to be released today, comes days after the Labor Department reported that employers added 308,000 new nonfarm jobs in March, the strongest jobs report in almost four years. The lower office-vacancy rate was helped by new building completions, which were at their lowest number in at least five years as building activity has decreased in recent years. Rents declined for a 12th straight quarter, falling 0.7% to $20.41 a square foot from $20.55 in the fourth quarter of 2003. In the first quarter, companies absorbed 1.49 million square feet, down from 4.38 million square feet in the fourth quarter but much better than the negative 4.79 million square feet in the year-earlier first quarter. In individual markets, the San Francisco Bay area continued to suffer the most, with San Jose, San Francisco and Oakland all in the bottom five cities in effective rent growth, as the technology-sector bust continued to cripple the region's office markets. San Jose brought up the rear, with rents down 2.4% in the first quarter. San Francisco rents slid 2%, and Oakland rents fell 1.6%. In the apartment market, the average vacancy rate for the 58 biggest metropolitan markets in the U.S. rose to 7.1% from 6.8% in the fourth quarter, according to Reis, the highest since 1987, when it reached 7.5%. Effective rents, the rents landlords actually collect as opposed to what they hoped to collect, stayed flat at $867 a month. Absorption of apartments turned negative after being positive the prior three quarters. Average rents rose to $867 a month in the first quarter from $861 in the year-earlier quarter, according to Reis. The results show "the apartment sector is not on a direct path to recovery yet," says Man King Fong, a senior analyst at Reis. "Last year we saw a couple of quarters where there was demand, but in the first quarter we didn't see sustained levels of demand at all." Absorption was weakest in Chicago; Columbus, Ohio; Dallas/Fort Worth, Texas; Kansas City, Mo.; and Minneapolis, Reis said. It picked up, only slightly, in Palm Beach, Fla.; New York; Los Angeles; Denver; and Las Vegas. Greg Willett, director of research products at apartment-consulting firm M/PF Research Inc. in Dallas, said vacancy rates declined the most in Tampa, Fla.; Las Vegas; Orlando, Fla.; Atlanta; and Austin, Texas. Mr. Willett attributes that in part to job gains in Tampa, Las Vegas and Orlando. Drastically lowered rents in Austin and Atlanta helped stimulate demand there, he said. Ronald G. Johnsey, president of Axiometrics, a apartment-research firm in Dallas, said his firm's survey of U.S. apartment properties showed a decline in the vacancy rate on a year-over-year basis, to 7.1% from 7.6%. The vacancy rate rose to 7.1% from 6.9% in Q4-03, he said. Vacancy rates rose the most in the first quarter in Columbus, Ohio; Sacramento, Calif.; St. Louis; Hartford, Conn.; and Albuquerque, N.M., according to Reis. Markets where vacancy rates fell the most included Palm Beach, Fla.; Tucson, Ariz.; New York; Denver; and Cleveland.
REITs, relative to stocks, are trading at a P/E -- with the E referring to adjusted funds from operations, or AFFO, a conservative definition of cash flow that accounts for capital expenditures that aren't always expensed on the income statement -- of about 18.5, which is a little higher than the 17 on the S&P. That isn't normal. The 10-year average price-earnings ratio on REITs is 12 and the S&P 10-year average is very close to its current level of 17. So, relative to stocks, REITs look much more pricey than they ever have. Relative to bonds, the earnings yield on REITs is about 5.4%, which is materially lower than the yield on the 30-year corporate bond, which is just north of 6%. That isn't the norm either. REIT earnings yields usually exceed bond yields, as opposed to now where they are actually lower. Relative to any historic benchmark, they are pricey. From Jon Fosheim, of Green Street Advisors: NAV isn't the final answer as to where REITs should trade, and some companies are just flat-out better than others. Some have better management teams, or operate in a sector where there are more lucrative opportunities for value creation at a given point, and those companies should logically trade at larger-than-average premiums to NAV. Also, some REITs have a lower tax basis than others. All things being equal, it's better to own a REIT with a high tax basis and therefore low embedded capital gains, than to own a REIT with a low tax basis and high embedded capital gains. Quick Facts, Stats & Opinions During a week crammed with first quarter earnings announcements, retail REITs stood out as strong performers. With few exceptions, mall REITs and strip center REITs posted increases in revenues, funds from operations and dividends. "The performance of these retail REITs is not one bit surprising," said Lou Taylor, a REIT analyst with Deutsche Securities. However, what is surprising is that investors have been selling off their retail REIT stocks despite the strong earnings. (CPN 4-30) The Morgan Stanley REIT Index took the biggest hit in its near 10-year history to begin the week, closing down 5% at 570.9. Early in the session, the gauge touched on 560, a level not seen in over five months. The index had recovered near 578 by midday Friday (4-16). "We believe that a correction down to the low 500, high 400 range on the Morgan Stanley REIT Index should not be ruled out over the balance of this year," Prudential Equity Group analyst James Sullivan wrote in a note to clients. "That would provide investors with a better risk-reward ratio than REITs provide currently." (Shawn Langlois, CBS.MarketWatch 4-16) Last week, UBS cut its ratings on several REITs, including Pan Pacific Retail (PNP), Simon Property (SPG), Rouse (RSE) [and reversed the downgrade on 4-23] and General Growth (GGP), all to "reduce" from "neutral". UBS also sliced its ratings on Boston Properties (BXP) and Prentiss Properties (PP) to "neutral" from "buy". (Shawn Langlois, CBS.MarketWatch 4-16) The overall vacancy rate for central business districts throughout the U.S. was 15.2%, unchanged from the fourth quarter and down from 15.3% a year earlier, real estate services provider Cushman & Wakefield said said. Washington's first-quarter vacancy rate was 8.5%, the lowest in the U.S. Downtown Manhattan's vacancy rate fell to 12.9% from 13.5% in the previous quarter. (Bloomberg via LA Times 4-14) According to analyst Raymond Mathis, who follows stocks of real estate investment trusts for Standard & Poor's, the broad sell-off has provided an enhanced buying opportunity for selected REITs that carry wide positive yield spreads vs. the 10-year note, such as Hospitality Properties (recent price, $42; recent yield, 6.85%). Also attractive: REITS whose dividend growth should outpace an interest rate hike, like Vornado ($56; 5%), or that are leading a segment recovery, such as lodging company La Quinta ($7.60; doesn't currently pay a dividend, but S&P expects it to pay one in the next 12 months). Each of those stocks carries S&P's highest investment opinion, 5 STARS (buy). (Business Week 4-08) In 2003, untraded [Private] REITs raised $7 billion, compared with $8.1 billion for traded REITs, according to figures released by Robert A. Stanger & Co., an investment-banking firm specializing in so-called direct-investment securities. Over the past five years, sales have totaled $13 billion for untraded REITs, compared with $22.2 billion for traded REITs, according to Stanger, which cited data from the NAREIT. (Ray Smith, WSJ 4-07) Increased expectations of a tighter monetary policy by the Federal Reserve "may push long- and short-term rates up, eroding the yield advantage of REITs," said Jonathan Litt, an analyst for Smith Barney. He's predicting a second-half pullback in the group also because of (1) an expected increase in equity issuances by companies; a possible slowdown in investor fund flows as yields become less appealing next to stocks such as utilities; and (2) new supply in the real estate market in all property types. (Jenny Park, Dow Jones Newswires 4-05) REITs are generally much better companies than they were not too many years ago in terms of disclosure, transparency, share liquidity, depth of management and corporate democracy. (Jon Fosheim of Green Street Advisors, Barrons 4-05) DDR agreed to acquire 110 retail real estate assets from private developer Benderson Development Co. for $2.3 billion. As a result, the company is revising its 2004 FFO guidance upward to $3.00/share, compared with its previous forecast of $2.85 to $2.90 a share. DDR is also raising its quarterly dividend in Q3-04 by 5 cents. (Dow Jones Newswires 4-01) Wall Street no longer rewards companies for expanding operations and hiring more employees. Stock prices go up when you lay people off and make do with less. In that kind of environment, who's going to run out and start hiring thousands of new employees and renting empty office buildings? (Steve Brown, Dallas Morning News 4-1) According to the annual survey of 202 locations in 45 countries by Cushman & Wakefield, London's West End is by far the most expensive location in the world, according to the survey, with an occupancy cost of $164.70 per square foot. Occupancy costs include rent, taxes and utilities and were measured per square foot per year. Paris comes in a distant second at $105.78 a foot. Tokyo was third at $91.33 a foot. New York came in fourth at $84.82 a foot. (Ryan Chittum, WSJ 3-31) Commercial real estate executives in the Big Apple are counting on 2004 to be the year the office market begins its upswing. The inventory of sublease space is shrinking. According to Cushman & Wakefield, 12 of the 25 largest new leases in 2003 were subleases, and the brokerage company reports the amount of sublease space fell 20.5% to 12.9 million square feet, from 16.3 million square feet, between year-end 2002 and year-end 2003. (CPN 2-16) Update: Second Experiment in Stock Picking 4-30-04 A sector balanced portfolio is summed and compared with the average of two REIT index ETF's: ICF [Cohen & Steers Realty Majors - the top 30 REITs by market cap] and RWR [the REIT Wilshire Index]. The first experiment went from Nov 02 to Oct 03 and this experiment began at the end of April of 2003. NOTE: ICF and RWR dividends were added in March. ICF special dividend to be paid in December was never quantified on the Amex spreadsheet. So ICF's return be slightly understated. ICF div'ed again on 3-29 - payable in April - but that div is included in the March ending figures. Earnings Guidance: CARS expects 2004 FFO of $2.52 to $2.56 a share, up from its prior guidance range of $2.47 to $2.52 a share. Thomson First Call currently targets FFO of $2.51 a share for the year. On 1-21 CARS increased its quarterly dividend to $0.4165 from $0.4140. The new annual rate is $1.666 per share. CARS also reaffirmed its 2004 annual dividend guidance of $1.70 per share. The company expects 10% to 15% of that dividend to be a return of capital. CARS on 4-13 announced that it declared a quarterly dividend of $0.4200 per common share of beneficial interest for Q1 ending March 31, 2004. The dividend is payable on May 20, 2004 to shareholders of record as of May 10, 2004. RSE expects FFO of $4.10 to $4.20 per share in 2004. The forecast trails analysts' average expectations for FFO of $4.27 a share, with nine estimates ranging from $4.20 to $4.35. RSE increase in its common stock cash dividend to 47 cents a share from 42 cents. RSE expects that only 30% of 2003's cash dividend will be subject to the standard income tax rates, while the rest will qualify for the lower 15% federal tax dividend rate instituted in mid-2003. -- On 4-19 RSE said it expects FFO to be in the range of $3.75 to $3.85 per share. The outlook includes a 35-cent-a-share charge for the termination of the company's pension plan. Analysts on average expect the company to post full-year FFO of $3.93 per share. [Yahoo has the average at $3.84] AMB gave 04 FFO guidance of $2.30 - $2.40/share in their Q4 conference call on 1-14-04. The current consensus estimate is $2.34. AMB declared a regular cash dividend for Q1-04, of $0.425 per common share. The dividend reflects an annual rate of $1.70 per share, an increase of 2.4% over the 2003 dividend of $1.66 per common share. The dividend will be payable on 4-15-04, to common stockholders of record at the close of business on 4-5-04. UDR estimates that recurring cap-exp for 04 will be $470 per apartment home, or $0.25 per share. UDR's guidance for 2004 FFO is a range from $1.48 to $1.60 per share; and guidance for Q1-04 FFO is a range from $.37 to $.38 per share. UDR announced a regular quarterly dividend on its common stock for Q1-04 in the amount of $.2925 per share, payable on April 30, 2004 to shareholders of 4-16-04. This represents a 2.6% increase over the same period last year. OFC gave 04 FFO guidance of $1.66 - $1.71/share in their Q4 conference call on 2-11-04. The current consensus estimate is $1.69. MLS increased the common stock cash dividend for Q1-04 by 5.3% to $0.595 per common share. The dividend will be payable 5-3-04 to shareholders of record on 4-23-04. MLS 2004 FFO Projection: $3.90 - $4.00. The current consensus estimate is $3.96. ARE on 3-17 declared a quarterly cash dividend of 60 cents per common share for Q1-04. The dividend is payable on April 15, 2004 to shareholders of record on April 2, 2004. The quarterly common share dividend represents a 3% increase to 60 cents per share from 58 cents per share paid for Q4-03. With one of the industry's lowest payout ratios, the Company announced this dividend increase after an aggregate dividend increase for 2003 of 16%. Update: Third Experiment in Stock Picking 4-30-04 A less than sector balanced portfolio [see last sentence] is summed and compared with the average of two REIT index ETF's: ICF [Cohen & Steers Realty Majors - the top 30 REITs by market cap] and RWR [the REIT Wilshire Index]. The first experiment went from Nov 02 to Oct 03 and the second experiment began at the end of April of 2003. This experiment continues a shift towards being over weighted in retail and having two key holdings - MLS and VNO. REIT Links CIRE - Commercial Investment Real Estate Development Magazine Divident Discount Model @ REIT-Net NAREIT Real-Time Market Index National Real Estate Investor Real Estate Journals & Organizations ULI's Real Estate Capital Markets Update
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