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Yet prices paid by buyers of apartment buildings have continued to rise. In June 2002, Summit Properties, a publicly traded REIT, N.C., paid $17.7 million to buy the San Raphael, a luxury complex near the Galleria mall in Dallas, where the apartments have bay windows, balconies with French doors and wood-burning fireplaces.One year later, the company put the 222-unit complex on the market and received nearly two dozen offers. Summit sold the San Raphael to the Hayman Company for about $19.1 million. While only an 8% increase in price, on a leveraged basis this would result in a return on investment of 15% or more, a real estate specialist said. In the Seattle area, where the vacancy rate is about 8%, a private investment company, the Prometheus Real Estate Group, paid $19.1 million in February for the 260-unit Mission Ridge apartment complex in suburban Renton. The seller, Waterton Associates, bought the property in October 2002, for $15.6 million. Across the country, trading in apartment properties is continuing at a feverish pace, despite a national vacancy rate that stood at 7.1% in the first quarter, the highest level since 1987 and four percentage points higher than it was at the end of 2000, according to Reis. About $2.6 billion worth of significant deals were reported in the first five months of the year, nearly twice the volume during the corresponding period last year, according to Real Capital Analytics. And buyers have been willing to accept very low rates of return on their initial investment - now at an average of 6.5%, or two points less than what they were two years ago. The bulk of these buyers are private investors who are able to finance as much as 95% of the deal. As interest rates have begun to climb, trading activity has accelerated, real estate specialists say. About $3.2 billion in properties went on sale in May, more than any other month on record, said Robert M. White Jr., the president of Real Capital Analytics. "The number of offerings has really spiked in the past 60 days," he said. The surge in offerings may reflect a concern that prices could well be at their peak because of increasing interest rates, said Will Balthrope, the senior director at Cushman & Wakefield of Texas in charge of multifamily housing. As interest rates rise and investors have to spend more to borrow money, prices are likely to soften because other types of investment may become more appealing, decreasing the competition, he said. Other investors and developers, on the other hand, are counting on higher mortgage rates to induce more people to rent rather than buy. A report by M/PF Research Inc. and Torto Wheaton Research found that by the end of 2003, the cost of monthly mortgage payments was higher than the average rent. "The gap is likely to widen further if home prices and/or mortgage rates continue to increase," the report said. (Some analysts warn, however, that, to become homeowners, more people may simply accept the risks of adjustable-rate mortgages.) Many apartment owners are also increasingly confident that the job market will continue to expand, thereby spurring young workers to set up households. Richard J. Campo, the chairman and chief executive of Camden Property Trust, a REIT that recently built $350 million worth of apartments in California, said that among people in their 20's, "we know there is pent-up demand - that people have roommates they don't like." After trailing for several years, the stock prices of apartment REIT's have fared better than publicly traded office and industrial shares in recent months. Investors seem to feel that landlords have more flexibility to respond to improving market conditions by raising rents than do office landlords, who may be locked into their rental rates for five years or more, said Craig Leupold, an analyst with Green Street Advisers. Conditions in many areas do seem to be improving for the industry, at least slightly. Lloyd Lynford, the chief executive of Reis, said the average vacancy rate might be declining, reversing the trend of the last two quarters. But even as more apartments are filled - and landlords cut back on generous concessions - many areas will continue to feel the consequences of overbuilding. The excess supply is most pronounced in metropolitan areas where there are few constraints on new construction and housing prices are still low enough to provide an alternative to renting; Atlanta, Dallas, Houston and Phoenix are among the cities that are considered overbuilt. As for promising markets for investment, Maury Tognarelli, the president and chief executive of Heitman, a real estate investment management company that advises pension funds, singled out Southern California; the Southeast, particularly Florida; and the Northeast. In Denver, the combination of vacancies and concessions means that landlords are currently taking in 30 to 35 percent less than they would if their properties were fully leased, said Jeff Hawks, a Denver-based principal of Apartment Realty Advisors, a national brokerage company. "There's going to be a shortage of new product in Denver a couple of years out." But not every community has exercised that type of discipline. Real estate specialists say they are mystified that developers keep building when demand is low, thereby preventing the vacancy rate from decreasing even when the market begins to show signs of life. "The level of construction is still high," Mr. Lynford said. "I've never been able to make sense of it."
Two recent research reports, by Deutsche Bank Securities Inc. and J.P. Morgan Securities, quantify the effects rising interest rates will have on estimated and actual REIT funds from operations -- a commonly used measure of REIT financial performance -- by looking at companies' exposure to floating-rate debt as of the end of the first quarter. Both conclude that fears of substantial damage to REIT earnings from rising rates might be overblown. Deutsche Bank says its funds-from-operations estimates for the sector would decline an average of 1.1% in 2004, 2% in 2005 and 2.4% in 2006 if interest rates rise one percentage point above the firm's forecast for short and long-term rates. Deutsche Bank has forecast that short-term rates will rise to 4% in 2005 and that the rate on the 10-year Treasury note will rise to 6% that year. Meanwhile, J.P. Morgan estimates that a one-percentage-point increase in short-term rates would cut funds-from-operations growth 1.8%. "Even if you were to dramatically raise rates above what many people forecast, the impact [on REIT earnings] would be relatively minor," says Louis W. Taylor, analyst at Deutsche Bank. Of course, some sectors will be more affected than others. Both Deutsche Bank and J.P. Morgan conclude that the real-estate sectors likely to end up a bit bruised include mall, apartment, industrial, and lodging REITs, since they have the highest variable-rate debt exposure. The least likely to be affected are self-storage and health-care REITs, which have low exposure to floating rates. Office REITs fall somewhere in-between. Among the REITs with higher-than-average floating-rate debt levels -- and therefore more exposure to higher interest rates, according to Deutsche Bank -- are the Chicago industrial REIT CenterPoint Properties Trust , with about 45% of its debt floating rate; Arlington, Va., retail REIT Mills., with about 26% of its debt floating rate and maturing during the next three years; and Charlotte, N.C., apartment REIT Summit Properties , with about 26% of its debt floating rate. Officials from each company said they have hedges in place to minimize exposure to rising rates. J.P. Morgan's research lists office-and-industrial REIT Prime Group Realty Trust, apartment REIT Gables Residential , and Mall REIT Macerich as some companies with the most exposure to rising interest rates. Marvin R. Banks Jr., chief financial officer at Gables, said about half of the company's floating-rate debt is associated with assets it intends to sell this year. Buyers of those assets would assume that debt, removing it from the company's books, he says. Thomas E. O'Hern, chief financial officer of Macerich, says the company typically locks in its floating-rate debt for six months to a year, which makes it less interest-rate sensitive. He added that the company has little debt maturing in 2004 and 2005. Officials at Prime Group Realty declined to comment.
While the developers are not showing all their cards, speculation is that both centers will be turned into multilevel structures with parking garages. When renovations are completed, the centers' new designs could mark the beginnings of a major shift in the way shopping centers are built in Houston. Historically, Houstonians have shunned multistory strip centers with parking garages. Most of us are used to parking and walking just a few steps to our destinations without having to climb stairs or wait on elevators. But land prices have reached a point in this part of town where developers can't make much money if they build just one level of leasable space and a huge parking lot. Scott Shillings, vice president of Staubach Retail, said multistory retail developments with structured parking are the wave of the future.
Employment gains in the area have led to demand for more than 8,000 new apartments in 2004, up from 6,800 units last year, real estate brokerage firm Marcus & Millichap said this week. Developers in the District alone have more than 2,500 apartments planned, the highest amount of apartment construction in more than a decade. Economists said residents in the Washington area will fill more apartments than in other areas of the country because more of them are working. Employment growth in this region is expected to reach 2.3% by year's end, compared with 1.5% nationally. The region will create 65,000 jobs in 2004, many of them in high-paying industries, Marcus & Millichap said. Analysts cautioned, however, that people are not flocking to apartments just yet. Apartment vacancy rates are expected to reach 5.3% in 2004, up from 4.8% at the end of last year. [From Lemke 6-25: The apartment vacancy rate in the Washington area is about 3.1%, compared with 6.7% nationally, according to Delta Associates.] Investors will be betting that vacancies will begin to decline by the end of the year, and that rising rents will offset the lack of revenue from empty apartments. Asking rents in downtown Washington will rise 3.2% this year, from $1,125 to $1,160 per month, Marcus & Millichap predicted. Rents in 2002 rose just 1.6%. The higher rents could lead to higher prices on the sale of apartment buildings; Marcus and Millichap estimated that properties will sell at $90,000 per unit, about 10% more than last year.
David Lereah, NAR's chief economist, said 1.2 million payroll jobs were added to the economy during the first five months of this year. "We could see an average of 210,000 to 240,000 new jobs per month over the next two years, which will create additional demand for commercial real estate," he said. "A rise in net absorption of commercial space is expected over the course of the year. Rents are firming and all sectors can expect higher rents in 2005 as vacancy rates decline," Lereah said. Office properties continue to dominate investor interest. During the first quarter, $27.0 billion worth of commercial real estate traded hands. Of that, 41 percent was spent on office buildings. Net absorption of office space, which includes leasing of new space coming on the market as well as space in existing properties, is projected to rise significantly this year to 77.6 million square feet from only 28.2 million in 2003. Even so, a large volume of new office space means vacancy rates in the 54 markets tracked should decline only 0.5 percentage points to 17.4% in 2004. With plentiful supply, office rents are expected to average 1.9% lower this year before rising 2.4% in 2005. In the retail sector, net absorption is forecast at 102.7 million square feet in 2004, up strongly from 77.9 million last year. The average vacancy rate for retail space in the 54 metro markets is projected to drop to 12.4% this year from 12.9% in 2003. Retail rents should rise by 2.8% in 2004 and another 1.9% next year. Warehouse net absorption is seen at 92.6 million square feet this year, a healthy rise from 72.3 million in 2003. The national vacancy rate is expected to average 10.1% in 2004, down from 10.5% last year. Warehouse rents are projected to slip 0.2% in 2004 before rising 1.7% in 2005. The apartment rental market - multifamily housing - should experience a net absorption of 143,900 units in 2004, compared with 131,500 last year. The average vacancy rate is expected to hold at 7.1% in 2004, unchanged from last year, with average rent forecast to rise 0.3% in 2004 and another 1.8% next year.
Construction started on 46 million square feet of office space in the first four months of 2004, up slightly from a year earlier. The last peak in office construction was in 2000, when 149 million square feet of office space was built in the 54 U.S. markets PPR tracks. Not all the space that enters the planning or the final planning and bidding stages gets built. Still, the amount of office space in the pipeline, especially in the final-planning stage, is "real worrisome," says Paul Briggs, senior real-estate economist at PPR, given that demand is unlikely to increase that much. Tampa, Indianapolis and Chicago in particular face the "potential threat" of overbuilding, says Beth Holzberger, a real-estate economist at PPR, which plans to send out this report to clients next week. Those areas were at the top of the list in terms of the amount of space planned as a percentage of total office inventory, but they ranked near the bottom in terms of growth of office jobs. On the flip side, developers appear to be chasing demand in Fort Lauderdale, Fla., Raleigh, N.C., and Las Vegas. Each of those markets had a high amount of new office space planned as a percentage of total inventory, but also ranked near the top in terms of office job growth.
Sakwa said the real estate sector has had a good run in the last month, bringing it to a level where it appears "fairly valued under a best-case scenario and modestly overvalued under a worst-case scenario." Relative to net asset value, REITs are now trading at 107 percent vs. the sector's long-term average of 102 percent. "More importantly, we expect net asset values to grow less than 2 percent over the next year, due to our belief that rising cap rates will partially offset improving property-level net operating income." Historically, according to Sakwa, investors look for a dividend yield from real estate stocks of 1.20 percentage points over the yield on the benchmark 10-year Treasury note to justify their investment in the sector. At the beginning of the year, the spread between the dividend yield on the RMS index and the 10-year Treasury yield was 1.38 percentage points. Although both bonds and REITs have corrected since early April, the spread has narrowed and currently stands at 99 basis points, with the RMS index yielding 5.77% vs. 4.78% on a 10-year Treasury note. But this spread is not enough to whet investor appetite, indicated Sakwa. "A 'spread' of 125 to 150 basis points is reasonable compensation for the risk inherent in the dividend stream of REITs," he said. "A spread of less than 125 basis points diminishes the appeal of REITs vis-à-vis fixed income securities." With the prospects of the yield on the 10-year note rising to 5% or 5.25%, Sakwa added it is possible the RMS index could decline 4% to 8%, assuming the sector's historical spread of 1.20 percentage points remains in place. The 16 REITs downgraded to "neutral": Weingarten, Public Storage, BRE Properties, AMB Properties, Archstone-Smith, Boston Properties, Equity Residential, Kilroy, Kimco, Macerich, Prologis, Rouse, Summit, Trizec and Vornado. The nine real estate investment trusts cut to "sell" Duke, Equity Office, Alexandria, Camden, Colonial, Developers Diversified, New Plan, Tanger and United Dominion. Sakwa did raise his stance on Manufactured Home Communities and Carr America to "buy" from "neutral." In both cases, the moves were based on each company's attractive valuation. Shares of Manufactured Home are currently trading at 87% of the broker's first-quarter 2004 net asset value estimate of $35.39, while Carr America shares were at 86% of its first-quarter 2004 net asset value forecast.
A report last fall by Ashok D. Bardhan and Cynthia Kroll of the Fisher Center for Real Estate and Urban Economics at the University of California, put the upside of square footage lost at 800 million feet over 10 years. Reis expects absorption of space to fall 26% from its peak to an average 68.7 million square feet over the next three years, due partly to outsourcing. But new research from LaSalle Investment Management and PricewaterhouseCoopers concludes that such forecasts are overly pessimistic. Both point out that [those studies overlook] insourcing of jobs to the U.S., with foreign companies hiring employees in the U.S. Ohio, Georgia, Michigan, Pennsylvania and New Jersey rank among the top states for insourcing, according to the Organization for International Investment. And certain markets are expected to be protected from loss of jobs overseas. The effects aren't expected to be felt much in metropolitan markets. And government centers like Washington or Sacramento shouldn't see big losses. However, suburban, secondary and tertiary markets that serve the call-center and data-processing industries are widely expected to be hardest hit. Bill Maher, director of North American research and strategy at LaSalle Investment Management, says cities such as Tampa, Jacksonville, Fla., and Tucson, Ariz. -- areas known for having a large call-center concentration -- could see short-term employment and real-estate problems until new businesses create jobs for laid-off employees. But, he says, many of the major call-center locations are in high-growth areas that tend to create numerous jobs. "Overall growth in these high-growth cities should keep employment and office demand at relatively high levels," he says.
Cases like Hilton's have captured the attention of the commercial real estate industry. Lenders are trying to develop new approaches and policies for guarding against mold, microscopic organisms that have been known to cause allergic reactions in some people and that can seriously reduce a building's value. Fitch Ratings has warned lenders in large transactions to make sure that inspectors test for mold because of the potential risk for income-producing property. In recent years, insured losses for mold damage have risen so sharply - from $700 million in 2000 to $3 billion in 2002 for property damage alone - that insurance companies no longer cover mold damage in conventional policies. Hospitals, where patients with compromised immune systems may be more susceptible to infection arising from mold exposure, and hotels, which have more bathrooms than other buildings and therefore may be more vulnerable to moisture damage, have higher mold insurance premiums if they can get coverage at all. Commercial property owners can still get some coverage but only as an addition to an expensive pollution liability policy. David J. Dybdahl, a senior consultant for American Risk Management Resources Network, a consulting company, estimates that fewer than .10% of property owners are covered. The premiums are costly, with high deductibles, and only property owners who can demonstrate that they have already taken action to prevent, identify and control mold can qualify. The average commercial loss for a single incident is $200,000, according to Mr. Dybdahl. Lenders say they are only now beginning to grapple with mold risks. Katie Schwarting, director of commercial real estate financing for the Mortgage Bankers Association, said lenders were not requiring borrowers to buy mold coverage because they believed that the insurers' caps on potential claims were too low. Mold litigation is entering a new phase, with the target no longer a property owner's insurance company but rather developers, contractors and subcontractors on commercial projects. Real estate specialists say mold has become more of a problem in recent years in part because buildings tend to be more tightly sealed to make them more energy efficient. This means that moisture is trapped inside. Mold does not proliferate just in areas with high humidity, but can also be a result of shoddy construction, sometimes because the contractor cut corners or did not install the roof properly, so that moisture seeps in. Mold is created when spores came in contact with moisture, heat and paper. Using materials containing fiberglass or gypsum instead of paper could eliminate the essential food source for mold.
"Institutional investors are getting access to properties they may not have otherwise been able to buy," says Hans Nordby, an analyst with Property & Portfolio Research in Boston. And don't expect the appetites of institutions for office product to wane this year, adds Nordby, since many have experienced a rise in the value of their stock portfolios recently and are currently under-weighted in real estate. But Nordby and others anticipate that some of the private-leveraged money will go away, perhaps flowing back into bonds.
7-Eleven plans to open 100 smaller indoor stores this year, up from 20 last year. The stores range in size between 1,400 square feet and 2,500 square feet, compared with 3,000 square feet for a traditional store. Whereas a regular 7-Eleven averages $465 a square foot in annual sales, the smaller stores post double-digit increases on a square-foot basis, the company says. The convenience-store industry is coming under the same competitive pressures that drove fast-food restaurants into schools, airports and malls a few years earlier. For starters, there are simply too many of them: some 135,000 convenience stores in the U.S., up 35% from 98,000 in 1993. "All the good street corners are gone, and the competition is so fierce for the ones that are left," says Jeff Lenard, spokesman for the National Association of Convenience Stores. At the same time, traditional gasoline stations are morphing into convenience stores, adding minimarts and selling everything from hot dogs to disposable cameras. And more consumers are buying their gasoline at discount retailers like Wal-Mart, taking away one of the reasons for stopping at a 7-Eleven in the first place.
So it's kind of the opposite swing here, but I think that the consistent commentary from the companies that I follow is that we are somewhere near the bottom. It's going to be a little choppy. We are going to see the volatility, but unless something negative happens from a macro perspective, then we are hopefully going to see 2004 as the bottom point of this earnings cycle. Jay Leupp of RBC Capital Markets: The earnings reports have been relatively good, particularly for apartments and this is the first time in a long time that everyone's come in basically in line and maintained guidance rather than missing or coming in in line and then lowering guidance. We see the same-store net operating income, although negative for every company in the apartment space that we follow, inching toward the breakeven point and we think that line gets crossed over sometime in the next two quarters. We're near the bottom in the apartment business. I would say the same thing for the industrial REITs, as well. Right now, it looks like we're entering into a period where we've had extremely healthy retail REIT fundamentals and maybe we're seeing (at least in the mall area) a peak in terms of near-term earnings performance and maybe we'll just settle into a more average range there. But right now, the malls continue to post very healthy results, especially the ones that we follow. That's likely to continue into a recovering economy. Quick Facts, Stats & Opinions The number of 401(k) plans offering a real estate fund has doubled in the past five years. (Robert Barker, BusinessWeek 6-28) Koger Equity (NYSE: KE) today announced a name change to CRT Properties (NYSE:CRO) to be effective on or about July 1. Since joining Koger, CEO Thomas J. Crocker and his team of former Crocker Realty Trust senior executives have repositioned Koger's portfolio, starting in December 2001 when the Company sold more than $300 million of non-core properties. Since that time the Company has acquired interests in more than $480 million of Class A office buildings. (BusinessWire 6-23) At a recent NAREIT conference, Chris Mayer, director of Columbia Business School's Paul Milstein Center for Real Estate, noted that in March, REITs traded at a 22% premium over the net value of their assets. That's up from a 19% discount in 2000 -- the highest level since '97. They now trade 10% above net asset values -- and those asset prices are up a lot, too. One REIT exec after another at the conference testified as to how pricey real estate has gotten, with bountiful pension-fund dollars chasing deals. (Robert Barker, BusinessWeek 6-28) On 6-14, Merrill Cuts Duke Realty To Sell From Neutral, cut United Dominion Realty To Sell From Neutral, cut Alexandria RE To Sell From Neutral and cut Camden Ppty To Sell From Neutral. Merrill Ups CarrAmerica To Buy From Neutral and Ups Meristar Hospitality To Buy From Neutral. (WSJ) Houston's office vacancy rate is above 17%, and demand for new space is low. Landlords have offered up to $40 per square foot for space improvement allowances, more than double what's typically offered. (Nancy Sarnoff, Houston Chronicle 6-12) Falling rents and aggressive lending over the past couple of years should create "huge gaps" between past financing levels and current levels, said William Walton, managing member of RockPoint Group LLC. And this could lead to distressed property owners, which in turn, could create buying opportunities. The overbuilding problems and rising interest rates that pushed real estate off a cliff during the last recession aren't there this time around - not yet anyway. The cycle has seen a surprising pullback in new construction, with the industry's biggest challenge being a lack of demand - not an oversupply of space. As rates tick up, property owners could face distress, but likely won't be forced to sell assets at fire-sale prices as quickly as they did in the last cycle. (Janet Morrissey, Dow Jones Newswires 6-02) According to Lloyd Lynford, the president of Reis, companies in the 61 largest metropolitan areas allocated an average of 227 square feet for each employee in the 1980s. These days, he said, the average is from 150 square feet to 200 square feet. From 1997 to 2002, managers and professional and technical employees saw their offices shrink by as much as 14 percent on average, according to the International Facility Management Association, a trade association in Houston that periodically surveys companies in a range of industries. An average senior manager's office, for example, was 193 square feet in 1997 but 169 square feet in 2002, the latest year for which figures are available. (Terry Pristin, NY Times 5-29) From "Why Real Estate? - An Expanding Role for Institutional Investors" by Susan Hudson-Wilson, Frank J. Fabozzi and Jacques N. Gordon The definition of real estate for institutional investors has broadened to cover four structures: [1] private commercial real estate equity, held as individual assets or in commingled vehicles; [2] private commercial real estate debt, held as either directly issued whole loans or commercial mortgages held in funds and/or commingled vehicles; [3] REITs and REOCs; and [4] public commercial real estate debt structured as commercial mortgage-backed securities (CMBS). The performance of each real estate investment is produced by a mix of equity-like and debt-like behaviors. For example, consider the polar case of a private real estate equity asset leased to a single credit tenant with a long-term, triple-net lease. The payments on that lease resemble the fixed payments one associates with a bond, not with equity. The value of this asset to the investor fluctuates in step with the same factors that influence the value of a bond or a mortgage, such as interest rate movements, inflation, and the credit-worthiness of the tenant. At the other extreme, an equity position in an empty, speculative, multi-tenant property is driven almost entirely by equity forces. The value of the building is a function of supply and demand for space in that market, at that particular time. As the building becomes more fully leased, it changes from a "pure" equity to a debt-equity hybrid, and perhaps - if fully leased to long-term tenants - becomes very debt-like. In analogous fashion, as the net lease on the building in the first example ages, the residual value of the property at lease-end becomes an increasingly important, and finally dominant, component of the asset's value. Equity issues, such as real estate market forces, economic health, tenant demand, interest rates, and the idiosyncratic nature of the property, such as its location, history, visibility, and neighbors, increase their influence on the asset's value. (See David Booth, Daniel Cashdan, and Richard Graff, "Real Estate: A Hybrid of Debt and Equity," Real Estate Review, Vol. 19 Spring 1989) Five Reasons to Own Real Estate There are five primary reasons to consider real estate, or any category of investment, for inclusion in an investment portfolio: [1] to reduce the overall risk of the portfolio by combining asset classes that respond differently to expected and unexpected events, [2] to achieve absolute returns well above the risk-free rate, [3] to hedge against unexpected inflation or deflation, [4] to constitute a part of a portfolio that is a reasonable reflection of the overall investment universe (an indexed, or market-neutral portfolio), and/or [5] to deliver strong cash flows to the portfolio. The Test Susan Hudson-Wilson, Frank J. Fabozzi and Jacques N. Gordon ran stats to test the above five reasons to see if they were valid. They ran the test against a sector weighted average of four segements of real estate investment. As of mid-year 2002, the current weighting for private debt was 50% [$1,298 billion], 28% for private equity [$735 billion], CMBS accounted for 15% [$393 billion] while REITs encompassed 7% [$173 billion] (source: Roulac Capital Flows). The average return for the real estate investment universe for the 21-year period of 1982-2002 is 10.32% with a standard deviation of 6.89 %. When the very high-return/high-volatility early years of the mortgage index are dropped, and the index statistics are calculated from 1987 to 2002Q3, the real estate index falls to a 7.60% average return. Real Estate and Risk Reduction In testing risk reduction they found the correlations between real estate and stocks, real estate and bonds, and real estate and cash suggest that real estate can play a significant role in a mixed-asset portfolio. Real Estate and Total Returns In testing absolute returns, and found that real estate did not outperform stocks and bonds in absolute terms over the past 14 years. But one compoonent of real estate -public equity real estate [REITs] - well outperformed bonds during the period. And real estate outperformed both stocks and bonds on a risk-adjusted basis when applying the more commonly used standard Sharpe ratio and assuming a risk-free rate of 5.4% (the cash return for the period). Real Estate as Inflation Hedge Is real estate an inflation hedge? Current inflation raises NOI by increasing the rental rate on new leases, but lowers NOI by raising all expenses. In the office, warehouse, and apartment markets, current inflation causes NOIs to fall as the rise in current rents associated with recent leases does not fully offset the increase in expenses, which impact the entire asset. However, in the retail sector, current inflation raises NOI, as the impact on rents and percentage rents (which apply to all, or much of the square footage in the building) more than offsets the impact on the few expenses that are not passed through. Retail then has two characteristics (percentage rents and generous pass-throughs of expenses) that render it a very capable transmitter of inflation to asset performance. Inflation also affects the cap rate directly by influencing NOI growth expectations and, therefore, investors’ demand for real estate investments. The direct capital value impact of inflation is significantly positive for apartment and office properties, but not significantly different from zero for warehouse. Thus, the empirical assessment shows that private equity real estate is a very useful, partial inflation hedge. That said, it is also clear that the degree of inflation-hedging capacity is not uniform across the property types. As is the case with most debt, real estate debt is not a good inflation hedge because unexpected inflation and concomitant increases in nominal interest rates negatively hit the value of outstanding securities (mortgages and CMBS). Publicly traded forms of equity real estate will capture some of the benefits of the inflation hedge but are less successful transmitters of this value than private equity because of links to the stock market, which is generally damaged by inflation. So, if inflation hedging is a key reason why an investor chooses an allocation to real estate, that investor must tilt the portfolio toward private equity. Real Estate and Deflation Real estate has also shown that it is less prone to the deflationary pressures associated with global supply-side pressures or quantum improvements in technology. Real estate cannot be produced more cheaply in China and imported to the United States. It also does not suffer rapid obsolescence, so common in the world of computers and telecommunications. Unfortunately, the time to put a hedge in place is before, not once, inflation or deflation occurs, so investors with real liabilities really need an exposure to inflation and deflation hedges at all times. A Proper Weighting of Real Estate The Roulac Capital Flows Database published in Investment Property provides an estimate of $2.6 trillion as the current total size of the real estate market. Using those figures for the size of the market and data from the Flow of Funds report from the Federal Reserve Board for the size of the stock, bond, and cash sectors puts real estate at approximately 8.3% of the current investment universe. Pension fund portfolio allocation to real estate is now approximately 4.8% (3.9% in equity real estate, 0.9% in mortgages). Insurance company allocation to commercial real estate is currently averaging 10% of the portfolio. Real Estate and Cash Flow When it comes to to deliveingr strong cash flows to the portfolio, real estate is a head-and-shoulders superior producer of “cash, cash, cash” for investors. Update: Third Experiment in Stock Picking 6-30-04 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. 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 increased its common stock 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%. More REIT Links
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