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Real-estate professionals are hoping the shorts are wrong -- or at least too early -- about a downturn in the market. "The real-estate sector has gone up dramatically over the last few years, so it's not unusual to have a bit more of the short-sellers standing there than before," says Bruce Schonbraun, managing member of the Schonbraun McCann Group, a real-estate advisory services company. "But I haven't really seen anything over the last couple of weeks that would be any indication to me that anything material has happened in the marketplace at all." Diversified, office, industrial and shopping-center REITs are among the sectors most targeted by shorts. Lodging and self-storage REITs are the only sectors seeing declines in short activity, according to Banc of America. Lexington Corporate Properties Trust and Maguire Properties Inc., two office REITS that both recently announced major portfolio acquisitions, were among those that saw the biggest sequential increases in the monthly periods measured by Banc of America: Short interest rose 55% at Lexington and 48% at Maguire. Others seeing big sequential gains included Inland Real Estate; U-Store-It; Highwoods Properties; Correctional Properties Trust; Parkway Properties and Mack-Cali Realty, where shorts rose 149%, 148%, 49%, 46%, 39% and 37%, respectively.
After reviewing data from the past six years, Sakwa concludes that a 150-basis point rise in the 10-year Treasury will push cap rates (returns) up 60 basis points, which in turn will lower a company's net asset value, or NAV, by 9%. In other words, if the Treasury approaches 6%, NAVs could decline by 9%, he predicts. The mall sector would likely be hit hardest due to its higher use of leverage, said Sakwa. He sees mall REIT NAVs falling 11.4% in this scenario. Apartment REIT NAVs would slip 10.4%, factory outlet NAVs 10.3% and shopping center NAVs 9.3%. The least affected would be industrial REITs, whose NAVs would drop 6.9%, he said. Equity REITs currently trade at about an 8% premium to NAV, which is ahead of the sector's historical average of 3%. Although rising rates will likely take a toll on valuations, Sakwa believes "well-run REITs should trade at modest 5% to 10% premiums to NAV." Also, as rates tick up, REIT dividend yields will become less attractive. The recent interest rate runup narrowed the spread between bonds and REITs to only 53 basis points, down from its long-term average of 118 basis points. Sakwa maintains a cautious outlook for REITs due to valuation and the near-term pressure from rising interest rates.
"At the moment, I think the opportunities for acquisitions and the opportunities for consolidation are much more interesting outside real estate," says the investor. Mr. Zell's investing fancy has turned from office buildings to river barges, pharmaceuticals and Home Products International, a company that makes clothes hangers and ironing boards. An investment group including Mr. Zell's Equity Group Investments LLC last year took over Home Products, which had $233 million in sales in 2003. He talks of using the company as an acquisition vehicle to create a consumer products powerhouse with the heft to negotiate on equal terms with big retail chains like Wal-Mart and Target. Equity Group also owns about one-third of cough medicine maker Adams Laboratories. The new investment focus recalls the corporate takeovers that earned Mr. Zell the nickname "Grave Dancer." In the 1980s, he earned big returns spotting value others overlooked in companies like rail car lessor Itel Corp. and wire-maker Anixter Bros. After cashing in many of those investments, he returned to real estate, where he'd started his investing career in the early 1960s as a University of Michigan law student, buying apartment buildings. Scooping up bargains in the wake of the early-1990s real estate collapse, he assembled portfolios of office buildings, apartment houses and mobile-home communities. He was among the first real estate investors to offer shares in his REITs to the public. Since 1994, when Morgan Stanley created a benchmark performance index for REIT shares, Mr. Zell's Equity Residential LLC apartment REIT has returned 312% to investors, and his Equity LifeStyle Properties LLC mobile-home REIT 261%. The index's return for the same period was 262%. "These companies are doing fine," he says. "They are worth measurably more than the price they're trading for and I think they have fulfilled their objectives to shareholders." Mr. Zell's Equity Office Properties Trust, the nation's largest owner of office properties, has returned 67% since it went public in 1997, trailing the index's 118% return for the same time frame. Uncharacteristically, Mr. Zell paid top dollar for a Northern California office portfolio at the height of the dot.com boom, a move that dragged down returns when the region's economy tanked several years ago. Equity Office shares also suffered from investor skepticism of Mr. Zell's theory that larger REITs will produce higher returns through economies of scale. "I would much rather have a value creator than somebody who goes for economies of scale," says Jerry Ehlinger, portfolio manager in the Chicago office of Rreef Funds, a real estate investment advisory firm. In the last five years, returns (share price appreciation plus dividends) have lagged at all of Mr. Zell's REITs. While the Morgan Stanley REIT Index climbed 156% during the period, Equity LifeStyle returned 146%, Equity Residential 125% and Equity Office just 79%. A big reason for the poor showing is Mr. Zell's failure to invest in the two hottest real estate sectors of recent years, retail and industrial. REITs in those sectors posted average returns of 218% and 164%, respectively, in the last five years, while office and apartment markets suffered. Mr. Zell is unapologetic, blaming the real estate cycle, not his strategy, for the weak performance. He's confident his REITs will beat the market over time. Nobody has more riding on the REITs than Mr. Zell, who serves as chairman of all three. His combined holdings in Equity Office, Equity Residential and Equity LifeStyle are worth $900 million, about 41% of the $2.2-billion net worth Forbes magazine estimates for Mr. Zell. So far, there's no sign the REITs' diminished performance has dimmed Mr. Zell's star power on Wall Street. His presence as an investor in Desarrolladora Homex SA helped the Mexican homebuilder pull off an initial public offering in the U.S. last year. Its shares are up 62% since its IPO. "The most important asset I have is my name," Mr. Zell says.
The 2003-2004 success was driven primarily by fund flow, experts say, as many investors who had been burned in tech stocks turned to real estate seeking income and appreciation. Yet those days likely are near an end. With the sector's strong correlation with interest rates, the Morgan Stanley REIT Index (RMS) is already down more than 5% for the year. When rates spike, which they have lately, prices on bonds plummet -- as do the returns on REITs. Analysts such as RBC Capital Markets' Jay Leupp sees total returns falling up to 10% in 2005, while Lehman Brothers' David Harris has an even more bearish prediction -- an 18% decline. "As yields increase in the stock market or in the bond market, the attractiveness of REIT dividend payouts decrease as their dividend yields look less attractive," says Michael Knott, an analyst at independent real estate research firm Green Street Advisors. Analysts are especially negative on residential REITs, such as Archstone-Smith (ASN), AvalonBay (AVB), and Essex Property Trust (ESS). Residential REITs generally are among the most expensive subsectors, but these particular ones are considered likely overvalued because they hold coastal properties, says Harris. At the same time, "single-family housing starts are up to all-time highs, and there's also some excess building around the condominium sector, especially in South Florida, Washington, D.C., and Southern California," he adds. Despite the bearish outlook, REITs still make sense for anyone looking to diversify their portfolio with some income-generating real estate. Over the past few years, the stocks have proved to be a profitable defensive investment, with average dividends of 4% to 6% on top of stock-price appreciation. Despite his negative prediction for the sector this year, Leupp, like many other experts, believes REITs remain a strong investment class. "The fundamentals -- earnings growth and dividend growth -- are still positive," says Leupp. "High-quality, well-maintained, well-positioned real estate assets will provide investors with superb returns over the long term." Analysts point out that the fundamentals found in certain sectors mean they'll likely hold their own in comparison with others in a Goldilocks economy -- one not too cold, not too hot. "Retail REITs have tended to remain strong, particularly in the mall area," says Lehman Brothers' Harris. REITs specializing in buying and managing mall properties are a favorite of analysts and managers in 2005 because of their economies of scale and national tenant base. Some mall-subsector REITs such as Simon (SPG) and General Growth Properties (GGP) have seen a real improvement in fundamentals. They also have an advantage in this sector because it's difficult to add to capacity of existing malls or build new ones to compete, says Richard Cervone, portfolio manager of Putnam Investors Fund. Cervone and Harris like these two REITs, both of which have made significant improvements to the malls they own. Also General Growth Properties recently acquired Rouse Company and its portfolio of properties. Harris includes Macerich (MAC) and Developers Diversified (DDR) among his top picks as well. Office REITs are also looking cheaper compared to most other sectors and have the greatest growth potential, says Green Street's Knott. He recommends Boston Properties (BXP), whose properties are concentrated in top markets such as New York, Washington, D.C., and San Francisco. Investors looking to make a killing in REITs have probably missed their chance this cycle. Returns of more than 30% in all likelihood won't be repeated anytime soon. But for careful long-term investors looking for diversity and to keep a portion of their portfolio in real estate, REITs can still do the job.
"We're either into a new paradigm or about to experience a tremendous readjustment - in other words, a crash, in real estate," said Mack. "I would be real careful about the cheap land and the cheap buildings in anyplace but the real bustling metropolitan areas," he said. "I think we've got to be very careful as we look at real estate." "To me it feels like we're sitting in a craps game and we've got a really hot shooter. And he's into his fifth or sixth pass. And I don't know if he's going to make 12 passes or 15 passes - but one day he's going to crap out," said Mack. "And when he does crap out, we have to all be very careful." Zell and Roth are more bullish. Zell believes this is a different era, where real estate won't crash and burn - at least not in the next few years in major markets. He noted that liquidity is at record highs and there's little new office construction going on. "There is nothing more relevant in our business than capital - the cost of capital and the availability of capital," Zell said. "And we're in the middle of a period right now...where we're inundated with liquidity." Roth said he isn't expecting the industry to suddenly "viciously" correct. "People who get too cautious too early and prepare for the burst of the bubble too early, are going to miss the greatest buying opportunity in the history of man." "We are no where near the end of the cycle. Interest rates are meandering up - not enough to create a vicious correction," said Roth. He believes a correction is "years away." In the past, there were clear signs that led to the crashes that occurred in 1974, 1981, 1986 and 1990, said Zell. "You had to be blind to not know what was happening and what was coming," Zell said. "Of course the industry is full of blind people - but that's another story," he quipped. If someone can buy a property today and finance it for 10 years at 5% and there's a minimum of 3% inflation, "I like my odds," said Zell.
Based on strong expectations on all those measures, Fort Lauderdale, Fla., rose 10 spots -- one of the biggest year-over-year moves -- to top the 2005 ranking, displacing Washington, D.C., which fell to No. 2. Other coastal markets that moved up in the rankings include Miami, which rose seven spots to seventh place, and West Palm Beach, Fla., which rose two spots to 10th place. The other top-10 ranked markets included Orange County, Calif.; Riverside-San Bernardino, Calif.; Manhattan; San Diego; Tampa, Fla.; and Los Angeles. There were no significant shifts in those already strong markets. The markets that had stronger-than-expected moves in the rankings were some of those hurt the most during the economic downturn, largely at the hands of the technology bust. Vacancy rates rose and rents fell in those markets. "Companies are taking advantage of cheap rents, so consequently what companies are doing is taking space ahead of the actual need in clear anticipation of the need," said Alan Pontius, national director of Marcus & Millichap's national office and industrial-properties group. "We see substantial [investor] interest in these markets not because of fundamentals in these markets at the minute but because there is interest in how these markets will rebound." Seattle had the biggest jump, moving 20 spaces to 15th place. The city had higher-than-anticipated job growth of 2.1% in 2004 and better-than-expected leasing of additional space, Mr. Pontius said, which bodes well for 2005. Denver moved up six spots to 24th place, as defense contractors expanded employment, in part because Colorado has fast become "the operational nerve center for Homeland Security," said Brad Calbert, president of Denver-based commercial real-estate-services firm Colliers Bennett & Kahnweiler. What's more, there hasn't been a large amount of commercial construction in Denver in recent years, he said. With supply tight and employment growing, office buildings should become more attractive to investors. As in many of these recently beaten-down markets, investors have bid up the price of buildings in anticipation of a rebound. In Denver, there has already been a 50% increase in office-building transactions in the past 12 months, Mr. Calbert said, which has resulted in "escalation of pricing." The markets at the bottom of this year's ranking, including Milwaukee, Cincinnati and Columbus, Ohio, continue to be challenged by below-average economic outlooks, Marcus & Millichap said.
Beacon Capital completed another quick flip in October of 2004 when it sold Trillium East and West in Woodland Hills, Calif., for $162 million to Douglas Emmett & Co. Beacon Capital, which acquired the 655,000 sq. ft. complex in September 2001, made a tidy gross profit of $28 million in that deal. And the kicker? The buildings weren't on the market, says Alan Leventhal, Beacon Capital's CEO. “We typically like to hold assets for the long term,” says Leventhal, who plans to increase the firm's office portfolio to 20 million sq. ft in 18 months. “But certainly there have been dramatic changes in the marketplace, so we've been selling assets that we expected to own longer.” Beacon Capital is hardly the only office investor taking advantage of the frothy capital markets which are driving up values and creating a seemingly limitless investor appetite for property. New York-based real estate investment research and consultant firm Real Capital Analytics, which tracks sales of $5 million or more nationwide, says that 2,070 office buildings sold in 2004. Of that activity, some 270 transactions, or 13% of all sales, involved assets that had been held approximately four years or less. Those 270 transactions alone generated an aggregate gross profit of nearly $3 billion. While corporate owners and small opportunistic value-add investors accounted for some of the sales, the list is also peppered with the names of several large national and regional landlords that manage funds for pension plans, endowments, private foundations and other deep capital sources. Some of the names include Houston-based Hines, San Francisco-based Shorenstein Co., Chicago-based Walton Street Capital, and Newark, N.J.-based Prudential Real Estate Investors. So, are private investment funds turning into short-term holders of office assets in return for fast profits, or are they simply taking full advantage of the wide-open capital spigot that's flooding the property markets? A little bit of both, according to experts. Yes, the capital markets are fueling rapid-fire transactions. But increasingly, portfolio managers are earning financial rewards for seizing opportunities that return big profits. In turn, that has generated typical ownership periods of five to seven years compared with hold periods of about 10 years that were common a decade ago. There's an expression that if you didn't sell the asset, then you bought it again. Translation: If owners fail to take advantage of the current seller's market today, they may have to accept a lower price tomorrow. Owners are taking a more active management approach with their portfolios. Fund managers typically they receive a share in the portfolio's returns. In fact, Hines receives such incentives for its management role in National Office Partners, a partnership that Hines and the California State Employees' Retirement System (CalPERS) formed in 1998 to acquire and operate office properties. Generally, Hines receives a 20% share of the internal rate of return over and above a threshold of 9.5%, though Hines also must meet other performance standards to qualify for the incentive. The incentive structure is part of a nearly 20-year shift in real estate asset management. Fifteen years ago, for example, compensation generally wasn't tied to the investment returns of a portfolio. Instead, investment advisors would buy assets for a pension fund, for example, and would typically receive straight fees for services such as acquiring, managing and leasing the properties. Most property owners have had no problem figuring out when to sell given the roiling demand for real estate over the last couple of years. In 2004, office buyers and sellers completed 2,200 transactions valued at $53 billion, according to Reis, which tracks deals of $2 million and higher in 80 markets. To put those figures in perspective, the number of transactions rose 22% over 2003 while the total dollar value of transactions spiked 32.5%. Meanwhile, the average office value in the top 50 U.S. markets climbed 3.3%, to $139 a sq. ft., from the third quarter to the fourth quarter of 2004, according to Reis. But buyers paid an average of $171 a sq. ft. during fourth quarter of 2004, or a 23.4% premium above the average value. The rampant trading of office buildings resembles a game of musical chairs: As soon as investors sell, they must reinvest the proceeds somewhere — and much of the time they plow the cash back into real estate. But investors may eventually get stuck holding under-performing office buildings when capital dries up, particularly with no clear sign that robust occupancy and rent growth is returning to most areas of the country. National average vacancy, which peaked at 16.9% in the first quarter of 2004, dropped to 16.2% in the fourth quarter, according to Reis. About 700,000 new office jobs were created in 2004, which helped generate absorption of 40.8 million sq. ft. for the year. That marked the first time in three years that office users moved into more space than they abandoned; in 2003, for example, negative absorption was 8.5 million sq. ft., according to Reis. Experts project that anywhere from 400,000 to 700,000 new office jobs will be created in 2005, which could translate into absorption of 60 million sq ft. to 80 million sq. ft. But mergers between companies such as Sprint Corp. and Nextel Communications, and AT&T and SBC Communications, likely will result in tens of thousands of job cuts and throw vacant space on the market. Moreover, uncertainty hangs over the general economy: inflation, interest rates and the federal deficit. Thus, it could be a good two or three years before many markets see large occupancy gains, suggests Nicholas Buss, senior vice president and group manager for real estate market research and valuation at PNC Real Estate Finance in Pittsburgh. “What we saw last year was that the office job growth backfilled shadow space,” he says. “I think we'll see similar office job growth this year, and it should move the vacancy figure down a little further.” Real estate experts wonder how long the market can sustain the lucrative profit-taking, particularly as buyers continue to bid up prices. Indeed, major markets have seen a rash of sales that have either set new price records — or have come close to it. In December, TIAA-CREF acquired National Office's 3-year-old IDX Tower in Seattle for $368.6 million. At $411 per sq. ft., that was a record. Trizec's $435 million purchase of Bank of America Plaza? At about $310 per sq. ft.: a record for Los Angeles. Investors insist that prices are still below replacement cost, given the general price increases of steel, lumber and other commodities last year. In January, Beacon Capital purchased the 970,000 sq. ft. Bay Colony Corporate Center in Waltham, Mass., from Shorenstein for $274 million. At $280 per sq. ft., the price was thought to be a record in the suburban market, but the four building office park on 58 acres would cost upwards of $300 per sq. ft. to build today. Additionally, Beacon Capital beat out four competitors for the Bay Colony property. The bidding wars likely won't end anytime soon. Why? The often-repeated reason is that more attractive investment alternatives to real estate simply don't exist. But given the extraordinary amount of capital chasing deals, which is pushing down capitalization rates, the property markets may be losing some of the sheen they had three years ago, says Beacon Capital's Leventhal. “Real estate is still attractive,” he says, “but there's not as much of a disparity between real estate and other asset classes as there once was.” That's not slowing down investors. National Office, for example, anticipates having an investment capacity of $1.5 billion in 2005 and plans to aggressively seek new acquisitions and development opportunities, according to MacEachron. Meanwhile, CommonWealth Partners has more than $1 billion available for office acquisitions next year via its Fifth Street Properties fund, which is a partnership between CommonWealth, CalPERS, and Rockefeller Group International. But CommonWealth is taking advantage of the demand for real estate, too. In late January, the real estate investment firm agreed to sell 5 million sq. ft. and four development sites within the Fifth Street portfolio for $1.5 billion to Maguire Properties, a Los Angeles-based REIT that owns 10 million sq. ft. of office space in southern California. While CommonWealth held the assets slated for disposition for an average of six years, it acquired one of the buildings, the 1 million sq. ft. 777 Tower in downtown Los Angeles, in July. The pressure building in major markets, however, is beginning to send investors to secondary markets to search for opportunities, say experts. While smaller markets in the U.S. may offer investors better capitalization rates — 8.5% rather compared with 7% or less in major cities — that potential bump up in yield is in markets where occupancy and rent improvements have failed to keep up with the major cities, says PNC Real Estate Finance's Buss. The danger: Investors may find themselves stuck with illiquid assets if the fundamentals fail to improve as fast as hoped.
With office rents slowly rising, it's logical that large corporate space users would want to lock in long-term leases now at still attractive rental rates. “The most lucrative concessions have already disappeared in some metropolitan areas,” says Bob Bach, national director of market analysis with Grubb & Ellis. “If you're a large user, you should lock in your rate soon.” So why are so many tenants ignoring that advice? For many corporate tenants, cost reduction is no longer the primary driver in real estate strategy, says David Kilborn, senior vice president at Atlanta-based Carter, a full-service real estate company. In an era of short production cycles and rapidly changing business models, the new mantra in corporate real estate is flexibility, which is often equal to, if not more important than, achieving the lowest occupancy cost. “It varies from case to case, but if you're looking for a majority consensus, tenants prioritize flexibility over price,” Kilborn says. That reluctance of being tethered to a space beyond its usefulness makes some executives reluctant to sign a 7- or 10-year lease. Experts say the right lease provisions can allay those fears, particularly for tenants that act before the market pendulum swings back in favor of landlords. Given the improving but still soft fundamentals in most office markets today, tenants are in a good position to demand low rent, long terms and the flexibility they crave. A growing number of tenants are seizing the opportunity to lock in leases now while markets are soft and rents are low, rather than later when rent and occupancy will most likely favor landlords. That trend is reflected in the average term of U.S. office leases tracked by Grubb & Ellis. The average office lease term fell with the onset of the recession, from a high of 63 months in the fourth quarter of 2000 to 57.3 months in the first quarter of 2001, according to Grubb & Ellis, which tracks office leasing in about 50 U.S. markets. At the end of 2004, the average office lease spanned 58.7 months. Accounting consultant Robert Vallone advises tenants against “warehousing” space, or leasing room for future expansion as part of an initial move-in. Vallone suggests tenants planning future growth secure an expansion option or first right of refusal on additional space, thereby avoiding extra rent until the space is needed. He also suggests adding a termination clause that would enable the tenant to exit the space at a specified future date if, for example, its needs change five years into a 10-year lease. Should the tenant act on a termination clause, he warns, most landlords will expect the tenant to pay any remaining costs of tenant improvements. In negotiating either a new lease or a restructuring or renewal, Vallone suggests tenants ask the landlord to pay for any tenant improvements, even if that requires the tenant to pay more in rent. That's because current tax laws spread the depreciation on those improvements over 15 years, even if the lease lasts only a fraction of that time. For tenants that want to upgrade standard allowances of particular items such as carpeting or floor tiles, Vallone cautions against accepting a lump sum from the landlord for the construction allowance, which is immediately taxable. A tenant in that situation is better off paying for improvements in exchange for a rent credit from the landlord. Now is also a good time to revisit lease provisions relating to both maintenance and operations costs, which over time can escalate to equal base rent. Any expense for elevators, lobbies, common areas, extended operating hours and the like that the landlord agrees to pay for will reduce a tenant's overall occupancy cost. “When the markets are weak, it's a good time to reach in for not just rent, but many other aspects of a lease that are of interest to a tenant,” explains Rick Liebermann, executive vice president of Grubb & Ellis Corporate Services in Newport Beach, Calif. Working flexibility into a lease can add to the rental rate, but most tenants welcome the tradeoff, says Paul Waters, senior vice president in the national sales group of tenant representation firm The Staubach Co. “Tenants will pay a premium for flexibility in a lease. It could be 50 cents or $1.50 per sq. ft. on top of the base rent, depending on the market.” Lease provisions are just one component of flexibility. Barbara Hampton, vice president of knowledge management at CoreNet Global, a coalition of corporate real estate professionals and service providers, says that a range of flexibility options are coming into the marketplace. Nokia, for example, signed a five-year agreement in 2002 to move 20% of its worldwide workforce — about 10,000 employees — into executive office suites provided by Regus Group. Those employees can work from any Regus office that suits their needs, shifting from New York one day to Singapore the next, without being tied to any particular office. Hampton also cites an arrangement between Bank of America and American Financial Realty Trust (AFRT) as an example of how providers can offer flexibility. Bank of America sold 8.1 million sq. ft. to AFRT and leased back approximately 5.2 million sq. ft. with the ability to expand, contract or trade space in any of AFRT's properties under pre-arranged pricing. “Bank of America committed to millions of square feet, but there is flexibility at the individual site level for them,” Hampton says. Limited development has kept supply closer in line with demand in many markets than in previous downturns. New construction accounted for an average of 7.9% of available office inventory in the five years leading up to and through the recession of 1990-91. That compares with an average of only 3.28% for the same period through the 2001 recession, according to Grubb & Ellis. With fewer surplus properties, rental rates and land prices will increase faster than in previous recoveries. Still, Bach of Grubb & Ellis believes tenants will continue to find deals in most U.S. markets this year. “Essentially 2004 is the year that the market turned around, but it's going to be a slow recovery. It will be another two or possibly three years before we get back to an equilibrium of 10% to 12% vacancy, so concessions will disappear gradually.”
Robert Sammons, director of research at Colliers, said average rental figures have been held down primarily by the Midtown South and Downtown markets. Demand for prime real estate, in typically hot Midtown submarkets near Rockefeller Center, Times Square and Grand Central, has taken off recently, a sign the economy is recovering, Sammons commented. Midtown Manhattan vacancy fell to 8.3% from 8.4% in January and 10% in the same period a year earlier as several law firms renewed or expanded their leases and Citigroup Inc. (C) snapped up 176,000 square feet of a recently completed building at 731 Lexington Ave. Average asking rent for class A space in Midtown rose to $57.15 a square foot from $57.10 a month earlier and $52.74 in the prior-year period. Midtown South's class A vacancy rate fell to 6.7% from 7.2% in January and the average asking rent dipped to $33.50 a square foot from $33.94. Downtown Manhattan's class A vacancy rate dipped to 13.2% from 13.4% in January and 13.8% a year earlier as Fried Frank Harris Shriver & Jacobson renewed and expanded a lease on 380,000 square feet at One New York Plaza, in the largest deal of the month. The law firm may become an anchor tenant for 7 World Trade Center, which is under construction. Sammons believes activity in the Downtown market, which has struggled in the past four years, has picked up and rents there are expected to rise 4% to 5% in 2005. Also, Sammons said sublease space has eased to 7.7 million square feet in February from 9.7 million square feet a year earlier, and has been shrinking at a better clip than direct space. This bodes well for office real-estate investment trusts and operating companies such as Boston Properties Inc. (BXP), Vornado Realty Trust (VNO) and Brookfield Properties Corp. (BPO), which have big holdings in New York and don't typically benefit from sublease activity.
In 2004, Washington wrapped up the year with the lowest office vacancy rate of 7.1%, thanks to the federal government and its ancillary industries. Midtown Manhattan finished the year just over 10% while Palm Beach, Fla., ended 2004 at 11.1%. Others in the top 10 included Orange County, Calif.; Portland, Ore.; downtown New York; Boston; Oakland, Calif.; and Orlando, Fla. Among suburban markets, Los Angeles North wrapped up 2004 with the lowest vacancy rate at 10.1%. Others in the top 10 included Long Island, N.Y., Bellevue, Wash., Orange County, suburban Maryland, northern Virginia, Fort Lauderdale, Fla., and Miami. Large corporate expansions helped northern Virginia, while tourism and the weak dollar helped some of the major cities. Employment growth in southern Florida is rising at two to three times the national rate, which is bolstering the office sector there, she said. Sicola said employment is expected to grow more than 6% in Tampa, and about 5% in both Fort Lauderdale and Palm Beach in 2005, outpacing the national average of 2.8%. Sicola is predicting about 44 million feet of office space will be leased up in each of the next two years, up from 38.4 million in 2004. At the same time, new construction has been limited, which should prevent the overbuilding problems that brought down the industry in the early 1990s. She expects about 28 million feet to hit the market in 2005 and 25 million feet in 2006, which is "nothing like the volume of construction that we saw in the 80s, 90s and even the early part of this decade." Sicola expects to see a "steady, slow decline" in vacancy in 2005 and 2006, leveling off at about 14% in major markets and 18% or 19% in suburban markets. However, she said it will likely be late 2005 or 2006 before the industry sees significant gains in rents. Rising interest rates and consolidation within the financial-services industry could have a negative impact. On the sales side, the office market was robust. The volume and price of trophy properties set new records in 2004, with 150 properties priced higher than $100 million changing hands in the last six months, she said. The trends are happening "against a backdrop of four years of the worst underlying fundamentals that we've seen in the office markets since the late 80s and early 90s," said Bear Stearns analyst Ross Smotrich. But the big question is when will these improving trends translate into significant improvement on an office REIT's balance sheet? Although market rents are starting to tick up, many companies will still be seeing rents on expiring leases fall since market rates haven't yet caught up with lease rents. "In most office REIT portfolios, we expect to continue to see some rent rolldown here," said Smotrich. As a result, there will be a delay between the time industry fundamentals improve and the time they translate into earnings growth. Some analysts, such as Goldman's Carey Callaghan, have already started turning bullish on office real estate investment trusts, and are recommending investors start rotating back into the beaten-down sector. They reason that jumping into the sector now will allow investors to reap the benefits that job growth and the economic rebound will have on office demand. "On the one hand, it seems very obvious that the office markets are firming on a national basis, looking at absorption and declining vacancies and the potential for rising rents," said Smotrich. However, he believes part of this recovery has already been priced into the stocks.
The result is a widening of the gap between the cost of renting and the cost of buying in some of the nation's hottest housing markets -- a gap now at its biggest since at least 1994, according to Torto Wheaton Research, and by some accounts at its biggest since the 1970s. The data suggest the economic case for renting, at least in the short term, has grown significantly in these markets. With interest rates falling, it's "not surprising that the relationship [between rents and home prices] has changed," says Mark Zandi, chief economist of Economy.com. "What is surprising is that it has changed so much." In San Francisco, the monthly cost of renting an apartment is just 45% of the monthly cost of buying a home, down from 67% in 2001, according to an analysis of 21 key markets prepared for The WSJ by Torto Wheaton. In Washington, D.C., rental costs are now just 59% of the cost of owning, down from 82% in 2001. In Miami, rental costs are 63% of the cost of homeownership, down from 89% in 2001. The potential cost savings for renters could well be even larger, given that the analysis doesn't factor in property taxes and other expenses associated with homeownership. Despite the lower comparative cost of renting, the enduring tug toward homeownership -- coupled with the fear of missing out on further price appreciation and even being shut out of the market for good -- still is driving many people to buy. The rate of homeownership in the U.S. was 69.2% in Q4-04, compared with 67.5% in 2000. Many buyers who have done the math are betting that rents eventually will rise and that any savings from renting will be more than offset by rapid gains in home prices. Still, many economists say those outsize gains are likely to become a thing of the past as interest rates move higher. The fact that the cost advantage of renting has widened in many areas is even more remarkable given that apartment rents have begun to edge upward. Those modest rent increases were more than offset by strong gains in home prices in many parts of the country. Average home prices climbed 8.3% last year and 7.5% in 2003, according to data compiled by M/PF YieldStar, with many markets posting double-digit gains. Rents, meanwhile, inched up 1.7% last year, after falling 1.6% in 2003. Because housing and rental markets depend on local circumstances, the relationship between home prices and rentals varies significantly around the country. The median home price in metropolitan Las Vegas is $266,400, which works out to $1,274 a month, assuming a buyer puts 20% down and takes out a 30-year fixed-rate mortgage, according to HSH Associates. The average rent for a two-bedroom apartment there is $860. In the San Diego metro area, the median home price is $551,600, which works out to about $2,686 a month, while the rent on a two-bedroom apartment is $1,625. The national apartment market was hurt severely by the economic downturn. In Phoenix, a one-bedroom apartment that fetched $700 a month a year or two ago now can be had for $550, says Lisa Sampson, a broker with All Star Apartment Rentals. Meanwhile, "the same house you could have bought for $150,000 last year is now $250,000."
Generally, student housing is viewed as cheaper and more stable, from an occupancy perspective, than traditional apartments. Even savvy real estate investment trust, Vornado Realty (VNO), renowned for its opportunistic investments, snapped up a 16% stake in GMH late last year. However, higher repair costs and competition between the three REITs for acquisitions could drive up expenses and cut into the sector's profits in the long-term. As a result, some investors, such as Sam Lieber, co-chief executive of Alpine Woods Investments LLC and president of Alpine Funds, are sitting on the sidelines waiting to see how it plays out before jumping in. On the surface, student housing REITs appear more attractive than traditional apartment REITs. GMH Chief Financial Officer Bradley Harris estimates student housing is a $159 billion industry, with only 3% owned and operated by major companies or REITs. "It's a big, untapped market," he said. "We perceive an opportunity for consolidation." Enrollment at colleges is expected to increase 13% to 17.7 million students between 2002 and 2012, according to the U.S. Department of Education. "The baby boom echo" is driving demand, said Bill Bayless, chief executive of American Campus Communities. Also, "the student housing that currently exists on campuses was built in the 1950s and '60s for the first baby boom," and most are outdated buildings that few students today want to live in, he said. Budget constraints prevent colleges from updating dorms, triggering a higher demand for private sector investment and ownership of student housing, he said. Occupancy at student housing properties tends to be stable, regardless of where interest rates sit or how well the economy is. By contrast, conventional apartment properties tend to get hit by falling occupancies and rents when rates drop as renters migrate to home ownership. Student housing often faces fewer rent defaults than traditional apartment properties, as "Mommy and Daddy will backstop their kids," said Lieber. Harris estimates 95% of his leases have parental guarantees. However, rents often don't increase at the same pace as university tuition rises. "You have more stable occupancies but less room to raise rental rates in a strong market," said analyst Rob Stevenson of Morgan Stanley. "18- to 22-year old college students and their parents are going to be more price-sensitive than young professionals." Student housing REITs offer bigger dividend yields than apartment REITs, said Lieber. However, valuations aren't cheap. "None of these deals were sold cheap when they went public last year. They were pretty rich," he said. Also, institutional investors traditionally tend to target conventional apartment properties, not student housing, for investment. This is good news for student housing REITs, as it means fewer investors are chasing after student housing properties and bidding up prices the way they have for traditional apartment buildings, said John Vojticek, vice president of real estate securities at RREEF, the pension-fund advisory arm of Deutsche Bank, which holds shares in several student housing REITs. As a result, student housing REITs tend to get bigger returns on acquisitions than apartment REITs even though they share similar valuations in the public markets, Vojticek said. "They get a higher multiple in the public market than they do in the private market, and that's where the arbitrage exists," said Vojticek. However, some market experts wonder how acquisition prices and other expenses will affect theirgrowth in the longer-term. Many speculate prices will start to climb now that three public REITs are jockeying to buy the same properties. Vojticek said he has already noticed an increase in acquisition prices since the three REITs went public. "Some of the private developers who have been doing this a long time are now able to play one off the other" when selling properties, he said. "Since these three have come public, you're seeing an increased amount of that." Lieber said it's not known if the REITs have the development expertise to build properties in the future or if they will have to rely solely on acquisitions for growth. Student housing also tends to incur higher repair and capital costs than apartment properties just from regular wear and tear. "I remember my days as a college student - fondly of course," said Lieber. "They tend to get beaten up more. When you have lots of people crammed into individual apartments - anywhere from two to four typically - they tend to be a little bit rougher, there's a little bit more use and abuse." He believes the capital spending needed to repair carpets, walls and other areas will be higher than they are for traditional apartment owners. "I think the capex numbers may be understated at a lot of these companies," he said. If this happens, it could translate into higher-than-anticipated repair expenses and lower-than-projected funds from operations growth. "I haven't seen these companies budgeting significantly higher capex dollars than apartments do and I suspect they should," Lieber said. Harris and Baylessshrug off suggestions the properties will cost significantly more to maintain. "If your question is - Is it the Animal House type of mentality? It's not at all," Harris said, noting that student housing today resembles a resort-type property, with swimming pools, fitness clubs, game rooms and other features, rather than the bare-bones dormitory or shoddy housing operated by absentee-landlords your parents stayed in. Bayless said his company staffs the residences around the clock. "We have a zero-tolerance policy for damage," he said. Bayless said a property manager typically offers a $500 reward to anyone with information on someone who caused damage to the property. "Students love money. They will turn each other in," he said. "We will pay that reward and we will publicize the heck out of it." Recently, two of the REITs - GMH Communities and American Campus - lowered FFO guidance for 2005 to reflect the competitive acquisition environment. Executives blamed the timing on the closing of certain acquisitions for the pullback in FFO. Harris acknowledges that prices have started to rise, which "makes us a little more selective in the properties that we are acquiring." Vojticek said it's not known if student housing properties can generate the same growth over the long-term as apartment properties. "That's yet to be seen," he said.
Fed up with long commutes and bedroom towns with no sense of place, the new American families want more vibrant communities where housing, jobs, retail and entertainment are all interwoven. The demand for higher-density housing, such as apartments, will hit new highs by 2015 due to an influx of: [1] 78 million Baby Boomers who are downsizing;[2] 78 million children of the Baby Boomers graduating from college and entering the workforce; and [3] 9 million new immigrants. Communities that want to attract the best — young professionals, knowledge workers, the creative class, vital municipal employees — need to offer them the vibrant neighborhoods they desire. To do that, they must embrace higher-density housing. This development should create a new appreciation for apartment living.
The moves by Equity Residential, Post Properties Inc. and United Dominion Realty Trust Inc. are a logical response to weakness in the rental market. So far, at least for Equity Residential, the REIT furthest along with its in-house condo business, the efforts are profitable. The Chicago-based REIT saw 2004 profit from condo sales of $32 million, 45% higher than prior guidance it gave for the year. Equity Residential expects $50 million in 2005 condo sales. But these moves add another layer of risk to these companies, which typically aim to produce steady streams of income by renting apartments. That contrasts with the condo market, which can tank if interest rates jump or the economy slows. Rod Petrik, an analyst with Legg Mason Wood Walker Inc., warns that the in-house condo conversion business "is cyclical and adds some volatility to REITs' earnings streams because if the REIT has a strong second quarter of condo sales, in order to replace that income next year and provide earnings growth, they have to match what they sold and then a little bit more," he says. There's also the risk that interest rates rise and slow the housing market. "Where you run into problems is when you get halfway done with the condo-conversion process and mortgage rates spike and demand for condos goes away and you're left with a project where half of the units have been sold," says Robert Stevenson, analyst with Morgan Stanley. Because of that potential earnings volatility, Mr. Stevenson thinks apartment REITs engaged in in-house condo conversions should command lower valuations. He says a good comparison are home-building companies, which are valued at multiples of between eight and nine times earnings, rather than 15 or 16 times for apartment REITs. Executives at Equity Residential, Post Properties and United Dominion each say the in-house condo sales can offset weakness in the soft apartment market. These businesses can also offer REITs a way to capture the money left on the table when apartments are sold to a converter and then sold to individual buyers, as well as existing renters who might have otherwise left to buy homes from another company. Still, Post Properties and United Dominion are entering the condo-conversion on a small, measured scale. Dave Stockert, chief executive of Post Properties, says the company will also be selective about where it sells condos. "The markets where we will look to do this are where the price and availability of single-family homes make our product very competitive," he says. Craig Leupold, an analyst with Green Street Advisors Inc., a Newport Beach, Calif., research firm, thinks these REITs can generate strong financial results. But he adds that investors should recognize the risks they are taking, especially for Equity Residential, which by virtue of its size will be converting more units to condos than other apartment owners, meaning the fluctuations in the housing market will have a bigger impact. "To the extent that interest rates increase, that will affect Equity Residential to a greater extent than its peers because of its exposure to single-family housing," Mr. Leupold says. Sam Zell, Equity Residential's chairman, believes the risks his company faces are limited, especially as converted units are often less expensive than new condos. "At least from our perspective, the buyers of our lower-priced condos are generally single people and people with much higher disposable incomes," he says. They should be less hurt by higher interest rates than families who are financially stretched, he says.
The strongest outlook is for companies that own enclosed malls in top-tier markets, where any empty stores will be filled quickly. REITs with a lot of shopping centers anchored by grocery stores face greater challenges than companies that own shopping centers anchored by "category killers" such as Wal-Mart, Circuit City, Barnes & Noble and other big-box retailers. "For dominant malls with strong sales, any closings should be a net long-term positive, allowing the owners to fill the space with a more productive retailer at potentially higher rents," says Ross Nussbaum, REIT analyst at Banc of America Securities. Nussbaum indicated that 10% of malls owned by REITs, as opposed to those that are privately held, had an overlap between Federated and May. Simon had the largest overlap, with 27 centers, followed by GGP, with 20 centers. Mr. Nussbaum said a significant number of the properties where overlap occurs are dominant malls, which possibly means that Federated wouldn't close stores at those locations. "Even if they did," he wrote, "the space should be easily re-tenanted, or redeveloped at attractive returns." Some analysts say it is a different story for weaker malls, especially ones in third-tier markets. "With the weaker malls, those anchors will be harder to replace," says Craig Schmidt, a REIT analyst with Merrill Lynch. "For the most part, the REIT industry has better malls. But those [REITs] who have weaker portfolios may have some challenges." He cites mall REITs with properties in smaller markets with lower densities as particularly vulnerable. Two firms that could have trouble filling slots if a Federated or May's store is closed are CBL & Associates and Glimcher Realty Trust. These REITs focus on second-tier markets, according to Richard Moore, a REIT analyst at KeyBanc Capital Markets. They have one and two malls with store overlap, respectively. On the shopping-center front, with Wal-Mart nipping at grocery stores' heels, shopping centers anchored by such stores could face strong head winds. What's more, grocery-anchored centers often are filled with stores that are vulnerable to competition from bigger rivals that can offer lower prices. Executives at the International Council of Shopping Centers conference on open-air centers in Phoenix two weeks ago said landlords are scaling back tenant improvement allowances for video-rental stores and athletic-shoe stores because they believe those businesses are volatile and that bankruptcies and consolidation will lead to a lot of closed stores. Matthew Ostrower, a REIT analyst with Morgan Stanley, says shopping centers anchored by discount chains such as Target or category killers should fare better. He says Developers Diversified Realty tends to have the least concentration of grocery-anchored centers. [Note: This was a point DDR stressed in last month's conference call. And a point I have argued on the message boards. Two pieces of data are relevant: [1] Domestically, the Wal-Mart division plans to open approximately 240 to 250 new Supercenters (those with grocery departments) in the fiscal year 2005 - and approximately 1,000 over the next five years; and [2] Retail Forward predicts that for every new supercenter that Wal-Mart opens, two supermarkets will close. ] "To varying degrees, everyone else is more than half [grocery-anchored]," Ostrower says. Shopping-center REIT Regency Centers is about 90% grocery-anchored, he says, while Kimco Realty, New Plan Excel and Weingarten Realty have more of a mixture. UBS Investment Research analyst Ian C. Weissman estimated that Equity One and New Plan are most vulnerable to Winn-Dixie, with earnings exposure of 5.3% and 3%, respectively, should Winn-Dixie reject all its leases. Equity One announced two weeks ago that none of its 16 Winn-Dixie locations are included on the list of store leases for which Winn-Dixie has petitioned the bankruptcy court for immediate relief and rejection. New Plan said it is in active negotiations for replacement tenants at two locations where Winn-Dixie has filed a motion to reject leases.
Mr. Wexner is pushing Limited to develop new nonapparel products faster and demanding that the company look to other businesses for advice and partnerships. In this new order, Bath & Body Works and Victoria's Secret are the stars, while Express and Limited, the clothing chains, are laggards. The new focus at Limited reflects a big shift among consumers: Clothes are increasingly out of fashion. After declining for three consecutive years, U.S. apparel sales nudged up 4% last year to $172.8 billion, according to market-research firm NPD Group. Last year Victoria's Secret's sales increased 11% and operating income rose 16%, to $822.2 million. At Bath & Body Works, sales rose 12% and operating income increased 18%, to $417.6 million. But at the apparel chains, Express and Limited, sales fell 7.7%, and operating income dropped 60%, to $36.1 million. Other specialty retailers are also feeling the pinch. Sales at Gap stores in the U.S. were flat last year at $5.3 billion, below the 2000 high of $5.5 billion. Gap, too, has embraced more nonapparel products. In 1998, it began opening GapBody stores, which sell lingerie and some beauty products. The company's upscale Banana Republic division has made a major push into jewelry. Mr. Wexner, whose family owned a clothing retailer, founded Limited in 1963, choosing the name because his store's selection was limited to women's sportswear. By the 1980s, his company was the nation's largest specialty retailer. Mr. Wexner challenged the notion that American women's fashion sense lagged behind the rest of the world. "Never underestimate the sophistication of your customer" is one of his favorite sayings. He frequently went directly to Europe for inspiration and mimicked the newest fashions for his stores. He also came to appreciate the emotional attachment shoppers have to strong brands. That insight played a big role in the rise of Express, with its international flavor, and Abercrombie & Fitch, which Mr. Wexner transformed from a sportswear and sporting-goods store into a trendy teen-clothing chain. By the mid-1990s, Limited was a holding pen for 14 different brands, many of which it had created, including Cacique, another lingerie chain; Limited Too, aimed at preteen girls; and Structure, for young men. Stores under its various brands peaked at 5,298. But trouble was already brewing as other retailers caught on. Limited's growth slowed dramatically and profits grew erratic as competitors like Gap swiped market share. In 1995, the company did an initial public offering of 16% of its Intimate Brands division, which included the faster-growing Victoria's Secret and Bath & Body Works divisions. The deal raised cash for the company and allowed investors to benefit from those businesses' faster growth. As apparel sales waned, Limited kept paring itself down, closing a total of more than 1,300 stores from 1995 to 2000. It also spun off Abercrombie & Fitch and Limited Too, which remain independent companies. With pressure also building from Wal-Mart, Mr. Wexner began to think about applying more of Limited's brand-building skills to cosmetics and personal-care products. "Our customers are dominantly female and, at every stage, I wonder what they're going to be interested in next, and is there a market opportunity for a different approach?" he says. One catalyst for Limited's evolution was Vice Chairman and Chief Operating Officer Leonard Schlesinger, 52, a former professor who met Mr. Wexner while teaching at Harvard Business School in the early 1990s. Over the next few years, the professor -- who has taught business, sociology and public policy -- and the executive met periodically. They often chatted about common interests: the processes of creating brands and changing organizations. Limited began to develop its own design skills. It hired more product designers and reorganized so that administrative tasks common to many brands could be handled centrally, freeing creators to create. Mr. Wexner hired Dr. Schlesinger in 1999 to help him devise strategies to organize the company better, among other things. Today, Dr. Schlesinger focuses on organization and finance, freeing Mr. Wexner for creative thinking. By 2002, Intimate Brands, with its emphasis on lingerie and beauty products, accounted for 90% of the corporation's operating income. Limited bought back the unit's shares, citing value to shareholders and creation of a simpler structure that would help the retailer focus on its best brands. The move cemented Victoria's Secret and Bath & Body Works as the corporation's heaviest hitters. Mr. Wexner began pushing Limited to develop products more quickly, to stay ahead of competitors. The company has cut lead times for new Bath & Body Works products to as little as six months, from as much as two years. One result was a product called "Tutti Dolci," Italian for "all sweets." Limited had spotted a trend in "gourmande," or food-inspired, scents. In early 2004, a small project team began developing a line of products such as lotion and lip gloss in fragrances like lemon meringue, angel-food cake and chocolate fondue. Limited launched Tutti Dolci products in all 1,600 Bath & Body Works stores in October -- for a 10-month development turnaround. The company says the products are selling well. Victoria's Secret also has stepped up new-product development. The unit created Pink, a brand of lingerie and pajamas for younger customers that has exploded in popularity. It recently hired a top executive from Avon to expand it. At the same time, Mr. Wexner pushed the company to seek the help of other businesses, either by having them sell Limited goods -- as with the Victoria's Secret perfumes being sold in the U.K. -- or working with them to develop new products. Competitors were moving too fast merely to copy anymore. Mr. Wexner admired L'Occitane, a French brand of personal-care products with a chain of U.S. stores. Soon the companies were collaborating on "Le Couvent des Minimes," a line for Bath & Body Works named for a French religious order. Limited turned over much of the development to L'Occitane. The changes didn't go over well with some Limited employees. At a meeting in Columbus last year, Dr. Schlesinger made a speech explaining the push to search widely for innovation. The presentation included a song by country singer Gretchen Wilson: "Victoria's Secret/Well their stuff's real nice/But I can buy the same damn thing/On a Wal-Mart shelf half-price." In addition to issuing a wake-up call, Dr. Schlesinger says he wanted employees to know they had to broaden their outlook and pay attention to how their brands are perceived. "When was the last time you were at a Wal-Mart?" he asked them. After the speech, employees asked why the retailer had spent so much time building an internal design structure if it was now going to seek partnerships with other companies. "We have no choice," he recalls telling them. In January, Limited formally reorganized into three business groups: beauty and personal care, lingerie and apparel. Dr. Schlesinger oversees beauty and personal care, and Mr. Wexner took over lingerie. For apparel, Limited hired Jay Margolis, 56, former president and chief operating officer of Reebok. Mr. Wexner hasn't totally given up on apparel. Limited is trying to smooth the highs and lows of fashion to make the business more predictable. Instead of having many varieties of pants, the chain focused on a new style it dubbed the "Editor," which has sold an encouraging 5.1 million pairs in the 18 months since its launch. The underlying theory is that women care less about the number of styles than the way the pants fit. Overall results have continued to be rocky, though. During the holiday season, sales for the Limited and Express chains declined 14%, to $713.3 million, and operating income dropped 69%. Operating margins for the apparel division were a tiny 1.4% last year, compared with 19.3% for Bath & Body Works and 19.4% for Victoria's Secret. But Mr. Wexner says fashion lends balance to the company because it changes more quickly than the other divisions' businesses. Also, when the apparel segment is healthy, it generates hefty amounts of cash. In the October investor meeting, Mr. Wexner said productivity improvements could eventually double the apparel chains' sales to $6 billion. Some observers who wish Mr. Wexner would run even faster from apparel wonder if he's too emotionally attached to the Limited chain he started 32 years ago. "Just not so," he says. Dr. Schlesinger adds: "Les loved Abercrombie. He loved Limited Too." He got rid of both.
"REITs have never been too M&A intensive," said Keven Lindemann, director of real estate at SNL. In spite of that, "this was a very active year." By comparison, 2003 saw 18 major REIT deals. Of that, 15 were completed totaling $5 billion. Last year, three Philadelphia-area real estate companies were involved in noteworthy transactions that either helped transform their company or handily complemented the company acquiring them. The reasons for the high influx of M&As last year among REITs can be attributed to the industry experiencing heady stock prices. REITs were coming off some very strong years in terms of stock performance, Lindemann said, adding that REITs have significantly outperformed every major market index since the end of 1999. The high share prices, along with cheap debt financing, have given the companies relatively inexpensive capital to finance the deals, he said. This has enabled them to make deals at the right number that may have previously not worked out under other conditions. The other motivator is growth. "Companies are trying to figure out their next avenue of growth and opportunity," said Joe Smith, senior director of ING Clarion Real Estate Securities in Radnor. The firm owns stock in Brandywine and ProLogis, which bought a local industrial REIT. In these deals, buyers typically are looking for added revenue streams or adding key markets, Smith said. For the sellers, it was either the right time to sell from an organization standpoint or because the price was right. The Brandywine deal, which was the largest real estate transaction in the region's history, exemplifies a desire by public and private real estate companies to strike while market conditions are right for both sides. The investment community viewed the deal positively, Lindemann said. In the case of Rubenstein, the private company could sell its assets at a time when they would be desirable to an acquirer. For Brandywine, a public company, it could buy a cluster of attractive properties in new submarkets, such as Radnor, and grow its portfolio in the Philadelphia region. That sealed its strategy to be a dominant player where it owns office buildings. By gaining Radnor, Brandywine also knocked out a direct competitor for its office space in King of Prussia and Conshohocken, Smith said. The Brandywine transaction included 14 buildings totaling 3.5 million square feet in Radnor, Philadelphia and Wilmington. The deal made the Plymouth Meeting company an immediate major player in Center City by buying One Logan, at 594,000 square feet, and Two Logan, at 697,000 square feet. The company made its initial entry downtown with the construction of Cira Centre, a 28-story, 727,000-square-foot building rising adjacent to Amtrak' s 30th Street Station. With the addition of Logan Square, the company's downtown holdings total 2 million square feet. Historically a suburban office developer, Brandywine's One and Two Logan purchase wasn't a strategic shift, said Jerry Sweeney, chief executive, at the time of the merger. If anything, it complements the company's desire to be a leading player in the markets it serves. Post-sale, Rubenstein decided it will continue to be involved in real estate and is considering its options, though none have been finalized. While the Brandywine deal was the largest local transaction the region has rung up, Keystone Property Trust arranged a major sale last year that made it the second largest deal of the year across all industries. ProLogis of Denver and affiliates of investment companies managed by EatonVance Management acquired the West Conshohocken industrial REIT and its subsidiaries for a total of $1.7 billion. Founded in 1997, Keystone owned 143 distribution properties totaling 34 million square feet in the eastern United States. ProLogis is the largest owner of distribution facilities, with more than 1,700 facilities owned, managed and under development in more than 70 markets throughout North America, Europe and Asia. The deal was key to boosting ProLogis' holdings in New Jersey, eastern Pennsylvania, Indianapolis and the Miami airport area, which are key logistics markets. Then, in December, Kramont Realty Trust, a REIT that owns neighborhood shopping centers along the East Coast, indicated it would be acquired for $610 million in cash by an affiliate of Centro Properties, a Melbourne, Australia, company. Kramont had amassed a portfolio of 93 properties encompassing nearly 12.6 million square feet of space in 16 states. Nearly 80 percent of Kramont' s centers are grocery, drug or value retail anchored. The transaction highlights a segment of an emerging trend being forged by U.S.-based REITs, which have increasingly expanded their presence overseas to seek out more opportunities and become more global to serve international retailers. The Kramont case highlights a portion of that overriding trend by allowing an Australian company to become more diversified in the American markets. The transaction brought to an end the creation of two regional competitors with long local ties. Kramont was the result of the 2000 merger of Kranzco Realty Trust and CV Reit Inc. Norman M. Kranzdorf established Kranzco Realty in 1979, and in his 70s, had sought a way to wind things down. The merger was orchestrated by Louis P. Meshon, who had founded Plymouth Meeting-based Montgomery Development Corp. in 1974, which ultimately merged with CV Reit. The deal between Kramont and Centro is expected to be completed during the first quarter.
Short interest as a percentage of total equity float rose 9.6% during the latest four week period, compared with an 3.5% increase experienced among New York Stock Exchange companies, the report said. "Some of the short interest increase is likely due to increased hedging of long REIT positions," the report said. During the same period, REIT stock prices rose 1.6%, partially rebounding from a stumble they took at the beginning of the year. The companies seeing the biggest increase in short interest over the past month include the following: Affordable Residential Communities (ARC), Brandywine (BDN), Home Properties (HME), Healthcare Realty (HR), Entertainment Properties (EPR), National Health Investors (NHI), Getty Realty (GTY), EastGroup Properties (EGP), and First Industrial (FR), where shorts soared more than 50%. Four of the 10 companies showing the biggest sequential increases were REITs that recently reported fourth-quarter earnings and offered either below-average growth projections or stretched valuations, the report said. There were 11 companies that had short interest ratios greater than 10 days, including the following: FelCor Lodging Trust Inc. (FCH), Town & Country Trust (TCT), Host Marriott Corp. (HMT), First Industrial, Shurgard Storage Centers Inc. (SHU), Camden Property Trust (CPT), Colonial Properties Trust (CLP), Glimcher Realty Trust (GRT), Nationwide Health Properties Inc. (NHP), Regency Centers Corp. (REG) and Realty Income Corp. (O).
That's one problem with REITs: Nothing grows at a 21.3% annual pace forever, even in a red-hot market. To put that in some perspective, the last time the S&P 500 turned in a similar performance was the five years ended October 2000, a few months into the biggest bear market since the Great Depression. No one is predicting a real estate depression. But some investors worry about REITs because of [1] prices, [2] yields and [3] interest rates. [1] Prices After such an impressive run-up, you'd suspect that REITs would be on the pricey side, relative to their earnings - and you'd be correct. Wallace Weitz, manager of Weitz Value fund and one of the nation's top bargain-hunters, says he no longer has REITs in his portfolio. They're too expensive, he says. "I've talked to three analysts who follow REITs closely," he says. "It's a bad thing when they have nothing to recommend." Kenneth Heebner, manager of CGM Realty Trust, has also evicted REITs from his portfolio. Instead, the fund is mainly invested in hotel and homebuilding companies. "The move up in REITs has ignored a decline in operating results," Heebner says. "I'm concerned there could be a pullback." [2] Yields REITs offer juicy dividend yields when compared with most other stocks. But five years ago, the average REIT yielded 8.48%, vs. 5.13% now. As the Federal Reserve (news - web sites) raises rates - and it has done everything but put up billboards saying it will do so - REIT yields become less appealing. [3] Interest rates REITs have fallen 5.3% this year, at least in part because of interest-rate jitters. Just as rising rates disqualify borrowers from the housing market, they would also disqualify some borrowers from loans on office buildings and strip malls. And borrowing costs would increase for those who could qualify for the financings, increasing their costs. Several academic studies have shown that REITs are not terribly sensitive to rising interest rates. But on Wall Street, perception is reality: If investors think REITs will get hurt when rates rise, they will sell their REITs when rates rise. That's exactly what they did in April, when interest-rate jitters sent REIT shares tumbling 18%. Samuel Lieber, manager of Alpine U.S. Real Estate, is a bit more upbeat - but not a lot. "I'm cautious but constructive," he says. Institutional investors, tired of being burned by the S&P 500, began moving into real estate a few years ago, bidding up REIT prices, Lieber says. He thinks that institutional buying will continue for another 18 months to two years, which will keep REITs from tumbling. Historically, dividends have accounted for two-thirds of the overall return from REITs, Lieber says. In recent years, however, price gains have powered the majority of a REIT's total return. Until the market digests all its price gains, Lieber says, dividends will probably account for most REIT gains - meaning single-digit returns for the next few years. It's not all doom for REITs. Among the 10 largest, insiders are selling fewer of their own stocks than before, says David Coleman, editor of Vickers Weekly Insider Report. That's usually a bullish sign. Some real estate sectors, most notably lodging and hotels, have excellent prospects, Lieber says. Who should invest in real estate funds now? If you're looking for an investment that doesn't move in lock step with the S&P 500, a real estate fund is a good diversifier. If you're looking for a fund with an above-average dividend yield, a real estate fund is a good way to go. Just don't expect to build a fortune on REITs. You could end up with a case of buyer's remorse.
In 2004 the EPRA/NAREIT Global Real Estate Total Return Index rose almost 38% [with a 5yr compound annual total return was 16.8%]. Those numbers compare with a 30.4% return in 2004 for the NAREIT Composite Index of publicly traded U.S. REITs [with a 5yr compound annual total return was 22.5%]. The 2004 total return for the global index, not including North American companies, was 43.4% (52.7% for Europe, 36.8% for Asia). The choices for putting money into commercial real estate abroad are more limited than in the United States, but new options should be available in the coming years as countries continue to create REIT-like structures. REITs will broaden the shareholder base in global real estate and make it easier for smaller players to invest, observers say. Before looking at the current options for investing, let’s get a sense of the global commercial real estate market. A December 2004 report by UBS Investment Research estimates $5.95 trillion in commercial real estate is held worldwide in both the private and public markets for investment purposes. The report estimates that the United States has 42% of that total, but only 12% of U.S. commercial real estate is securitized. Although the United States has by far the largest commercial real estate market in the world, most properties are owned directly or by private companies, notes NAREIT’s Grupe. NAREIT estimates REITS own only about 15% of U.S. commercial properties, and Grupe expects that percentage to grow slowly but steadily to between 30% and 50% over the next 15 years. Although commercial property markets are much smaller in other countries, some are more securitized than in the United States. For example, UBS estimates the United Kingdom has 8% of the global investable real estate universe, but 17% of its market is securitized. Australia has only 2% of the total, but 52% of its market is securitized. Scott Crowe, director and global real estate strategist for UBS Investment Research, says the number of publicly traded, or listed, real estate firms worldwide is growing and their market capitalization should double to about $1 trillion by the end of the decade. When looking at the listed real estate universe, Crowe says, companies fall into two categories: developers and investors. Developers, firms that create real estate product and sell it, account for about 16% of total market capitalization, the UBS report says. One of the largest companies in this category is Hong Kong’s Sun Hung Kai P., a residential developer with a market cap in U.S. dollars of more than $24 billion in December. Others include Singapore-based City Developments Ltd., an international property and hotel conglomerate operating in 21 countries, and Mitsubishi Estate Co., one of Japan’s largest real estate firms. Investors, companies that own property and get at least 70% of income from rent, represent about 84% of listed real estate firms. About three-quarters of investor companies are REITs or similar structures, with others being listed property companies, Crowe says. A large, well-known example of an investor firm is Australian-based Westfield Group, a limited property trust (Australia’s version of a REIT) and one of the largest retail property companies in the world with investment interests in 127 shopping centers in four countries. Others include Rotterdam-based Rodamco Europe, the largest listed property investment and management company in the retail sector in Europe; London-based Land Securities Group PLC, the United Kingdom’s largest listed property company; and U.S.-based Equity Office Properties, the country’s largest publicly traded office building owner and manager. Buying into U.S. REITs is relatively easy for U.S. investors, but what if your client wants global real estate exposure in publicly traded securities? Investors may be able to buy individual shares of overseas companies on a foreign exchange through their broker, but trading costs can be relatively high and making good choices can be challenging if you aren’t familiar with various real estate markets. Another option for high-net-worth individuals might be to include some of these stocks in a managed account. For example, ING Clarion offers real estate separate account strategies that include a global real estate portfolio that invests in the United States, Europe and Asia. Yet another choice would be to invest in U.S. REITs that have overseas investments. Grupe says he’s seeing more U.S. REITs expand internationally, particularly in the industrial and retail sectors. AMB Property and Prologis are examples of U.S. REITS that have taken significant steps in this direction, he notes. But if foreign real estate exposure is strictly what your clients are after, probably the least complicated and more effective way to invest would be to buy shares of a global real estate mutual fund. Morningstar does not break out the category and only a handful of these specialized funds exist now, but more money managers have been getting involved over the last few years or are looking to do so. In addition to its separate account strategies, for example, in November 2001 ING introduced the ING Global Real Estate Fund. Its three-year annualized return as of February 3 was 24.31% and its one-year return was 23.47%. A newer entrant to the field is Fidelity's International Real Estate Fund [FIREX]. “We have been looking at this type of fund for many years. We finally felt there were enough companies and market cap from an investment standpoint to have a large enough universe,” says Steven Buller, the fund’s manager. Buller says the new fund includes publicly listed REITs and other types of property companies. He is focusing more on picking solid companies, with a secondary look at whether to overweight or underweight particular countries. From its inception on September 8 through December 31, the Fidelity International Real Estate Fund (FIREX) posted a cumulative total return of 18.61%, and as of January 4, the fund had net assets of $122.88 million. As of November 30, the countries in which the fund had the most assets invested included United Kingdom, 23.6%; Hong Kong, 17.3%; Australia, 12.9%; Japan, 11.5%; and the United States, 8.2%. Cohen & Steers, an income-oriented portfolio management firm that says it is the nation’s largest U.S. REIT manager, is becoming more involved in international real estate as well. The company filed last year with the SEC to launch closed-end and open-end global real estate funds for U.S. investors, says John McCombe, executive vice president and head of the firm’s sales and marketing. Although the company doesn’t have a launch date for the funds, McCombe says he expects it will be this year. According to the firm’s November 23 SEC filing for the open-ended Cohen & Steers Global Realty Fund, Cohen & Steers Capital Management Inc. will be the fund's investment advisor and Houlihan Rovers S.A. will be the subadvisor. On December 14, Cohen & Steers announced it closed on the acquisition of 50% of the capital stock of Houlihan Rovers, a Belgium-based global real estate securities asset manager with approximately $500 million under management. At the time, Robert Steers, co-chairman and co-chief executive officer, commented the investment would allow the firm to offer its clients more choices as REIT-like vehicles are adopted around the world. One of the oldest real estate funds around (U.S. or international) is Alpine International Real Estate Equity Fund, started in 1989. According to Morningstar, the fund returned 36.1% last year. On an annualized basis, its three-year return was 30.94%, its five-year return was 19.52% (both as of February 3) and its ten-year return was 9.68% (as of December 31). “It’s relatively recently that international real estate investing has taken hold, in part because the performance of real estate over the last five years has been quite good, not just through funds or REITs but through direct investment as well,” notes Samuel A. Lieber, president of Alpine Mutual Funds and portfolio manager of its U.S. and international real estate funds. Lieber has found Europe attractive, partly because of currency issues and also because more REIT-like structures are available. France is particularly attractive, and he also thinks Spain and the Scandinavian countries offer opportunities. “Everything is being globalized in the world, and real estate is one of the next frontiers. Investors here are looking for greener pastures abroad,” Lieber says. In the next several years, choices should increase for individuals interested in investing in international real estate as more countries adopt REIT-like structures and more firms create mutual funds that invest in them. According to NAREIT, at least 20 countries have created or moved toward creating structures similar to U.S. REITs, first introduced in 1960. Like the United States, Australia has long offered REIT-type investments. Other countries with them include the Netherlands, Canada, Belgium, Singapore, Japan, France and Hong Kong. The United Kingdom also is planning to introduce REITs. Although similar to U.S. REITs, which must distribute at least 90% of taxable income to shareholders annually through dividends, the foreign versions often have somewhat different investment restrictions, tax requirements and payouts. Some are more attractive than others. For example, Andrew A. Davis and Chandler Spears, portfolio managers of the New York-based Davis Real Estate Fund, are among those who have spent a lot of time looking at the J-REIT, Japan’s vehicle, and they don’t like its externally advised and managed structure. Outside managers are paid to manage assets and they get paid to buy more properties, which creates conflicts of interest, they say. France, in contrast, has a very good REIT structure, they add. The U.K. is where they’ve focused most internationally, investing in listed property companies. Carol Broad, director of real estate research for Russell Investment Group, also is carefully watching trends in property securities overseas. She expects more offerings in parts of Asia and Europe over the next several years. In areas that already have REIT legislation, a lot of initial public offerings are queuing up to come into those markets, she adds. “Most of the market today is in the U.S., and there are limited advantages to going overseas, but as those markets become more developed, they will become more interesting opportunities,” she says. Rating Agency Updates Moody's Investors Service has affirmed the senior debt rating of Vornado Realty Trust at Baa2. The rating outlook for Vornado remains stable. According to Moody's, this rating action is in response to Vornado's announcement of its acquisition of Toys "R" Us in a joint venture with Kohlberg Kravis Roberts & Co. and Bain Capital LLC. The transaction is valued at $6.6 billion. The three partners share equally in the joint venture, and Vornado plans to fund its $400 million share with unsecured debt. Moody's believes that this acquisition could be a positive strategic step for Vornado to gain access to a diverse and potentially valuable retail portfolio of over 1200 stores in the USA and overseas. Moody's notes, however, that as a result of the transaction Vornado's effective leverage (debt + preferred / gross assets) will increase, and its fixed charge coverage will be reduced, slightly. Offsetting these negatives, Vornado's secured leverage is projected to improve due to low levels of secured debt in the Toys "R" Us portfolio. Still, Moody's views this JV as highly illiquid, and anticipates it requiring significant senior management attention over several years-- a credit concern. Vornado's Baa2 senior unsecured debt rating continues to reflect its respected management team and a successful track record of adding value and operating profitably while managing the risk of a diversified portfolio of highly productive assets. The stable ratings outlook incorporates Moody's expectation that Vornado's credit metrics will return close to pre-acquisition levels in the near future. The agency also expects that Toys "R" Us will remain a viable business post-acquisition, and that the JV partners will cooperate successfully in extracting value from the venture. Moody's further anticipates that Vornado's unencumbered assets will exceed unsecured debt by at least 3X post-acquisition. Upward rating movement for Vornado would depend on the successful progress of the venture as well as on material improvement in Vornado's credit metrics: effective leverage (debt + preferred / gross assets, including JVs) closer to 50%, fixed charge coverage including interest, preferred dividends, OP distributions, capitalized interest, principal amortization and JVs, above 2.5X, and secured leverage (secured debt / gross assets with JVs) closer to 20%. The REIT's predilection for large and complex transactions limits its capacity for a rating upgrade. Negative rating pressure would result from any other material acquisition that is not financed to reduce leverage, or further deterioration in Vornado's credit metrics: effective leverage above high 50%, fixed charge coverage below 2.1X, and secured leverage above 40%. Operating reversals at Toys "R" Us would be a clear negative event. S&P comments on Archstone-Smith Trust Ratings press release via Reuters 3-08 Standard & Poor's Ratings Services today said that its 'BBB+' corporate credit ratings assigned to Archstone-Smith Trust and its operating subsidiary, Archstone-Smith Operating Trust, would not be immediately affected by Archstone's recent announcement that it intends to acquire a portfolio of multifamily communities from privately held Oakwood Worldwide. Archstone's management team has demonstrated its ability to integrate large portfolios of multifamily communities, and the REIT's conservative balance sheet is well positioned to absorb this $1.4 billion leveraged transaction. Archstone multifamily housing portfolio comprises a mix of 235 communities aggregating more than 81,000 units. In recent years, the REIT has aggressively repositioned its portfolio, selling over $5 billion of non-core real estate since 2001 and investing in higher barrier to entry markets such as the Washington D.C. metropolitan area and California. During the fourth quarter 2004, the REIT's same-store communities were 95% occupied and generated a 0.8% increase in net operating income (NOI). The Oakwood acquisition would add an additional 30 communities and 10,079 housing units to Archstone's portfolio. The transaction is valued at $1.4 billion, or $141,000 per unit, and appears fairly priced. Overall debt levels are expected to rise modestly, but remain below 50% of total capital (on a book value basis). On Dec. 31, 2004, debt was well below the peer group average at 46.7%, and funds from operation, excluding all gains on the disposition of real estate, covered debt service by 2.6x and fixed charges by 2.3x. Finally, although Archstone will assume a large component of mortgage debt, the percentage of overall NOI derived from unencumbered properties will remain comfortably above 50%. S&P Assigns 'BBB' Rating To Liberty Property Trust Dow Jones Newswires 3-03 Standard & Poor's Ratings Services today assigned its 'BBB' rating to Liberty Property Trust's recently issued $300 million senior notes due 2015. At the same time, the company's 'BBB' corporate credit rating and all other ratings are affirmed, impacting an additional $1.5 billion in senior notes. The company's outlook remains stable. The ratings acknowledge Liberty's solid leasing activity, strong tenant roster, and conservative financial position. These strengths are tempered by continued softness in many of the trust's property markets, material lease expiries over the next two years, and significant development exposure relating to the Comcast Center project. Liberty has consistently achieved solid leasing levels despite challenging market conditions. This speaks to the depth of property level management and the company's strong balance sheet, which has provided the flexibility to attract and retain tenants. S&P will review the rating outlook for possible improvement over the next few quarters, focusing on the progress of Comcast Center (development and leasing risk), management of near-term lease expiries (13% in 2005 and 12% in 2006), and prospects for improving trends in same-property NOI. Fitch Rates Liberty's $300M Sr Unsecured Notes 'BBB' Dow Jones Newswires 2-28 Fitch Ratings has assigned a 'BBB' rating to the recent offering of $300 million in senior notes due 2015 by Liberty Property Limited Partnership, the principal operating subsidiary of Liberty Property Trust. Fitch has also affirmed the 'BBB' rating on LPLP's $1.5 billion of existing senior unsecured notes due 2006 through 2018. The Rating Outlook is Stable. The ratings reflect Liberty's experienced and capable senior and regional management teams, diversity of asset type, and solid capital structure. Liberty possesses diversification across property sectors, including office (53% of annual rent), industrial-flex (22%), and industrial-distribution (25%). The company also has a manageable lease maturity schedule, with 14% of annual base rents maturing in 2005, 11% in 2006, and 12% in 2007. Liberty exhibits sound financial flexibility and continued access to capital, as evidenced by its two recent senior unsecured note offerings for a combined $500 million. As of 12-31-04 after application of the transaction, Liberty's debt maturity schedule is very manageable in the next few years, with 7% of total debt maturing in 2005, 9% in 2006, 5% in 2007, and 2% in 2008. Pro forma for the offering, almost the entirety (97%) of the company's recently expanded $450 million bank credit facility will be available. The ratings are balanced by Liberty's geographic concentration in the eastern Pennsylvania/New Jersey region, which accounts for approximately 46% of annualized base rent, low barriers to entry in predominantly suburban submarkets, and the current slow recovery of the office market. Same-store property level operating income decreased 1.1% on a cash basis for 2004 over that of 2003, providing evidence of continued weakness in property level fundamentals. LRY's development pipeline is modest at $144 million, or only 3% of total undepreciated book capital. Interest coverage and fixed-charge coverage ratios of 3.4x and 2.6x, respectively, are strong, in comparison with similarly rated REITs. Debt leverage stood at 46.1% of undepreciated book capitalization at the end of 2004, which is in line with comparably rated REITs. Since the debt offering will substantially pay down the credit facility, leverage will remain the same after the transaction. Pro forma for the deal, interest coverage remains stable. Moody's Cuts Rtgs Of Shurgard Storage (Baa3); Outlook-Neg Dow Jones Newswires 2-25 Moody's Investors Service downgraded the ratings of Shurgard Storage Centers (senior debt to Baa3) with a negative outlook. Moody's said that the rating downgrade reflects a series of accounting and control difficulties, most recently culminating in the REIT's inability to complete its Section 404 compliance requirements on time, and the negative impact that this could have on Shurgard's performance. Over the past few years, Shurgard has experienced a series of accounting difficulties, including restatements, insufficient accounting personnel, and late filings. In 2004, Shurgard completed a change in external auditors that precipitated a re-audit for the years 2001, 2002 and 2003. The REIT has been working to improve its internal controls, processes and procedures including bringing the European subsidiaries onto US GAAP, and hiring a new CFO, Corporate Controller, Director of Tax, Director of Financial Reporting, Director of Capital Markets, and Director of Internal Audit, all with public company and several with REIT experience. According to Moody's, Shurgard's self-storage operations outside the USA have been experiencing results lower than forecast, albeit improving, and this has crimped the REIT's overall financial metrics. Self-storage is a concept that is not |