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"There's an increasing demand to own commercial real estate," said Ralph Block, senior portfolio manager for the Phocas Financial Corporation, an asset management company, and author of "Investing in REIT's" (Bloomberg Press, 2002). "And I think that it's certain that we are going to see more specialties." REIT's have been outperforming most stocks and bonds in recent years. The specialty REIT sector, in particular, yielded [or 'returned'] 5.53%, on average, for the 12 months that ended on 6-30, and 26.85% for 2004, according to the NAREIT. By contrast, the NARIET composite index returned 4.90% at the end of June and 30.41% for 2004. The S&P500 index rose 6.32% for the 12 months ended on June 30 and returned 10.8% last year. Specialty REIT's come in many flavors. Capital Automotive buys auto dealers' properties. Entertainment Properties buys multiplex cinemas. Rayonier and Plum Creek own timberland. Global Signal owns telecommunication towers. Pittsburgh & West Virginia Railroad buys railroad properties and equipment. Correctional Properties Trust owns prisons. American Financial Realty owns real estate portfolios from financial institutions. Getty Realty buys gasoline stations and petroleum distribution terminals. Alexandria specializes in leasing properties to pharmaceutical, biotechnology and scientific research companies. Three REIT's invest in college housing: American Campus Communities; Education Realty Trust; and GMH Communities Trust. Many successful specialty REIT's have what are known as triple-net leases, in which the tenants agree to pay all the ongoing operating expenses, including the property taxes and insurance premiums. Most net leases are long term (10 to 25 years) with cost-of-living increases in the rent. Of course, they are only as good as the creditworthiness of the tenants. There are other risks with specialty REIT's: not only are they subject to the market conditions that affect commercial real estate in general, like interest rates, but their performance may also be tied to a mix of industry-specific variables. Because of those uncertainties, "they tend to trade at higher dividend yields than traditional properties," Mr. Block said. "A lot depends on the industry they're involved in and the competition within the industry," he added, "and whether they can find a niche that allows them some degree of pricing power or special relationships where they can capture returns on investment that were better than traditional commercial owners." But specialty REIT niches aren't easy for the average investor to master. Most of these stocks operate in sectors with few, if any, peers that can be used as a basis for comparison. "The typical investor should be prepared to spend more time understanding the dynamics of the particular industry in which they specialize," Mr. Block said. Many specialty REIT's have come and gone, like Golf Trust of America, which bought upscale golf courses; its shareholders agreed four years ago to liquidate the portfolio. Prison Realty Trust built prisons on speculation, an approach that resulted in high vacancies. "There's a wide range of outcomes for specialty REIT's," Mr. Block said. "It's like the nursery rhyme: when they're good, they can be really good, but when they're bad, they're horrid." The secret to success for specialty trusts, said Philip Martin, a senior vice president who follows REIT's at Stifel Nicolaus, "is a niche business model that provides stable, predictable cash flow through economic cycles." Mr. Block says he worries that "a lot of properties may not have alternate uses - you just can't go out and find a different tenant in a different industry and lease to them." So if there are high vacancy rates, "they may not be able to restructure to a different use." It is for that reason that Cohen & Steers Capital Management, which specializes in REIT mutual funds, usually sticks with specialty REIT's that "behave much more like core properties" that lend themselves to other uses, said David Oakes, a senior research associate at the investment firm. Entertainment Properties, the largest movie theater landlord in North America, is one of them. "It's not that different from owning a shopping center," Mr. Oakes said. The company's $1.3 billion in holdings include specialty restaurants and retail stores at properties anchored by multiplex theaters. Even though box-office sales have been slipping, Entertainment Properties continues to expand as it regularly doles out dividends. Capital Automotive is another standout. While domestic automakers grapple with poor earnings, downgraded debt and soaring employee health care costs, Capital Automotive prospers. The company recently reported Q2 profits more than doubled from a year ago. "It's a very good company; the dealers are in good shape," said Mr. Martin of Stifel Nicolaus.
"Biotechnology is a growing industry, and the real estate companies that service this sector are likely to see substantial growth over the coming years," Richard Moore, an analyst with KeyBanc Capital Markets, told clients in a research note Thursday. ARE, which was selected Wednesday to develop New York City's massive new biotech hub, saw its stock jump over 5% on Thursday to $80.10 after a bullish analyst upgrade. J.P. Morgan's Anthony Paolone raised his rating on ARE to overweight, citing the company's strong development pipeline. Construction on the massive East River Science Park in New York City won't begin until 2006, so the development won't help ARE's earnings for some time. But the company's investment pipeline now totals over $1 billion, by Paolone's account, and that will fuel earnings growth over the next few years. Paolone projects ARE's FFO to grow 6% to 8% over the next few years. This compares favorably with general office REITs, whose FFO growth rates are expected to be 3% to 5% in 2005 and 2006. In the meantime, BMR's stock has jumped 50% since its summer IPO in 2004. Moore of KeyBanc Capital Markets thinks BMR is a better play than ARE because of the company's cheap valuation and stronger earnings growth rate. BMR's one-year PEG ratio is 0.89, compared with 1.57 for office REITs in general, Moore said. With BMR's acquisition pipeline standing at $500 million, Moore expects the company's FFO growth rate to be 15.6% over the next year, compared with 9% at ARE. Both rates are significantly better than the 7% to 8% earnings growth rate the REIT industry as a whole is expected to average over the next year. Moore rates BioMed a buy. "The industry they're in is clearly an industry that has got a lot of legs to it ... that gives me confidence they are not a flash in the pan," Moore said.
As a result, the long-anticipated rebound in the apartment market could be stalled, especially among Class B apartment properties. Nussbaum cited United Dominion (UDR), Apartment Investment & Management (AIV), Camden (CPT), Essex (ESS) and Home Properties (HME) as REITs potentially affected due to their exposure to Class B apartments. On the retail side, publicly traded mall REITs tend to own Class A malls, which are "relatively immune" to the spending habits of lower-end consumers. However, "if middle/high-end consumers were to pull back on discretionary spending, we would expect to see a modest uptick in (store) closings," which would affect mall REITs, Nussbaum said. Mall REITs that have exposure to Class B malls, which could potentially be hit sooner by a pullback in consumer spending among lower-end consumers and store closings, include Glimcher (GRT), Pennsylvania Real Estate (PEI), and CBL. Shopping center REITs are largely insulated from a fallout from higher energy pricing and lower consumer spending because their centers tend to be anchored by grocery stores and drug stores, which sell necessities rather than luxury items. Consumers will buy groceries and drug store products in good times or bad. Office properties are relatively immune to escalating oil and gas prices. Higher energy prices could pressure operating profits for office tenants, which could potentially impact a company's decision to hire new employees and increase office space needs. However, Nussbaum said many office REITs have long-term leases with tenants, which could help to insulate them during this period. In the industrial sector, some warehouse and distribution center owners could benefit. Demand for space in some markets may increase as industrial tenants may want to spend less on transportation costs and therefore store goods for longer periods in the warehouses before spending money to ship them. Nussbaum cites CenterPoint (CNT) as a company that could potentially benefit from increased demand.
London's west end topped the list. Occupancy costs, which include utility expenses, maintenance and taxes in addition to base rent, totaled $178.67 a foot in London's west end, while midtown Manhattan fetched only $53.69 a foot. Rounding out the top five were Tokyo's "inner central" and "outer central" districts, the city of London, and Paris, where occupancy costs totaled $131.10 a foot, $123.39, $119.11, and $89.58 a foot respectively. One of the biggest surprises was Dublin, which cracked the top 10 for the first time in January 2003, and ranked as the seventh most expensive market in the latest survey with rents of $81.18 a foot. The most expensive place in the U.S. was midtown Manhattan, ranked 27th. That was followed by Washington at 37, Boston at 45 and Stamford, Conn., at 49. Beyond the top 50, West Palm Beach, Fla., came in 58th, San Diego was 68th, and downtown Manhattan ranked 71st. "It's more expensive to rent in Ho Chi Minh City, Vietnam than it is to rent in Boston - which floors me," said Ward Caswell, CB Richard Ellis' director of information management. Ho Chi Minh City ranked as the 39th most expensive city. "And it's more expensive to rent in Budapest than in any American city except midtown Manhattan."
Rodgers said apartment REITs have been underperforming many of the other real estate sectors, particularly mall and shopping centers, over the past several years. However, he said the group showed tremendous improvement in occupancy, rents and concessions between the first and second quarters. "Although not yet up to the pace of the malls or community centers, we are encouraged that apartments generated the largest improvement relative to the first quarter results across each of our sectors," he said. However, he lowered his rating on Home Properties (HME) to underweight from hold as he believes the company "continues to struggle to match the growth of its peers." He said the company has a big exposure to markets that have been weak, although it has been shifting its focus to increase its presence on the East Coast. "Particularly discouraging is the fact that Washington, D.C., already Home's largest market and arguably among the hottest apartment markets in the nation, produce negative net operating income growth in Home's portfolio in the second quarter," he said. Although the stock is relatively cheap compared to its peers, he sees "no near-term growth catalysts in sight."
Barron's: Can REITs keep going? Cohen: The replacement costs of real estate have risen dramatically; lumber, copper, steel and labor, the cost of land, particularly in major cities where land is at a premium. That keeps supply in check, because it costs too much to build a building today. If you were building a building on Park Avenue today, if you could find the land, it would probably cost you from start to finish about $1,000 a square foot. In that case you would probably need $100 per square foot in rent each year, but the market is priced at about two-thirds that. It is very difficult to build apartments because the rent required would be prohibitive for most people. That's why a lot of multifamily construction is condominiums. Barron's: Is this the new reality? Cohen: If the economy continues to grow and there is more job creation and more demand for space, then this situation is going to continue for the foreseeable future with respect to office buildings, multifamily buildings and hotels. Many hotels are being converted to condos. They are trying to pass a law in New York to prevent any more hotel conversions. For major property types in major cities, construction is pretty much prohibitive, and that makes replacement costs high and creates a great pricing umbrella for the owners of property. Barron's: What's another factor in REITs' favor? Cohen: What's also interesting are takeovers. The private market for real estate is very rich because of replacement costs and demand and liquidity. The public market is cheaper than the private market. So companies that want to expand are buying public companies. Shurgard Storage, Gables, CRT Properties and Catellus. These are multibillion-dollar deals. There's also a new mode of REIT financing: joint ventures. Australian companies, U.S. institutions and private capital are forming joint ventures and providing capital to REITs. It has been a way for REITs to expand their portfolios and platforms without having to constantly sell equity. The bane of the REIT industry in 1998, which precipitated the last bear market, was the unprecedented issuance of equity to finance growth. Now equity issuance is very low, and the capital that REITs are accessing is primarily through these joint ventures. They are not diluting current shareholders. They are not flooding the market with their shares and they are able to expand their earnings. None of this is well understood. Barron's: What could derail the REIT market? Cohen: In order for the REIT market to turn down, you need at least two of three things to happen. The economy has to turn down. The economy is the single most important factor. If you believe as I do that the Fed will stop tightening at some point out of fear of precipitating a recession, there won't be an issue with respect to the economy. Liquidity is important. When you look through history, real estate has done the worst when liquidity has been taken away from the system. This is what happened in the 'Seventies and the 'Nineties. Today, though, there is a record amount of liquidity, and there is a tremendous desire to put money to work in real estate. Another potential problem is excess supply or overbuilding. In the Chicago and South Florida condominium markets, there is excess supply. But if you look at the major property types, there is very little new supply coming into the market. So with none of the three factors most responsible for wreaking havoc with REITs in existence today and no prospects of them for the foreseeable future, I don't see how real estate can do poorly. You are going to have intermittent corrections in the REIT market. So if you dive in now, you can expect a correction will occur along the way. But I don't see the seeds of a bear market. The worst market we had for real estate was 1989-91. Then, we had a recession. We had an oversupply of office space around the country. We had a total removal of liquidity because of the savings-and-loan crisis. That was the killer scenario for real estate. There is not a single prospect of any of that today. The last time there was the whiff of any of that was in 2000-01, when the economy turned down and there was a little bit of oversupply in some markets like Silicon Valley and New York City because of the technology boom. But there was plenty of liquidity. All in all, REITs did very well in that period. REITs haven't had a down year since 1998. Barron's: How are REITs affected by the housing bubble? Cohen: The housing-affordability index, which is a combination of incomes, prices of homes and prices of fixed-rate and adjustable-rate mortgages, is at its lowest and least-affordable level since 1992. Also, the ratio of what it costs to own versus what it costs to rent is high, and so either one of two things has to happen. Either housing prices has to come down, or the cost to rent goes up. I think both of them will happen. There'll be an increase in rents. We are just starting to see occupancy and rent increases in the multifamily REITS. If I'm right on where we are in the cycle, housing starts to level off, and at the same time multifamilies start doing better. Again, the key is the economy. If there are no jobs created, then all bets are off. Barron's: What is your favorite area of the REIT market? Cohen: Office REITs, particularly the companies that have offices in major cities, are our favorite because the replacement costs of these assets have risen so dramatically and we're getting turnovers in rent that will create a great profit profile that could go on for several years. The multifamily market is our next favorite. Once you see accelerating earnings growth, stocks typically perform very well, and we're going to see that with these stocks this year. Barron's: How do you assess whether a REIT is overpaying for properties? Cohen: It's strictly a cash-flow business. If you can buy a property below its replacement cost and with cash flow above your cost of capital and manage that property properly, that's a great position to be in. By and large, the REITs have been extremely disciplined with respect to their property purchases, so I'm not as concerned about them overpaying. In fact, many of them have been net sellers. That's another part of the capital story: You are seeing extra dividends being paid. Companies have been net sellers of property, and to retain their REIT status, they have to distribute their gains to their shareholders. Barron's: Within the sector, are there any overlooked opportunities? Cohen: If you buy AvalonBay Communities, Boston Properties or Vornado Realty Trust, you will benefit from most of the trends I've talked about: good markets, high replacement costs, rising rents and good management. Then there are a few that are not as well known. An interesting one is Mission West Properties. This is a smaller-cap name. Mission West owns property exclusively in Silicon Valley. They've cut their dividend. They have a high vacancy rate, and if you believe the economy is going to recover and technology is going to recover, then it is a very interesting turnaround play. They are earning the dividend they are paying, so I don't fear a dividend cut. They are starting to lease out some of their vacant space. This is a budding turnaround. Another area of the market that is interesting is specialty REITs. I've not typically been a lover of these, but there are two kinds that have become more interesting. One is a research and development/biotech property, a quasi-industrial REIT that came public recently: BioMed Realty Trust. It has a lot of room to grow. The other area I like is student housing. American Campus Communities is my pick there. There is a huge demand for student housing and little new supply. Barron's: What's your view on mall REITs? Cohen: The mall is the dominant retail venue, having survived threats from catalogs, discounters, super stores and the Internet. Same-store sales, occupancy rates and profit growth of the mall owners has never been better. Think supply and demand. They build maybe three or four malls a year and only in areas where there is demonstrated demand for them. So the dominant malls in major cities are almost like fortresses. The world has begun to accept that, and the mall stocks have done extremely well. The two that we like best are Simon and Mills. Simon is enjoying an accelerated pace of growth and is also on the forefront of international expansion in Europe and in Asia. Mills is making a major expansion in Europe. I visited their major mall in Madrid and I think they are going to duplicate that success in other cities in Europe. Remember, in businesses like malls, the real value of a mall owner is in his tenant relationships, and when you have the size and the scope that these companies have, then those tenant relationships keep those malls full and help you raise rents. Barron's: What area of REITs, if any, are you avoiding or underweighting? Cohen: I have to believe that mortgage REITs are going to suffer in a higher-interest-rate environment. It's already happening. I don't see it getting better. If the yield curve flattens further or stays this flat, there is going to be disappointment in a lot of the mortgage REITs. They've been sold or bought primarily for yield, and when those dividends get cut, investors are going to find out that they've lost more in capital than they earned in income. It's not a good trade-off. Mortgage REITs are the single worst REIT investment today. Barron's: Good to talk to you, Marty.
The sector with the highest increase in average values remains Class A retail (i.e., unenclosed shopping centers), rising 8.1% over twelve months to an average of $150 per square foot. The leading local market for retail value appreciation was Orange County, CA, posting an increase of 15.4% to an average value over $202 per square foot. Values of retail properties in Washington, DC rose 13.2%, the best among East Coast markets. Another California market followed, with San Diego ringing in a 13.0% rise in average values. Portland, OR and Houston, TX rounded out the top five for retail properties with increases of 11.9% and 11.6%, respectively. All of the 61 local markets analyzed by the National Real Estate Index posted increases in value in excess of 3.3% for Class A unenclosed shopping centers. The average value of Class A CBD office nationwide rose 6.6% over the past twelve months and stands at over $235 per square foot. The leading CBD office market was the one with the highest employment growth: Las Vegas. Class A downtown office buildings in Las Vegas increased 17.1% in value to over $204 per square foot. Next are two California markets, with San Francisco and San Diego showing value increases of 16.8% and 13.8%, respectively. Class A CBD office properties in Downtown Manhattan changed hands at an average of 12.2% higher over the past twelve months, rising to nearly $342 per square foot. Rounding out the top five local markets for CBD office is Washington, DC, with an 11.8% increase in value to an average just exceeding $407 per square foot. Average values of Class A apartments nationally increased 6.3% during the period. The increase would have been even larger if sales of properties earmarked for immediate conversion to condominiums were included. Population and employment growth-leading Las Vegas fashioned the largest gain at 25.9%. Apartment values in West Palm Beach, FL gained an impressive 13.4%, resulting from continued population and employment expansion in South Florida. Next were San Diego, CA; Honolulu, HI and Virginia Beach/Norfolk, VA, chalking up apartment value appreciation greater than 10.7%. Of the 61 local markets covered by the National Real Estate Index, only four apartment markets showed decreases in average apartment values. The weakest apartment market in terms of average values, showing a decline of 4.4%, was San Antonio, TX, followed by a 2.5% drop in Denver, Austin, and Detroit, had marginal declines in average apartment values of .9%. Average values for Class A industrial/warehouse properties increased of 7.0% over the past twelve months. Leading markets are located in close proximity to growing population centers in California. Phoenix recorded the highest increase in average values for warehouse properties, increasing 15.9% to $54.77 per square foot. San Diego and Oakland experienced similar increases of 13.6%, followed by Boston and Dallas. Following an extended period of falling prices for Class A suburban offices, the sector has shown signs of recovery, with national average values increasing 5.4% during the period to just under $190 per square foot. Markets located on the West Coast have seen suburban office values increase the most, with some select local markets posting spectacular increases. Of note, Seattle’s suburban office properties soared 22.2% to an average exceeding $230 per square foot. Two Southern California markets, San Diego and Riverside/San Bernardino, were next at 17.5% and 12.0%, respectively. Also in the top five are two Texas markets: San Antonio and Dallas saw increased values of 11.5% and 11.2% on average. Las Vegas, posting a composite value increase of 18.0% in the last twelve months, remains the local market with the highest appreciation in Class A property values. Employment growth continues to lead the nation. San Diego remains in second position, having recorded a 13.5% increase in composite commercial property values. West Palm Beach follows with an 11.0% increase in values. Next are three distinct local markets, each posting a 10.0% increase in values: Birmingham (AL), Orange County (CA) and Honolulu. Seattle represents the recovering West Coast markets, coming in with a 9.1% improvement in commercial property values. Rounding out the top ten are local markets in two regions that have flourished recently - the greater Washington, DC area and Southern California – with Richmond (VA), Norfolk (VA) and Los Angeles. As in previous periods, markets in the interior face lagging value appreciation. Included are markets in the greater Midwest and Texas – Cincinnati, Cleveland, Tulsa, Denver, Columbus (OH), San Antonio, Austin and Detroit. Class A property values for commercial buildings in Detroit dropped by .3%, the only market to do so over the past twelve months.
In the fast-growing Phoenix area, investor demand was so strong in Q1 that it pushed up the supply of rental homes in a number of fast-growing outlying areas. In Anthem, Ariz., the number of single-family homes available for rent doubled in Q1 versus the same period last year, while average rents for those homes fell by 9%. In Gilbert, average rents for homes fell nearly 5% as the supply of rentals more than doubled. In suburban Fairfield County, Conn., a glut of properties has pushed rents for homes down by roughly 20%, estimates David D'Ausilio, the broker-owner of Re/Max Results. "It used to be pretty rare to see a single-family house for rent," he says. But with more people investing in real estate, "there are now a large number of rentals." Competition among condominium investors in San Diego is so keen that many have been forced to throw in a month's free rent or a free gym membership. In Kansas City, rents have dropped to an average of 0.75% of the home's purchase price or appraised value from 1% five years ago, says Debby Barash, rental services manager for Reece & Nichols. Housing analysts say the growth of investor-owned properties represents a "shadow" supply of rental units that doesn't show up in traditional rental-market measures. In fact, rents are expected to rise an average of 1.2% nationally in 2005, according to Property & Portfolio Research, which tracks 54 markets. But a surplus of investor-owned properties is dragging down rents in certain segments of the market in a number of places, including Las Vegas, South Florida and Kansas City. The effects are greatest where many investors have purchased similar properties. Next year, as more condos purchased by investors come onto the rental market, the pressure on rents could become more noticeable. There are already strong indications that the number of investor-owned rentals are rising. The vacancy rate for one-unit rentals, typically owned by investors, stood at 9.7% in Q2, up from 8.7% in Q2-04, according to the U.S. Census Bureau. Vacancy rates for multifamily homes and apartment buildings fell during that time. The number of vacant single-family homes for rent now stands at a record 1.339 million, says Rick Murray, an analyst for Raymond James. In a report issued in April, Mr. Murray called the "hidden inventory" of single-family rental homes a sign of "irrational investment decisions." But in many areas, owners of rental properties are benefiting as developers turn apartment buildings into condos, reducing the rental supply. In the last 18 months, developers have purchased more than 127,000 apartment units for condo conversions, according to Real Capital Analytics. But many condo units are bought by investors who plan to rent them out. New construction is also adding to the supply of condos -- and the number of units that might enter the rental market. Pro's estimate that 78,000 newly built condo/townhouse units will be ready for occupancy this year and another 118,000 in 2006.
Analysts agree that compared with apartments and office buildings, hotels are reasonably priced. "The lodging sector versus other real-estate types offers very attractive risk-adjusted returns," says John Arabia, a hotel analyst with Green Street Advisors. Blackstone's recent buying spree began in May 2004 when it acquired Extended Stay America for $1.99 billion. Before the end of last year, it had bought Prime Hospitality for $564 million and Boca Resorts for $1 billion. The latest big purchase is Wyndham International Inc., which is expected to close in the next couple of weeks, for $1.44 billion.
The biggest deals include [1] Public Storage's $2.5 billion unsolicited bid for rival Shurgard Storage Centers; [2] Equity One's $379 million bid for Cedar Shopping Centers; [3] The $3.6 billion purchase of Catellus by ProLogis and [4] The acquisition by ING Clarion Partners of Gables Residential Trust for $2.8 billion. Industry experts say that these shopping sprees recall investors' last infatuation. "It's been a little bit like what happened in the 1990s in the tech boom," says Peter Baccile, global head of J.P. Morgan Chase & Co.'s real-estate investment banking group "There was a lot of money that wanted to get invested and values started to take off." The vast amount of capital chasing real estate is the key driver behind the REIT deals. For private firms that invest for pension funds, endowments and high-net-worth individuals, buying a REIT is the most efficient way to quickly build a real-estate portfolio. Analysts also say that this recent activity may point to a peak in pricing for REIT stocks. The Dow Jones REIT Equity Index, which hit a record last Tuesday, dropped 6.8% from last Thursday through Monday's close.
One building under construction is the 96-unit Folio Boston at 80 Broad Street. After a year of marketing, 62 units are under contract and the rest are on sale for $700,000 to $1.2 million, said the developer, Michael Rauseo, president of the Suffolk Companies, who in 2001 intended to build office space on the lower floors and about 35 condos above. The preference for residential projects reflects an office market with 16.6% of its space available for lease or sublease, only a slight improvement from the 20-year high of 19.7% reached in Q3-04. Average asking rents are about half the peak reached in 2000. This poor performance is a result of weak demand, and is segmenting the office market between premium upper floors and those below. By the end of June, 13.9% of space above the 15th floor was available at an average asking rent of $42.62 a square foot. On lower floors, an additional 800,000 square feet brought the availability rate to 16.6% with asking rents of $32.49, said Debra Gould at real estate developer Spaulding & Slye Colliers. "We're seeing a greater-than-usual spread in rents," she said. For the first time in many years, small to midsize professional firms can find 20,000-square-foot high-rise floors with expansive views. But big corporations that once filled sprawling 60,000-square-foot low-rise floors with clerical and administrative workers have moved these back-office operations to lower-cost sites, have adopted technology that enables them to further cut the number of employees or they need less space because of consolidation. So far this year, major financial tenants seeking to sublet their space have put 1.7 million square feet back on the downtown Boston market, which has a total of 56 million square feet. Despite lackluster leasing and growth prospects, commercial properties here are achieving record sale prices. Well-leased properties fetch $350 to $605 a square foot. But even those with, or anticipating, high vacancies are commanding solid prices. Last fall, 330 Stuart Street, a building that is about 80% vacant, sold for $267 a square foot. Earlier this year, One Faneuil Square, a retail and office building that was totally vacant, sold for about $450 a square foot. Landlords who can't find tenants are selling. But high sale prices reflect activity in financial markets, not the value of real estate. The discrepancies between real estate fundamentals and commercial property values also worry William McCall, president of McCall & Almy, real estate advisers. A landlord who in 2000 could net $25 a square foot for an office building now nets about $15 a square foot because of vacancies, lower rents and higher tax and operating expenses. Buyers paying high prices, therefore, are settling for annual returns around 6% rather than the 10% they may have realized five years ago, he said. "They'll stop buying offices when they find higher returns elsewhere," Mr. McCall said. "The big question: Is there an office market bubble here?" But the lure for residential developers is strong: condominiums sell for $750 to $1,500 a square foot. Such a prospect presumably moved Rose Associates of New York to change direction after spending four years planning to build the 214,000-square-foot Two Financial Center. In April, it won city approval to instead put up a $110 million 162-unit condominium.
• Negative Reports: The UBS sell-side research team downgraded a number of REIT common stocks on August 4 and this week’s issue of Barron’s includes a feature article that is negative on REITs. • Equity Offerings: Large equity issuance announcements by REITs, such as Vornado (VNO, 9.0 million common shares) and Strategic Hotel Capital (SLH 10.6 million common shares), have pressured supply/demand technicals. • Short-Selling By Hedge Funds: There has been significant short-selling using the iShares Dow Jones U.S. Real Estate Index Fund (IYR), which traded at 7.5 million shares on Friday, August 5, and 8.9 million shares today. • Jobs Report: The August 5 jobs report was stronger than expected. Total non-farm payrolls rose by 207,000 in July, above consensus expectations for an 180,000 increase. This increase in jobs is the highest level since February 2005 and may lead some investors to believe that the Fed will keep raising rates to contain inflation into 2006. (The 10-year Treasury bond yield, at 4.4%, is at its highest level since mid-April.) While REIT share prices historically have had a low correlation to interest rate movements over long periods of time, we have seen REIT investors react nervously to interest rate concerns over very short periods. • Profit Taking: Finally, with the sector up 22% over the past four months, profit taking by some investors is inevitable. Despite the recent decline in REIT prices, our views on the market remain unchanged, as we believe real estate fundamentals are improving. In our view, sector valuations are not at levels that indicate a peak in stock prices. Rather, we believe valuations are above historical averages because of continued prospects for further improvements in real estate fundamentals. In fact, over the past two weeks, there were two acquisition proposals made for REITs, both at 14% premiums to the market price (Shurgard Storage Centers and Cedar Shopping Centers). We expect the economy to continue to grow at a 3-4% pace over the next 12 months, which should support demand for real estate while supply (i.e. new construction) in most property sectors should be moderate over the next few years. This, in our view, should result in accelerating cash flow and dividend growth in the REIT sector. Hence, despite volatility over the past three days, we remain optimistic in our outlook for REITs.
Some cracks may be starting to form. REITs declined 2% Thursday and was down about 3% Friday, hurt by a setback in the bond market that followed the strong July employment data. The two-day selloff illustrates the volatility in REIT stocks. Still, REITs often appeal to risk-averse investors who don't recognize this. What could derail the REITs? Further interest-rate increases, a bursting of the property bubble, a slowing economy or a shift in investor preference toward common stocks. Danger signs abound. REITs look pricey based on virtually every historical financial metric: dividends, dividend yields relative to Treasury rates, and various earnings measures, including FFO. In fact, REIT dividend yields are at a 30-year low. And one measure of REIT's attractiveness -- their yields minus Treasury-bond yields -- is close to zero for the first time in seven years. REITs offered dividend yields of 8.75% in late 1999, now has an average yield around 4.5%. The low REIT yields mean the sector is far less defensive than it used to be. REIT investors have seemed unconcerned about rising yields, including the move in the benchmark 10-year T-note to 4.4% from a June low of 3.9%. As income vehicles, REITs become less attractive when yields on alternative investments move up. Short-term bond rates, now at 3.25%, probably are heading to 4%. That will hurt REITs that rely on floating-rate debt. REITs Have a Limited Upside The upside potential in REITs may be limited, barring a drop in long-term rates. REIT profits are rising, but outside the hot shopping-mall sector, the gains haven't been large. Profit growth could run at 6% to 7% annually in the coming years, barring an economic downturn. Mike Kirby, the director of research at Green Street Advisors, says that, if the U.S. is in a sustained period of low interest rates, REITs are apt to perform well. "The valuation question is tied up with the bigger-picture question of whether we're in a low-return environment for a long time. If that's the case, the 4.5% dividend yield on REITs doesn't strike me as too bad." REIT enthusiasts say that commercial real estate has undergone a revaluation that's unlikely to reverse, driven in part by the increased cost of new buildings, which reflects higher costs for land, steel, copper, cement and other materials. The cost of putting up a new office building in Manhattan can run a stiff $650 a square foot -- if a builder can find a lot to put it on. REIT executives point to the increasing demand among institutional investors for "alternative assets," as well as the underinvestment in real estate by pension funds and endowments relative to their equity holdings. The U.S. commercial property sector is pegged at about $5 trillion, about half the size of the S&P 500 index. It's notable that REIT shares bottomed just as the technology bubble was about to burst in March 2000. That was a time when many investors decided that commercial property was being rendered obsolete by the Internet. The thinking was that Americans were going to do their shopping at Amazon, banking online and working from home. The opposite is true now. "There's a global rush to buy real estate," Litt says. "It's driven by a desire to own hard assets, diversify and buy into a group that has been working." You Can't Make Money at these Cap Rates The yield demanded by institutional buyers on U.S. commercial property has fallen to the 4%-6% range from 9% as recently as 2002. These yields [cap rates] are based on the annual income generated by a property, divided by its purchase price. Litt points out that cap rates outside the U.S. now are comparable to those domestically, reflecting the growing efficiency of worldwide real-estate markets and the tens of billions of dollars looking for opportunities. Why Pay More Taxes? REIT dividends are disadvantaged relative to payouts on common stocks. The after-tax dividend yield on a REIT yielding 4.5% is around 3.2% for an investor in a high tax bracket. An investor could buy common shares of non-REITs yielding 4% and get an after-tax yield of 3.4% - beating the after-tax REIT yield. A month ago, Litt did a computer screen and found that 88 companies in the S&P 500, S&P MidCap 400 and S&P 600 Small-Cap indexes had higher after-tax yields than the average REIT, up from just 27 in May 2003. The list includes the Baby Bells, Merck, Altria, Citigroup, Bank of America and Sara Lee. REITs Use Distorted Metrics REITs tend to be valued based on measures other than earnings. In fact, their followers tend to ignore reported earnings, which are based on generally accepted accounting principles. Why? GAAP profits require a noncash charge for depreciation expense, which reduces reported earnings. REIT investors deem depreciation to be a phantom charge, like the depreciation of a cable TV facility, because the value of the underlying property probably isn't really falling. The preferred profit measure is FFO, essentially reported earnings with depreciation and certain other costs added back in. The problem is that, based on FFO, REIT stocks are at record valuations. The group trades for 15 times projected 05 FFO, versus an average multiple of 11 during the past dozen years, according to Morgan Stanley. The REIT FFO multiple is almost as high as the S&P 500's P/E multiple of 17, based on projected 2005 operating profits. That's a rarity; historically, the FFO multiple has been much lower than the S&P's P/E. The forward 12-month REIT FFO and S&P 500 P/E are about the same. FFO, however, overstates true REIT profits and cash flow. A better measure, according to Kirby and other analysts, is adjusted funds from operations, which takes FFO and strips out ongoing and necessary expenditures that realty trusts typically capitalize. For apartment REITs, it's the cost of new roofs, carpets, drapes and appliances. For office REITs, it's the cost of improvements to space rented to tenants on long-term leases, as well as commissions paid to brokers. While the gap varies by REIT, the difference between FFO and AFFO is often 25%. "The capital expenditures you deduct are really akin to the recurring cost of running the business," Kirby says. "To not factor them in is to miss a lot of information." Office REITs tend to have a big gap between FFO and AFFO while storage REITs usually have a small difference. Measured by AFFO, REIT valuations looks particularly stretched because the typical company trades at about 20 times estimated 2005 AFFO, considerably above the S&P 500's P/E ratio. And REIT dividends average about 90% of AFFO, a high percentage. In contrast, the S&P 500's payout ratio is around 30%. This means the average company in the S&P has far more room to raise dividends than the typical REIT. EQR is likely to have $2.44 a share in FFO this year. That's less than the $2.63 it earned in 2001, yet its shares, at their recent price around 40, were 60% higher. And its annual dividend of $1.73 will barely be covered by the $1.86 in AFFO it's likely to generate in 2005. EOP has risen 20% this year, to 35. Its projected 2005 FFO of $2.52 a share is less than what it earned in 2000. Boston Properties has risen 18% this year. It trades for a lofty 18 times estimated 2005 FFO, 25 times projected 2005 AFFO and yields just 3.6%. Mall REIT Simon recently reported a 16% gain in Q2 FFO. Its FFO is expected to rise 11% this year and 6% in 2006. Simon is trading for 16 times projected 2005 FFO and 22 times AFFO. REIT enthusiasts' counter that, while valuations may be stretched, based on FFO, AFFO or cash flow, they're still reasonable based on private-market values. The reasoning is that if Boston Properties liquidated its portfolio, it would realize more than its current stock price after paying off debt. Office REITs are Dangerous Office REITs continue to contend with [1] corporate consolidation; [2] the expiration of leases signed at high rents in 1999 and 2000; and [3] a frothy acquisitions market. Boston Properties has been a net seller of office buildings, while Vornado has shifted gears and has sought real-estate plays in the stock market. "Given our underwriting standards and our return requirements, we are seeing a paucity of acquisition opportunities," said Ed Linde, the chief executive of Boston Properties. Linde cited another sign of an overheated market. While buyers of office buildings historically have favored properties with high occupancy levels, many potential purchasers now prefer buildings with sizable vacancies because they assume they can push through big rent increases. Apartment REITs are Dangerous Apartment REITS are back in favor, partly because investors are figuring that they may engage in wholesale condo conversions to capitalize on the roaring condo market. Watch out if the condo market cools. Apartment REITs are upgrading their portfolios by buying properties in hot markets and selling them in weaker markets in the South and West, where rents are soft and barriers to new construction are low. The benefits to investors from this strategy are unclear because REITs are accepting earnings dilution by buying high and selling low. Mall REITs are Dangerous Mall REITs have enjoyed some of the strongest profit gains because of a robust consumer economy. But mall REITs face a challenge because of growth in off-mall retailers like Target and Wal-Mart and the consolidation among department stores. Guerrilla Capital's Peter Siris notes that America "remains overstored," yet investors are more bullish than ever about mall and strip-center REITs. Siris fears that with anchor stores closing, "a lot of the second-class malls will get hurt badly." Industrial, Health Care and Hospitality REITs are Dangerous [The Barrons article failed to mention these three sectors - but don't let that omission fool you - they are dangerous too.] And the Smart Money is Selling In real-estate investing, location, location, location isn't always the most important thing. Often, timing is. And for the California Public Employees Retirement System, it is time to sell. Calpers, which has one of the largest real-estate portfolios among public pension funds, has sold $7 billion of its $21 billion core portfolio since December. Calpers sold most of its office properties. "The prices that people were willing to pay were higher than what we felt the properties were worth," observes Michael McCook, Calpers' senior investment officer for real estate. He says the fund had bought the properties at cap rates, or yields, in the 7% to 9% range and sold them in the 4% to 6% area.
Pike said he sees 5% to 10% downside risk for these REITs in the second half of 2005. "Valuations are stretched on several metrics," he said. REITs are trading at about 14.6 times estimated 2006 funds from operations, which is about 34% above historical levels, he said. Also, so far in 2005, REITs have posted total returns of 16% on average, outpacing the S&P 500's 4% return and the Russell 2000's 5% return. The top performers have been regional malls, whose returns are up 25%, he said. Equity REIT dividend yields average 4.4%, which is only slightly higher than the 10-year Treasury's yield of 4.3%. "Historically this spread has averaged 185 basis points," he said. If the 10-year hits 5% as UBS is projecting by year's end, there would be a negative spread of about 60 basis points, he said. If this happens, the REIT index could decline as much as 30%, he estimates. This could be partially offset by REIT dividend growth and continued high investor demand for real estate as an asset class. Pike recommends investors pare back positions in growth-oriented commercial and residential REIT stocks in the near term. He continues to overweight the lodging and health-care REIT sectors. There are some caveats to his projection, such as consolidation. "M&A possesses a significant risk to our thesis, especially given the 10% to 15% take out premiums observed thus far this year," he said. Companies bandied about as possible takeover candidates include Home Properties, BRE Properties, Heritage and Pennsylvania REIT.
Retail has been the strongest sector in the commercial-real-estate industry, which in the past year has begun emerging from a three-year downturn that followed the recession and terrorist attacks of 2001. Consumers, buoyed by rising house values and low interest rates, kept spending through the downturn, helping retailers and their landlords emerge relatively unscathed. Investors have noticed, bidding up the prices of malls and the market value of publicly traded real-estate investment trusts, which own much of the prime retail real estate. In the past four years, retail REITs as a group have more than tripled in value, according to SNL Financial. I have looked for updates in August and so far have found none. On 7-25 Moody's Affirms Baa2 Sr Rtg Of First Industrial with a Stable Outlook. S&P Revises Ventas Outlook To Positive; Rating Affirmed on 7-11. Fitch Affirms Plum Creek Timber Co Ratings At 'BBB-' on 7-11. Fitch Upgrades Developers Diversified's Sr Unsec To 'BBB' on 7-06. Quick Facts J.P. Morgan downgraded Boston Properties (BXP) to neutral from overweight, saying that while it continues to believe BXP is a blue-chip firm, it doesn't see any near-term catalyst that could boost performance. The broker told clients that BXP's management, portfolio and development platform should enable it to drive above-average growth in FFO over the long term, but that the lack of investment opportunities is likely to result in mediocre growth in 2006. (Janet Morrissey, Dow Jones Newswires 8-11) "We believe that capital looking for property investment will prove to be quite sticky and will not disappear in a higher-yield environment," says Dave Harris, REIT analyst at Lehman Brothers. (Nick Godt, TheStreet.com 8-11) According to the National Association of Realtors' statistics, 960,000 condos sold this year as of June, 12.4 percent more than all of 2004 and up 46.1 percent from all of 2002. The average condo price was $223,500 in June, up 14.8 percent from last year and 57.1 percent from three years ago. (Adrian Sainz, AP 8-07) In the CRE conference call of 7-29, CRE noted that it is finding 'deal fatigue' in some real estate markets. While competition for property deals is still hot for trophy properties, some desirable properties over being slightly overlooked and can be purchased at reasonable cap rates. CRE's explanation: There are only so many people who are looking at the deals, and the number of deals has climbed as cap rates have fallen. (Factoids 7-29) More REIT Links News Links
Update: Fourth Experiment in Stock Picking 8-31-05 A less than sector balanced portfolio is compared with the average of two REIT index ETF's: ICF [Cohen & Steers Realty Majors - the top 30 REITs by market cap] and RWR [the REIT Wilshire Index]. This is part of a continuing experiment to see if an individual investor can find some benefit in buying individual stocks. Four of the stocks below [MLS at 50.72%, DDR at 38.25%, VNO at 44.24% and OFC at 44.62%] notably out-performed the REIT sector average of 32% for the full year of 2004. This portfolio beat the sector average in 2004 by 300 basis points - so some regression to the mean is to be expected. Note that this portfolio, while being weighted toward higher growth and lowering yielding REITs, still pays a dividend of $785 per quarter vs. RWR's $776 and ICF's $640. Earnings Guidance & Dividend Changes: OFC gave 05 FFO guidance of $1.78 - $1.85 per diluted share in their Q4 conference call on 2-10-05. The current consensus estimate is $1.84. OFC on 5-19 declared a quarterly dividend of $0.255 per Common Share of beneficial interest [an increase from 24 cents/share]. The dividend will be paid on 7-15 to shareholders of record on 6-30. UDR on 2-16 announced a 2.6% increase in its dividend for 05 to $1.20 per share. ARE on 2-14 updated its 2005 earnings guidance to an FFO of $4.78 [vs a current consensus of $4.80]. On 5-11, ARE announced expected 05 FFO/share to be $4.79. On 6-20 ARE raised dividend 3% To 68 cents per share. ARE announced 8-02 that expected 05 FFO/share to be $4.81. AMB on 3-01 declared a regular cash dividend for Q1 of $0.44 per common share. The dividend reflects an annual indicated rate of $1.76 per common share, an increase of 3.5% over the 2004 annual dividend. On 4-12 CARS announced that it raised the company's quarterly dividend to 43.8 cents per share, payable on May 20 to shareholders of record as of May 10. On 7-12, CARS increased its dividend 2% to 44.6 cents per share from a prior level of 43.8 cents. The company also reaffirmed its guidance for an annual common share dividend of $1.80 per share in 2005. HR on 4-26 announced its 47th consecutive dividend increase to $0.655 per share. At this rate, quarterly dividends approximate an annualized dividend payment of $2.62 per share. Update: Fifth Experiment in Stock Picking 8-31-05 Given the amount my portfolio has changed, I started a new 'experiment'. Or maybe I got tired of seeing my results trail the ETFs - and wanted to have something on this page that stroked my ego. I really should have bitten the bullet and bought VTR and a Hospitality REIT or two - but after buying a third MLP [XTEX added to existing holdings EPD and ETP] - I did not have the funds. Or maybe I just wanted the security of holding a bit of cash. So I am starting this experiment with a portfolio balance that is a bit off. But I do like the additions I made from the 05 starting portfolio [by adding CNT and GGP and more shares of CARS].
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