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Houston's multifamily market saw a boost after Hurricane Katrina hit and thousands of evacuees rented apartments here. More than 17,000 apartments in the Houston area were absorbed in September. That's nine to 10 times more than what's typical in the the peak summer months, said Richard Zigler, O'Connor's head of research. Citywide apartment occupancy rate spiked to more than 90% after Katrina. Before the hurricane, some landlords were offering two months of free rent to sign or renew a lease. Those generous concessions are shrinking.
The Presidio Apartments is just one of several Class B and C multifamily properties across the United States that have been acquired by joint ventures looking to reap a higher yield either from a cosmetic redo or a more-intensive redevelopment and repositioning. With sky-high land prices and rising construction costs, many equity investors see more opportunities with apartment redevelopment rather than ground-up development and even core acquisition. However, industry observers say that redevelopment can be more challenging than other joint venture investments. There are plenty of equity partners that are interested in value-added and redevelopment plays in the apartment arena, contended K. Brad Broyhill, executive director of multifamily investments for Denver-based Amstar Group. "Most equity capitalists look for higher returns, and everyone likes the story of repositioning versus modeling inflation," Broyhill explained. However, David St. Pierre, president of Legacy Capital Partners, believes that getting buy-in from equity partners for apartment redevelopments can be difficult, particularly when compared to investing in a core property where the historical operating numbers and existing cash flow scenario help support the investment, or ground-up development where the construction costs and rental performance can be predicted by other recently completed properties. "The general reaction from a potential equity investor when an operator says that they're going to improve something is, 'I don't see it, it's never performed at that level,'" St. Pierre explained, adding that the operator must provide a very well-defined strategy for the redevelopment, in addition to a timeline and an outline of suggested improvements. "You have a cultural and perception issue, and the question is how will you breathe life into it and change the image. It takes more than a new name and a coat of paint." When it comes to redevelopment, the most important aspect between equity partners and operating partners is sharing the vision for the property, said Joanne Lockridge, senior vice president of finance for Avalon Bay Communities. Lockridge recommend that operators make sure their equity partners have similar goals for the property. "It's critical to know how the partnership will proceed through the redevelopment and after," she said, pointing out that in some cases, market conditions might not allow for a quick exit strategy. With a recent JV on a Conneticut property, Avalon Bay wanted to complete the redevelopment and then hold the property as a cash-flowing investment, so it was important to find an equity partner that also desired a long-term investment. Some equity investors have very rigid deadlines - both for completing a project and executing an exit strategy. Specifically, equity investors who are driven by internal rates of return usually have to stick to a schedule. "Completing a redevelopment in three years versus two could kill an investor's IRR," St. Pierre noted. Moreover, operators that partner with inflexible equity sources run the risk of being punished financially if the redevelopment projects hit any snags, according to Joe Parsons, president of North American equity holdings for GE Commercial Finance Real Estate. "Being an equity partner in an apartment redevelopment requires more flexibility in terms of hold period and interim cash flow," Parsons said, adding that GE is particularly concerned about whether its operating partners can fund projects on an on-going basis if they become more complicated. Indeed, anyone who's been involved in a remodeling project - no matter how small - knows there are no guarantees about how it will turn out. "You never know what you're going to find behind the wall when you start tearing down to the studs," warned James Ebert, senior vice president of San Francisco-based Buchanan Street Partners. Like Tom Hanks and Shelley Long in the classic remodeling movie, "The Money Pit," JV partners have to be ready to tackle problems that can come out of the woodwork. "Redevelopment JVs can be tricky because the plans can and will evolve over time," noted Ryan Krouch, vice president of investments for Somera Capital Management LLC. The Santa Barbara, Calif.-based equity investor, for example, partnered with Cypress Equity Investments LLC, a Los Angeles-based apartment owner and manager, to acquire a 216-unit apartment portfolio in that city's Koreatown neighborhood. Somera and Cypress had planned to renovate the Class B buildings and to increase rents as much as 40% after the rehab. In an effort to empty some units to start the rehab, the Somera and Cypress partnership immediately raised rents to compel tenant turnover. In the process, the partnership found that residents accepted the rental increases without complaint. "At that point, we decided to hold off on the redevelopment plans for a while," he said. "Because of the uncertainty of how quickly you can turn over the existing tenant profile, get the work done and re-tenant the property - you need substantial flexibility with the timeframe," St. Pierre explained. Broyhill says that it is advisable to have the equity investors require their partners to set aside a larger contingency fund for redevelopment projects. "You always discover something when you start the rehab, such as a problem with the electric when you're working on the plumbing," he said, noting that operating partners should have on-going dialogue with equity investors, even if they are passive. "Apartment redevelopments inherently require more interaction from partners," said Kenneth P. Balin, president and CEO of AMC Delancey Group. When it comes to apartment redevelopments, the Philadelphia-based equity investor is more than happy to lend resources to its operating partners. "We have a suite of services beyond money," he pointed out. Yet, equity investors who partner with experienced operating firms armed with local market knowledge rarely feel the need to micromanage the redevelopment, industry experts agreed. Cleveland-based KeyBank Real Estate Capital, for example, takes a passive position for its redevelopment investments, according to Senior Vice President Dan Walsh. "We want to partner up with someone who has a great track record and leave them to it," he explained.
Still, the long uphill run may have set up REITs for a big fall. They’re pricey compared to other stocks. REITs trade at an average 19 times projected earnings, compared to a multiple of 14 times for S&P 500 stocks. Over the past ten years, REITs have usually traded at roughly 75% of the S&P 500’s multiple, so they’d have to plummet 45% to get back to that. That’s akin to the plunge in the Nasdaq index when the dot.com bubble burst in 2000. Fortunately, there’s a pretty good case to be made that REITs will hold up a lot better than dot.com stocks did after the Nasdaq hit 5000. First, Internet stocks didn’t have the underlying financial strength that REITs have. They are rich in hard assets and quite profitable. And most REITs are valued right in line with the underlying value of their real estate. Second, there's earnings growth ahead. The analysts at Green Street Advisors project the 60-plus REITs they follow will boost their adjusted funds from operations almost 9% next year. That’s up from the relatively meager growth of 6% this year. Office landlords, in particular, appear to be in for some nifty growth in earnings in 2006. The picture is especially sunny in Southern California. "Stable job growth has helped reduce office vacancy rates and raise rents throughout this region," says Delore Conway, a professor at the USC’s Lusk Center for Real Estate. The center's forecast for 2006, released last week, projected that real estate values would continue to stay aloft. Green Street figures that Los Angeles landlord Maquire Properties' earnings will grow 14% next year, compared to negative 8% this year. Kilroy Realty is supposedly in for 81% growth, more than making up for its 35% slide this year. Another SoCal office company, Arden Realty, is due to show a slip in earnings, albeit a small one of 1.7%. As for how the stocks trade versus underlying net real estate value--Green Street estimates an average discount of 3%. Over the last 12 years, REITs have traded at an average 7% premium. If you like buying real estate stocks at a discount to net asset value, look at the companies that own mobile home parks. The industry suffered from a high number of repossessions caused by overly loose credit standards in the late '90s and from residents leaving trailer parks for traditional houses during the housing boom. So Affordable Residential Communities, Equity Lifestyle Properties and Sun Communities trade at 24%, 10% and 34% discounts, respectively to their asset value. Green Street rates Equity Lifestyle its favorite among the three. There’s still plenty of capital pouring into real estate, too. A survey of smaller landlords conducted by real estate brokerage Marcus & Millichap found that 69% of respondents (on average, they owned $35 million worth of property) plan to increase their total investment in real estate in the coming 12 months. Just 7% intend to cut their exposure.
Whyte said he's much depends on how much and how quickly interest rates rise. So far, "longer-term rates have not risen in step with rates increases by the Fed," he said. "Unless long-term rates spike, we see limited near-term downside for the REITs." Still, he said valuations are high, which make REITs less attractive to investors. He believes REITs could outperform his expectations if the economy continues along its current trajectory or if a modest recession hits. If this happens, "REITs could remain a by-default group among yield-seeking investors because of persistently low interest rates and uncertainty surrounding the timing of the economic recovery," he said. Whyte revamped his ratings to reflect his 2006 outlook for various REITs and sectors. He upgraded the multifamily REIT sector to neutral from unfavorable to reflect improving fundamentals, and cut his rating on office REITs to unfavorable from neutral based on continued weak fundamentals and the potential for earnings shortfalls. Whyte maintained his favorable rating on mall and industrial REITs, and retained his unfavorable recommendation on storage, healthcare and manufactured housing REITs. He upgraded CLI to overweight from equal-weight, HIW to equal-weight from underweight, REG to overweight from equal-weight and TCO to overweight from equal-weight. He downgraded BXP to equal-weight from overweight, CRE to underweight from equal-weight, DRE to equal weight from overweight, and EOP to underweight from overweight. Whyte now has 13 REITs rated overweight, 16 at equal-weight and 12 at underweight.
The discordant forecasts aside, most market watchers at least agree that the economic fundamentals for commercial real estate remain generally favorable going into next year. "Currently, there is little or no overbuilding in any commercial real estate sector, and as the economy continues to grow and produce jobs, excess space is being absorbed, making occupancy rates rise," said Martin Cohen, co-chairman and co-chief executive of Cohen & Steers, which offers REIT mutual funds. "To build a building today costs materially more than six months ago or two years ago in most major cities." Mr. Nussbaum agreed that demand for commercial real estate would improve, but "performance by property type will vary widely." Mr. Nussbaum, for one, favors the industrial sector, which, he said, has underperformed in 2005. He says many companies are positioned to grow as demand for warehouse space increases and as they keep expanding overseas. Mr. Kriz agreed: "There are changing patterns in distribution in this country - we're going away from small warehouses to very large distribution centers. As the economy grows, there will be demand for industrial space." Many analysts continue to like self-storage facilities, which they say have evolved from a peripheral asset to the mainstream. "They've done very well, and we chalk this up to household formation, home sales and employment growth" said Raymond Mathis, who covers REIT's for Standard & Poor's Equity Research. Mr. Mathis also likes the hotel and lodging sector. "There is just not a lot of new supply coming on line," he said. "Tourism never went away. Business travel has turned around." Multifamily housing gets mixed reviews. Mr. Taylor of Deutsche Bank says he thinks that the prices of apartment REIT's have room to grow in 2006, citing declining vacancy rates and rising rents in many regions. And the supply of apartments has decreased, he noted, as developers have bought apartment units for condo conversions. But Mr. Mathis predicted that some of those condo conversions would eventually return to the market as rentals. The forecast for retailing REIT's is generally positive. Mr. Nussbaum notes that consumer spending remains healthy, though he favors REIT's that own higher-end shopping spaces rather than discount shopping malls. High energy costs and a "fragile" employment picture could cause less affluent consumers to tighten spending, he said. Many market watchers believe that office REIT's will improve in 2006. "It's certainly going in the right direction," said Mr. Cohen, the REIT fund manager. But analysts are also selective about the sector. "Stick with what works, namely well-managed companies focused in strong office regions," Mr. Nussbaum wrote.
Nearly 60 years later, Bellevue Square is now home to more than 200 stores. And the Kemper Development Company, predominantly owned by Mr. Freeman and other family members, has just opened Lincoln Square, a partly completed mixed-use development with street-level retail on the opposite side of Bellevue Way and connected to the mall by a pedestrian bridge. Kemper Development acquired Lincoln Square after an investment fund overseen by Lend Lease Real Estate Investments sank $215 million in the project but was unable to complete it, Mr. Freeman said. Ultimately, the 1.2-million-square-foot Lincoln Square will have 310,000 square feet of stores and restaurants, 148 condos and a 525,000-square-foot office building anchored by the headquarters for Eddie Bauer, the outdoor clothing retailer, Mr. Freeman said. Real estate specialists say that Bellevue Square has been critical to the success of this city of 117,000, a one-time second-home community that evolved into a car-friendly suburb with long "superblocks" and streets accommodating six lanes of traffic. These days, many Seattle residents commute to Bellevue and the surrounding towns on the so-called East Side, where Nintendo, Paccar (which makes Peterbilt trucks) and Costco also have their headquarters. By most yardsticks, Bellevue Square is a productive mall. Mr. Freeman said it brought in $600 in annual sales per square foot, putting it well ahead of the national average of $366 a square foot. But sales are lower than at other family-owned malls like the Bal Harbour Shops just north of Miami Beach and South Coast Plaza in Costa Mesa, Calif., because it has few luxury shops. "It's the best center in the Northwest," said Steven B. Greenberg, the president of the Greenberg Group of Hewlett, N.Y., which represents national retail tenants. "But I've always been a little disappointed that they haven't brought it more upscale." For more than a decade, Mr. Freeman said, he has been trying to lure Saks or Neiman Marcus - neither of them represented in the Seattle area - to his mall, knowing that other luxury retailers would be sure to follow. Mr. Freeman said his architect, Charles M. Kober, who died in 2001, taught him valuable lessons about how to keep customers at the mall longer so they would spend more money. The architect believed that customers left the mall because of a lack of places to sit down or convenient bathrooms or restaurants. At Bellevue Square, restaurants are scattered throughout the mall, not concentrated in a food court. Conforming to other design principles that Mr. Freeman believes in, the walkways at Bellevue Square are purposely narrow so that a customer can easily see the merchandise displayed in the protruding storefronts on both sides of the mall. With no chandeliers, gilded columns or marble floors, Bellevue Square's relatively austere décor is meant to function like a museum. "We want the stores to be the paintings," he said. "If we could, we would be invisible." As a private owner, Mr. Freeman said, he escapes the pressures imposed on REIT's to increase returns every quarter. He cited the example of a manager of a REIT-owned mall in the Seattle area who was forced to add more kiosks to his already cluttered walkways. Kiosks with smaller retailers generate an estimated $9 billion a year at malls, according to Patricia Norins, the publisher of Specialty Retail Reporter, a trade magazine. But Mr. Freeman bans kiosks. "They steal eyeball time," he said. To Mr. Freeman, public ownership and real estate are a bad mix. "Real estate is a long-term player," he said. "Wall Street is all about today."
Rents are rising in all parts of Los Angeles County, the forecast said. San Fernando Valley rates are growing fastest, with a 20% increase over last year because multiple tenants are competing for high-quality office space. West Los Angeles -- with its concentration of entertainment, technology and media tenants -- experienced the greatest absorption of space this year and commands the region's highest monthly rents at $2.79 a square foot. Vacancy rates have dropped substantially throughout the Los Angeles Basin. In downtown L.A., vacancy fell to 15.6% in Q3 from more than 19% a year earlier. That's the tightest downtown has been since the mid-1980s, when a massive office building boom got underway. Helping drive downtown leases are two $1-billion developments: the LA Live entertainment complex under construction near Staples Center and the planned Grand Avenue mixed-use project on Bunker Hill, the report said. Overall vacancy rates in Los Angeles County should fall slightly next year to about 11% from 12.2% now, while average monthly rents, now at $2.52 a square foot, should inch up about 5%, the report said. In Orange County, the area around John Wayne Airport in Newport Beach and Irvine is the dominant market with rents at $2.66 a square foot, an increase of almost 13% from a year ago. With vacancy at 8%, developers are starting construction on several office towers. Countywide, vacancy should fall to 7% next year and rents could climb as much as 6% more, the report said. The Inland Empire will continue to be California's fastest growing urban area over the next 10 years, gaining 10,000 residents a year through 2010, the report said. The office vacancy rate in the Ontario Airport area fell to a tight 4.5% last quarter from 8% a year earlier as high-tech firms and businesses that want to be near the airport absorbed space. "Many companies in the past few years have opened new offices or moved to the Inland Empire from Los Angeles, Orange and San Diego counties to accommodate shorter commutes and more affordable housing for employees," Conway said.
[1] Sound acquisition and deal-making skills - This can be done via doing off-market deals driven by special relationships, by doing transactions structured to be very tax-friendly to the sellers, buying properties that are poorly leased or that have significant lease expiration risk, buying assets that come with adjacent developable land or with redevelopment or re-tenanting potential. Two examples of great deal makers: VNO's Steve Roth and KIM's Milton Cooper. [2] Knowing when to fold 'em - When its a sellers market, smart REITs start selling. A great example of this is the sales of apartment communities to Condo Converters, as ASN, AVB and others have done at sub four cap rates. [3] Having a well-timed and well-executed development strategy - Examples include AVB and ASN in apartments, BXP, CUZ, DRE and perhaps KRC in offices, CNT, PLD and AMB in industrial, and GGP, REG and SPG in retail. [4] Having strong capital allocation skills - Cconservative and effective balance sheet management (including judicious and timely use of debt and equity) do not happen by accident. The same is true for the timing of stock repurchases and issuances, the volumes and types of acquisitions, and developments and asset sales. Some examples: ASN's opportunistic stock buybacks, GGP's capture of asset refinancing opportunities, PSA's heavy use of heads-we-win, tails-you-lose preferred stock, AVB's asset sales to condo converters, and CNT's and CUZ's asset recycling. [5] Having strong tenant relationships - All else being equal, the real estate owner that enjoys a great long-term relationship with a large base of quality tenants will be more competitive, and make better deals. ARE has proven their value in its niche of the office market. And these relationships have proven very important for warehouse space owners, particularly with respect to development opportunities. Retail is a sector where tenant relationships are crucial, as we know from following the likes of General Growth, Kimco, Regency, Simon, Weingarten and others. [6] Being the “local sharpshooter” - In the past there were several REITs that focused upon one property type in a fairly narrow geographical area of the U.S. Now most REITs have gone far and wide in their property-owning strategies, but BXP is still an example of a local sharpshooter in four markets (NYC, DC, Boston and SF). I see CNT as being a Chicago Industrial sharpshooter. I would also add three other strategies that add value: [A} Masters of the Niche: with examples ARE, OFC, EPR. [B] Accretive JV Strategies: with examples DDR and AMB. [C] Supply Constrained Market Strategy: with examples being supply constraints for offices in NYC, thus SLG comes to mind - or maybe you could call the strategy "Sometimes Sucess is as Simple as Location, Location, Location": ESS [Apartments in California], BXP & SLG [New York City]. Value destruction tendencies are important and should be taken into consideration when valuing the shares of REITs. What do these nefarious activities consist of? [1] Having a growth for growth's sake mentality - Pro Logis and Brandywine have performed below par this year, following their Catellus and Prentiss aquisitions at merger premiums that almost always redound to the benefit of the acquired company's shareholders. [2] Having poorly-conceived and badly-executed development efforts - MLS with Zanadu and TRZ. [3] Balance sheet mismanagement and poor allocation of capital - This includes over-leveraging a balance sheet, placing too much reliance upon short-term debt, issuing shares at NAV discounts, and mismanaging the dividend policy. [4] Poor corporate governance, conflicts of interest, excessive use of “weapons of mass entrenchment” such as poison pills and staggered boards of directors, excessive compensation to a small number of executives, and accounting problems such as experienced by Highwoods, Shurgard and Sun. Also, shareholder value has been sometimes compromised by a “failure to communicate” with shareholders. [5] Overpromising to shareholders and then underperforming.
Low interest rates and decisions by fund managers and pension funds to allocate bigger parts of their portfolios to real estate have caused a glut of cheap money to chase after property. This has led to gritty bidding wars that have sent prices surging higher. This, in turn, has made it difficult for savvy real estate players to win auctions for properties. "There's so much capital out there that you're competing against players" who aren't as experienced and don't know when to stop bidding, said Ed Linde, president and chief executive of Boston Properties Inc. (BXP). "You're only as good as your dumbest competitor." Michael Fascitelli, president of Vornado Realty Trust (VNO), said acquisitions are difficult to complete. "There's a lot of money out there - a lot of liquidity," he said. "We've lost an awful lot of deals we were competing for," because a competitor was willing to pay a higher price. As a result, many tycoons are focusing on developments and "offbeat" deals, rather than acquisitions. Linde is bullish on development projects in densely-populated cities where land supply is limited, such as New York City. "If we had another site at Times Square, we'd be building another building, and we'd probably be building it without a (leasing) precommitment," because demand is escalating and available space - especially large blocks - is limited, he said. Vornado's Fascitelli is more cautious about development deals. He said the residential condominium craze has caused land prices to skyrocket, and construction costs have also surged, cutting into the potential profit an office development can generate. Rob Speyer, senior managing director of Tishman Speyer Properties, sees the most profitable deals outside the U.S. "We are doing twice as much development outside the U.S. as we are inside the U.S., and I expect that proportion to potentially double again over the next five years," he said. Tishman Speyer has been doing development projects in India, China and Brazil, where demand and returns have been greatest, he said. These are the markets where companies have been expanding and "you have to be where your tenants are growing," he said. Although these markets have geopolitical, macroeconomic and other non-real estate-related risks, the returns are lucrative. "You can generate 30% and 40% returns on development deals...and that's not going to happen in the U.S.," Speyer said. He said his company's investors recognize this and want to put their money into these markets. "We have probably three or four times the amount of capital lined up internationally than we can put to work in those markets," he said. However, he said his company has to be especially careful to line up people in those markets who have "the right experience with the right connections and the right integrity level" to get the developments done. Several moguls said they have been seeking offbeat real estate deals to sweeten their profits in this environment. Vornado has been focusing on "quirky" deals, such as its acquisition of Toys "R" Us Inc., its stake in Sears Holdings Corp. (SHLD), and its recent investment in McDonald's Corp. (MCD), Fascitelli said. "We've been doing more out-of-the-box investments," he said. His company has also been seeking out "value-added" retail investments, where the company hopes to generate big returns by turning around troubled properties. "Stuff that has a lot of hair on it. Stuff that's ugly. Stuff that we can add a lot of value to," he said. Fascitelli said he preferred to have a controlling stake in a retailer rather than a minority stake since efforts to convince majority holders to sell certain retail properties can be challenging, even if the returns are big. Fascitalli said he's also bullish on condo-hotels. Some real estate companies have been selling land to residential condominium converters and developers. "We just could not resist the price they were willing to pay," said Linde. "We have residential developers paying as much for land as our total (office) project costs." In some cases, the company sells the land outright, while in other cases it forms a joint venture with a residential developer so that the company remains in the development deal. Ken Hubbard, executive vice president of Hines, said his company often changes plans for land use as demand fluctuates in order to get the biggest returns. Real estate executives also offered advice on what doesn't create value. Some said the recent fad whereby certain companies bring in big-name architects, such as Daniel Libeskind or David Childs, with much fanfare and expense to design their properties isn't worth it. "I think this fascination with name" is overrated, Linde said. "I don't think a tenant has ever paid a premium on their rent because it was Mr. Big-name architect" who designed the property, Linde said. As long as the building offers high-quality construction - regardless of the architect - tenants will pay the same price, he said. In fact, bringing in a high profile architect can actually be detrimental, he said. "If the architect is too ego-driven, which can happen, you get the opposite result."
Although REIT prices historically have moved in tandem with fund flow movements, they didn't this time. REITs did fall 8% during the first half of October when about $400 million flowed out of the mutual funds during this two-week stretch, but they rose 11% in the second half of October, despite $375 million draining out of the funds, said Nussbaum. This phenomena appears to indicate that institutional capital continues to chase after real estate, offsetting profit-taking from individual investors in mutual funds, he said. Jay Hyde, a spokesman for the National Association of Real Estate Investment Trusts, noted that REITs saw a 4.3% gain in November, doubling the year-to-date total returns for REITs to 8.5%.
Fact is, most REITs won't be able to drive FFO gains simply by adding properties to their portfolios. And rising energy expenses have partially offset gains from increased rents and high occupancy rates. REITs “tested the hypothesis that accelerating fundamentals will save the sector in a rising interest rate environment,” wrote Morgan Stanley REIT analyst Gregory White. The results were not encouraging: “Our analysis suggests that many more REITs than usual [40%] missed earnings.” But, he notes, “consensus estimates going forward have barely budged. This suggests there may be more pain ahead.” Third-quarter NOI growth slowed after nine straight quarters of year-over-year improvements. While revenue continued to rise due to higher occupancies and rents, rising expenses cut into NOI expansion - a trend that is expected to continue in 2006. According to John B. Levy & Associates, there is more concern for retail “than there has been in many years.” The company points to rising interest rates and energy costs, in addition to concerns about the continued risk Wal-Mart represents to the strip center segment. Another cause for concern is that some recent CMBS offerings have come in with extremely high leverage levels. The pool of loans in a recent securitization from Bank of America, for example, had an average loan-to-value ratio of 102%, according to Moody's Investors Service. Moreover, interest-only loans have now become prevalent in CMBS pools. During Q3, 65.6% of CMBS loans were partially or fully interest-only while a year ago the figure was only 19.2%. For REITs, however, rating agencies Moody's Investors Service, Standard & Poors, and Fitch Ratings have maintained, or even upgraded, ratings on retail REIT debt issuance in 2005. Fitch points to the fact that REITs typically have higher-quality properties than CMBS pools as part of the reason they aren't as concerned, yet. Investors have reason to be cautious, amid signs that valuations and cap rates on retail properties have peaked, and begun to flatten. On strip centers, cap rates even began to rise a little after hitting record lows. The cap rate figures also reflect that more recent sales have occurred in tertiary markets, indicating the risk of playing in cities where projects aren't as insulated from competition from new construction. High asking prices in major markets have also slowed the pace of activity. Most experts expect cap rates on retail real estate to remain stable and possibly rise slightly in 2006, although most don't think they will ever rise back to the 8% or 12% range they were at before the boom began. Transaction volume also has to slow. In the retail sector, it rose 240% since 2000, according to Marcus & Millichap. As transaction volume has soared, holding periods have contracted, indicating that speculation is driving deals. All told, almost 10% of recent sales have been on properties held for less than three years, according to Real Capital Analytics. Even though retail transactions are on track for another record year - sales are up 14% more than 2004's total through nine months - volume is slowing. In Q3, sales volume dropped to $9.6 billion after being at $14 billion in Q2, according to Real Capital Analytics. Retail is also exhibiting the smallest increase in sales volume of any property type - trailing behind apartments (up 90%), industrial (up 83%) and office (up 42%). Overall, retail accounted for 17.1% of commercial property sales in the first nine months of the year, compared with 22.8% during the same period in 2004. Prices on acquisitions have largely gotten too rich for REITs, which made a killing in recent years by growing FFO through purchases and mergers. REITs have been priced out of the market, as private and foreign investors swooped in and raised the stakes. So REITs are turning to development to drive gains in their portfolios. “REITs don't have anywhere else to go now,” says Greg Maloney, president and CEO of Jones Lang LaSalle's Americas retail group. “There are very few possible portfolio plays. There may be one or two consolidations. Ground up development is their opportunity now.” This is inherently more risky. Development activity is being accelerated by the quick rise in cost of materials. Developers want to get projects in the ground now, rather than in six months, to help save costs. As a result, General Growth Properties is investing $2.1 billion in its portfolio; Regency Centers is spending $1.2 billion, and Simon Property Group is spending $840 million. And it's not just the big boys who are out there spending heavily. “You're actually seeing rookie developers or speculators vying for retail development sites and competing with experienced retail developers in the market,” says Michael Dee, senior vice president and national director of retail for Grubb & Ellis. “These rookie developers are much more willing to take risk on because they feel like they can get them leased up in a reasonable period of time and they like the returns they are going to get.” This has also fueled the mixed-use trend that most retail companies have jumped on. “We're certainly not going to see much in terms of traditional mall development,” Dee says. “That lends itself to this emphasis on mixed-use, open-air type projects.” The answer, for some, has also been to stray from known formulas and look for offbeat acquisitions in search of higher returns. For now, the gamble to diversify is paying off, but the strategy entails more risk. Kimco has shied away from its core property type of strip shopping centers. In early November, Kimco paid $55 million to acquire a 50% interest in 57 net-lease industrial and distribution buildings in Mexico. The company said the cap rate for the properties is in the low double digits versus 7% for a comparable portfolio in the U.S. “We believe there continues to be an attractive arbitrage opportunity between property yields in Mexico versus the United States for net-lease buildings to strong credit tenants on U.S. dollar net leases,” said David Henry, chief investment officer. But down the line, does it make sense for Kimco to be operating international industrial properties when its expertise is in retail? Kimco has also invested in Canadian car dealerships and is working with Vestar Development to make over the Tustin Marine Air Base in California into a $140 million lifestyle center. And it acquired a downtown Houston office building for $14 million. Similarly, the Inland Real Estate Group has ramped up its mortgage business and acquired offices. And its Inland Western REIT, ostensibly focused on retail properties west of the Mississippi, this year has purchased properties in New York, Alabama, Georgia and other eastern states. And although Vornado Realty Trust acquired a few traditional mall assets in 2005, it made some unconventional plays by participating in the acquisition of Toys ‘R’ Us, and more recently, the purchase of $500 million of McDonald's stock. Interest rate pressure and alternative investments with similar yields represent more of a challenge. Yields on CDs and the 10-year Treasuries have risen, so the spread between them and real estate cap rates has closed. Cap rates were almost 150 basis points above the 10-year Treasury. Now the spread is almost zero. The question for investors has become whether they want to take on the risk of property ownership, or sit back and buy insured, guaranteed returns. More are opting for the latter. Many traded funds are turning away from real estate and toward treasuries. In fact, such funds have been flowing out of real estate since mid-August. Another reason for concern is that the much-ballyhooed housing bubble is at its end. Some markets have seen housing valuations begin to contract. If housing sales and starts slow down, so too will the string of mortgage refinancings. Homeowners will stop tapping in to the equity of their ever-appreciating homes, and cut back on spending. New homes also bring along a spur of retail spending — an average of $10,000. If home sales slow, so too will retail sales. While the supply of houses on sales in October in Washington, D.C. ballooned, the number of sales plummeted, causing price contraction. According to the Metropolitan Regional Information Systems in Northern Virginia, more than twice as many homes were available in October 2005 than in 2004, but sales were off 28%. In the city, listings were up 62% and sales were down 28%. In Montgomery County, Md., listings were up 49% and sales down 8%. Similarly, in California, the median price of a home was up 14.9% in a year-on-year basis - the smallest spread since June 2003. And the median price actually fell from September as did the total number of homes sold. Meanwhile, the Commerce Department reported that construction of new homes and apartments fell by 5.6% in October, the largest decline in seven months. Applications for building permits fell by 6.7%, the biggest decline in six years. Although there is no direct correlation between single-family sales and commercial real estate, analysts say there is a psychological link. If the single-family market sends a signal that real estate is cooling, that will likely have an impact on the commercial market. Given all the storm clouds gathering, retail real estate companies should expect 2006 to bring challenges they haven't faced in a while. Ultimately, the sector's fundamentals and landlords' ability to continue to raise rents will keep things moving. But it's not going to be all fun and games anymore.
“There's a sense of urgency on both sides of retail deals, stronger than I've ever seen, that's driving things,” says Dan Fasulo, director of the market analysis group at Real Capital Analytics. “On the seller's side, higher interest rates in the future will affect property values, and higher expenses will affect retailers,” according to Fasulo. “Buyers either have capital that needs a home right now, or want to borrow money on good terms while they can.” Indeed, the 10-year Treasury yield, the benchmark for permanent, long-term financing in commercial real estate, was hovering near a relatively low 4.5% as of mid-November. Fasulo is optimistic that the volume of investment sales still has several quarters to go before slowing down. “There's still that much money out there,” he says. “I'm also bullish because retail fundamentals are still strong. For instance, rents are still going up, especially for CBD retail. Demand from retailers is there.” In Chicago's central business district, which includes State Street, asking rents in Q3 averaged $50.30 per sq. ft., the highest since 2001. In the past year alone, asking rents have climbed 30%. According to Reis, retail completions are expected to reach 31.5 million sq. ft. and increase to 37.1 million sq. ft. in 2006, some 21.5 million sq. ft. of which will be community centers (grocery-anchored and the like), with 15.4 million sq. ft. in smaller neighborhood strip centers. “This volume of new space exceeds that of recent years by 5 million to 12 million sq. ft., and exceeds the expected absorption - most notably in 2006, when the difference will be 6 million sq. ft.,” wrote Lloyd Lynford, CEO of Reis, in an October national retail market report. As a result, the national retail vacancy rate will finish 2005 slightly higher, at 6.9%, rising to 7.1% in 2006. But this small change in vacancy won't be enough to contain upward pressure on rents. Reis forecasts that effective rents will rise 3.2% this year, followed by a 3% increase in 2006. Property owners are still pouring money into upgrading or reconfiguring their space to remain competitive. Changes in ownership, such as the purchase of May Department Stores by Federated, will also spur retail reconfigurations. “With the May-Federated merger, a lot of department stores are going to close in the not-so-distant future, and there has to be radical redevelopment of that space,” says Scott Wolstein, CEO of Developers Diversified Realty. That reconfiguration will lead to even further blurring of retail niches. “Malls will be converted to power centers, and power centers will add lifestyle elements,” says Wolstein. Whatever the outlook for malls, which represent a fully mature retail segment, investors are still keen on grocery- and drug store-anchored properties, despite the persistent threat of the likes of Wal-Mart and Costco to eat away at the market share held by traditional grocers. “Neighborhood shopping centers are still the property of choice, grocery- and drug store-anchored, but the demand is so great that not everyone can buy into that segment,” says Patrick Dempsey, a principal and real investment specialist with Lee & Associates in Phoenix. Investors don't seem to be differentiating among segments the way they used to, says Dempsey. “We've seen, in previous cycles, 100 to 150 basis points difference between quality, credit grocery-anchored shopping centers and strip centers,” Dempsey says. Now that gap has virtually disappeared in some markets, with investors willing to acquire either a solid grocery-anchored shopping center or an unanchored strip center at a 6.5% cap rate. This non-differentiation is likely a function of capital looking to buy anything at any price, say industry experts. Another possibility, Dempsey suggests, is that investors are now rethinking which class of retail offers the lowest risk - that is, which niche is the most resistant to Wal-Mart and its ilk. Properties previously thought to be riskier than grocery-anchored centers, such as strip centers and other convenience-oriented retail, might emerge as comparable investment choices. On 12-14: Taubman Centers (TCO) cut its FFO forecast to $1.99 to $2.02 a share, down from an October forecast of $2.12 to $2.15 a share. The analysts' mean estimate was $2.14 a share. For 2006, TCO expects 2006 FFO to range from $2.27 to $2.32 a share, which brackets Wall Street's mean estimate of $2.30 a share. On 12-14: Equity Office says it anticipates in 2006 FFO/share will be between $2.15 and $2.30 and its 2006 common share dividend will be $.33 per common share on a quarterly basis or $1.32 per share annualized, down from the current annualized dividend of $2.00 per share. 12-08: Alexandria Real Estate Equities raised its dividend to $.70/share for Q4-05. The dividend is up from Q3's $.68/share. 12-07: CalEast will acquire CenterPoint for $50 per common share in cash in March or April of 2006. CenterPoint expects to continue to pay regular common dividends, which are expected to be increased 8.2% to $0.4625 per quarter for 2006. 12-06: First Industrial Realty Trust announced that it has priced a public offering of 1,250,000 shares at $39.45 per share with an over-allotment option to purchase up to 187,500 additional shares. 12-02: Senior Housing Properties has priced its previously announced public offering of 3,250,000 common shares at last night's closing price of $18.90 per share. Equity One declared a cash dividend of $0.30 per share, a 3.4% increase over the most recent dividend of $0.29 per share for Q3. 12-01: Kimco buys Atlantic Realty Trust, which owns one shopping center in Staten Island, New York, for about $82.5 million. On 12-16 S&P cuts SPG to 4 STARS (buy) from 5 STARS (strong buy). S&P Analyst Robert McMillan noted that Simon Property shares have gained more than 15% in the past two months. We believe this strength was driven in part by expectations that Simon Property will continue to post solid results and expectations that the Fed is near the end of its interest rate tightening cycle. Although we expect operating trends to continue to improve, driven by an expanding economy and healthy retail conditions which should result in good occupancy levels and rent growth, given the price rise we are somewhat less positive on the shares. We are raising our target price by $1 to $85. On 12-16 UBS cuts Home Properties to Reduce from Neutral. On 12-12 Lehman Brothers cut Post Properties (PPS) to underweight from equal-weight, citing valuation, and downgraded Equity Office Properties (EOP) to underweight from equal-weight, citing the possibility of a dividend cut, and reduced Equity Residential (EQR) to equal-weight from overweight, saying the stock reached its target price of $40. On 12-08 Wachovia Ups Healthcare Realty To Outperform from Market Perform. On 12-07 Morgan Stanley Upgraded TCO from Equal-weight to Overweight and Upgraded REG from Equal-weight to Overweight. On 12-09 Citigroup raises Duke Realty to Hold from Sell, and Ryan Beck starts Capital Lease at Outperform. On 12-07 M Stanley cut Boston Properties to Equal-Weight from Over-Weight, cut CarrAmerica to Underweight from Equal, cut Duke Realty to Equal-Weight from Over-Weight, and cut Equity Office Ppties to Underweight, Upgraded CLI from Equal-weight to Overweight and Upgraded HIW from Underweight to Equal-weight. Morgan Stanley lifted their target price on AvalonBay to $90 a share from $81.50 and their 2006 FFO forecast to $3.95 a share from $3.92, on same-store net operating income growth, solid occupancy and four development projects scheduled to wrap up in 2006. Conversely, the analysts lowered their 2005 per-share FFO estimate for Apartment Investment & Management to $2.47 from $2.56, and the 2006 forecast to $2.86 from $2.90, citing damage from Hurricane Wilma. On 12-06 BB&T raised Commcial Net Lease to Buy from Hold. On 12-06 AG Edwards raised Healthcare Realty to Buy from Hold. On 12-05 Citigroup upgraded Mills to Hold from Sell. On 12-5 Hilliard Lyons Initiated coverage of LTC at Long-term Buy. Fitch affirms "BBB-" rating on CNL Realty offering Orlando Business Journal 11-17 Fitch Ratings affirmed a "BBB-" rating on Commercial Net Lease Realty's $150 million offering of 6.15 percent, 10-year senior unsecured notes. In addition, the New York City ratings firm revised CNL Realty's rating outlook to positive from stable. More REIT Links News Links
Update: Fourth Experiment in Stock Picking 12-16-05 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 higher dividends per quarter than RWR and ICF. 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 12-16-05 My portfolio has changed, so I am getting ready for the 2006 portfolio tracking with the numbers below. I bought Mall REIT GPP, triple-net O and hospitality ENN.
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