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Feldman succeeds Sullivan as the senior REIT analyst at Prudential. The four-analyst team rates 10 REITs at overweight, nine at underweight and 25 at neutral weight, and cites high valuations and weak REIT yield spreads to Treasurys as reasons for the unfavorable call. The team is bullish on regional mall, hotel and industrial REITs, which they rate at favorable, while they're bearish on office and apartment REITs, which they rate at unfavorable. They rate shopping center and healthcare REITs at neutral. In a note, Feldman said REIT valuations are high. He estimates REITs are currently trading at about 15.8 times 2006 funds from operations projections, which is far above the 10.6 historic average over the past 10 years. Also, the equity REIT dividend yield currently stands at 4.33%, which is 3 basis points below the 10-year Treasury of 4.36%. Historically, the REIT yield has averaged 110 positive basis points above the 10-year, he said. "We attribute recent multiple expansion to heightened interest in the sector, relative outperformance of REIT shares, and underlying real estate values," he said. However, Feldman sees five potential catalysts that could lead to a REIT market correction. First, if the 10-year Treasury hits 5%, he expects REITs will become less attractive since many investors seek out REITs for their dividend yield. Second, investor demand for REIT shares is starting to slow. He said REIT mutual funds received net inflows of $1.1 billion in 2005, which is down significantly from the $4 billion inflow in 2004, $3.6 billion in 2003, and $2.1 billion in 2002. Third, a slowdown in merger-and-acquisition activity could reduce the premium currently being built into REIT multiples in light of a surge in M&A activity over the past two years. Fourth, a highly publicized default on large real-estate assets could cause lenders to tighten underwriting standards and stop providing capital at historically narrow spreads. This could potentially cause a sharp decline in the amount of investors chasing after real estate. And fifth, the growth in the foreign REIT market could increase competition for both capital and assets. Even if a correction occurs, though, Feldman said he expects REITs to trade at a 15% premium to their historic multiple.
Merrill Lynch analyst Steve Sakwa, Lehman Brothers analyst David Harris, and Raymond James analyst Paul Puryear are predicting equity REITs will generate total returns, including dividends, of 8% to 10% on average in 2006. Deutsche Bank's Lou Taylor and FBR's Paul Morgan are more bullish, estimating 8% to 12% returns, and 10% to 12% returns respectively. The outlook is close to the 10% returns some economists are predicting for the S&P 500. Robert Promisel, principal at Adelante Capital Management, is expecting equity REIT returns of 4% to 8%. However, he said returns could be higher, depending on how strong investor appetite remains for REITs. Promisel said he expects the REIT dividend yield to remain around 4.5% on average. "We think that that's stable, and we don't envision any major REIT cutting their dividend as EOP did in December of last year," he said. At the same time, he sees FFO growth of 5% to 6% on average. Based on these assumptions, Promisel said the group has the potential to deliver returns "in the low double-digits." He also said he doesn't expect real estate prices, which have surged in the private market, to correct in 2006. However, Promisel said investor sentiment toward REITs could pressure these returns. He estimates that at the end of the 2005, the group was trading at about 15 times 2006 FFO. Historically, REITs have traded in the 8 to 12 range. As a result, he said the REIT multiple could contract slightly, bringing total returns down to the 4% to 8% level. Promisel said investor sentiment - more than fundamentals - is key. "If - for whatever reason - the broader market has investors a bit apprehensive or spooked, then perhaps the visibility and durability of REIT cash flows would prove to be more attractive and we could see further multiple expansion," said Promisel. "We believe worldwide and domestic money flows will have more relative influence on REIT share prices in the coming 12 months than at any time in the past, potentially overriding earnings trends," concurred Raymond James analyst Paul Puryear. Other factors that could pressure REIT returns in 2006 are yield spreads and the fallout related to a massive equity offering recently announced by Macerich (MAC). Spreads between yields on REITs and the 10-year Treasury have been contracting. But if the 10-year Treasury yield fell, REITs would look more attractive and more investors would move into the REIT sector, potentially driving returns up, said Promisel. REIT yields recovered slightly this week, with REITs averaging 4.38% Wednesday while the yield on the 10-year treasury averaged 4.33%. A decision last week by Macerich to do a $660 million overnight equity offering triggered a selloff in the REIT world as jittery investors wondered which REIT might be next. Morgan Stanley analyst Matt Ostrower described the offering as "perhaps the largest of its kind in REIT history." The offering "raised concern among investors that the spigot for new equity may increase if REIT prices continue to climb," said Merrill Lynch analyst Steve Sakwa, in a note. As a result, this could also temper REIT returns in 2006.
In April 1994, REITs treaded water before falling 9.2% by April 1995, said Bank of America analyst Ross Nussbaum. When spreads turned negative in December 1996, the REIT sector actually rose for about 12 months before plummetting 32% over a two-year period, he said. Nussbaum acknowledged that other issues also played a role in the 1997 selloff - in particular the investor shift away from old economy stocks and into technology and media stocks. However, he said the negative spreads also contributed to the sector's decline. "History does not always repeat itself, but we see risk to valuations by mid-year," Nussbaum said. "We believe the negative yield spread should at least sound some alarm bells." Nussbaum said REITs will likely continue to show gains in January and February, given the group's expected solid fourth-quarter results. However, he said "we believe the stocks will ultimately give back the year-to-date gains (and perhaps more) as investors revisit valuations, which now appear at best fully valued and at worst stretched on a number of different metrics." Equity REITs have generated total returns, including dividends, of 5.8% so far in 2006.
Meanwhile, "absorption" increased to 16 million square feet in the fourth quarter, up from 13.6 million in the third quarter. For the full year, the U.S. market absorbed 61.3 million square feet, the best performance since 2000, the firm said. Effective rents gained 1% in the quarter and 3.2% for the year, to $20.65 a square foot, the highest percentage increase in five years. "This is a continuation of the positive strides in the market, which we've seen over the last couple of years as the markets have gained momentum in their recovery phase," said Dan Quan, senior office analyst and director of quality control at Reis.
"After six years of outperforming the broad equity market, many investors believe that REITs are doomed for a correction based on the notion that all good things must come to an end," Sakwa said. "While we recognize that REITs have greatly benefited from macro-factors outside the scope of the real estate industry (such as a low interest rate environment), there are several positive forces that should allow the REIT sector to generate returns [good] as we enter 2006," he said. Sakwa said these positive forces include improving real estate fundamentals, aging baby boomers who are seeking dividend income to supplement their living expenses, and healthy capital flows into real estate. "Given the strong returns offered by real estate over the past 5 years many institutional investors continue to invest in the asset class and the 'queues' at the pension fund advisors to get this money fully invested is measured in quarters, not months or weeks," Sakwa said. "We believe that M&A activity between the private and public real estate markets provides a backstop for valuations in the REIT sector and a significant correction in REIT prices would accelerate the wave of privatizations." The analyst recommended a strategy change during the year, emphasizing stock picking over sector allocation. "This change in strategy stems from the fact that retail fundamentals are 'more cloudy' today while the recovery is well underway in the apartment, office, and industrial sectors," Sakwa said. For the apartment group, the analyst reiterated his "buy" ratings on Equity Residential and Archstone-Smith Trust due to high-quality assets. He said that both companies should continue to benefit from the U.S. housing market slowdown as pricing power continues to return to apartment landlords. The office sector should maintain its rebound in 2006 as corporations continue hiring new workers, although likely at a slower pace than previously forecast. Moreover, an acceleration in leasing activity and a slowdown in new supply have both lowered the vacancy rate at U.S. office properties — trends Sakwa sees as continuing in 2006, while rent growth accelerates. The analyst's top picks in the office group remain Vornado, Boston Properties and Kilroy because all three have exposure to some of the nation's healthiest office markets, like New York City, Washington, D.C., and Southern California. In the retail sector, GGP, Federal Realty and Regency made Sakwa's list of top picks for the year, based on General Growth's above-average growth prospects and the high-quality shopping center portfolios of the latter two. "Looking into 2006, we continue to believe that higher-end malls (those owned by Simon, GGP, and Macerich) should continue to experience solid rent growth on lease renewals (15% to 20% growth) which should allow these companies to generate same-store NOI growth in the 3% range over the next 12 months," the analyst said. "The negative side to 3% growth is that other asset classes such as apartments are exhibiting stronger pricing power which will allow many of these companies to generate 3% to 5% NOI growth over the same time period." Sakwa said that investors looking into neighborhood shopping centers should focus on companies with strong portfolios based on above-average demographics and high-quality supermarket anchors. In the industrial sector, the analyst noted that U.S. industrial markets have flourished as economic growth accelerated, beginning in the second half of 2004. The improvement in industrial fundamentals, similar to the domestic office market, can be seen in a decline in the national vacancy rate, which came in at 8.5% during Q3-05, compared to 9.5% in Q1-04. ProLogis topped the analyst's 2006 list due in part to its established footprint in Europe.
"We've been surprised that real estate has stayed as strong as it has at this point," said Daniel McNeela, a senior analyst at Morningstar, who is cautious again. "The underlying fundamentals hadn't improved nearly as rapidly as the stock prices have risen." There are some compelling reasons to sell right now. For one thing, holders who have long invested in real estate may want to cash out, at least to keep their portfolios' asset allocations in balance. And analysts continue to worry about where the economy and interest rates are headed and how those factors might affect REITs - the bulk of most of these funds' holdings. Some analysts say that REIT's themselves are becoming overvalued, along with the properties they buy and hold, and that returns this year will be less spectacular than in previous years. REIT's returned 8.3%, on average, in 2005, and 18.9%, annualized, over the last five years, as measured by the National Association of Real Estate Investment Trusts composite index. Still, the overall case for real estate remains strong. As the economy continues to grow and to generate jobs, demand for properties like apartment buildings, retail stores and office space will only rise, said Martin Cohen, co-chairman and co-chief executive of Cohen & Steers, whose Cohen & Steers Realty Shares fund was near the top of last year's performance list, returning 14.9%. The fund's main holdings include blue-chip REIT's like Boston Properties and Vornado, which own office buildings in strong markets like the Northeast; Simon; and AvalonBay. Mr. Cohen dismisses the skeptics. "I have been hearing this negative talk for the last five years," and each time there has been a decline, real estate quickly rebounded, he said. Real estate funds have been resilient partly because there has not been a major spike in long-term interest rates, which can prompt a sell-off in real estate investments, Morningstar's McNeela said. The funds have also benefited from the limited supply of commercial buildings being developed. "On average, the replacement costs continue to go up," said Theodore Bigman, who manages Morgan Stanley real estate funds, referring to the rising cost of essentials like building materials and land. That may also help to explain the higher-than-usual number of takeovers of REIT's last year - eight completed, six pending - from companies looking for an efficient way to expand their real estate portfolios without having to build, he added. One area that has had little activity is hotels. "After 9/11, the hotel industry had been in a virtual depression - new construction virtually disappeared," said G. Kenneth Heebner, manager of CGM Realty, the No. 1-performing real estate fund last year, with a 27% return. And the large number of hotel properties being converted into residential condominiums is shrinking the supply of hotel rooms, he said. CGM Realty has 71% of its assets in REIT's. Among its top 25 holdings are several hotel REIT's, including LaSalle Hotel Properties, Sunstone Hotel Investors, Innkeepers USA Trust and Host Marriott. Mr. Bigman, meanwhile, began loading up on hotel shares in early 2002, when many investors were dumping them after the terror attacks. His Morgan Stanley Institutional U.S. Real Estate A, No. 3 on the performance list with a return of 17.7%, is also invested in Host Marriott, along with Starwood Hotels and Resorts Worldwide and Hilton Hotels. Mr. Bigman says he still likes hotel stocks because demand for hotel rooms has grown faster than supply. The biggest holdings in Morgan Stanley Real Estate are Simon, AvalonBay and Boston Properties. Simon "represents a great way to get exposure to Class A regional malls," Mr. Bigman said, adding that he thinks the company is "undervalued versus both private real estate and its peers." AvalonBay, like other apartment REIT's, stands to benefit from the run-up in housing prices, as homeownership becomes less affordable, he said, and it has already profited by selling rentals to developers for condo conversions. Mr. Bigman likes sticking with companies that he thinks are poised for growth, and he bases his investment decisions on the quality of their underlying properties rather than on financial metrics like low price-to-earnings ratios. "Returns are directly tied to continued improvement to real estate property," he said. "Every time we buy a stock we view it as buying into a portfolio of real estate." Mr. Heebner, on the other hand, is quicker to change sector preferences. His decision over the summer to unload shares of home builders and to acquire coal stocks, which now make up around 18% of CGM Realty's assets, has paid off handsomely. Console Energy and Arch Coal are among the fund's largest coal holdings, and each had a stellar performance last year. An additional 7% of the fund is in the brokerage firm C. B. Richard Ellis. "We're bullish on energy prices," he said. And housing? "People are buying more home than they can finance." In other words: he thinks that there is a housing bubble. Other fund managers would agree that parts of Florida, California and Nevada have become overheated and overbuilt, but they caution investors not to confuse them with the commercial market. "They are looking at the bubble in residential real estate and translating that to a bubble in other parts of real estate," Mr. Cohen said. "They are unrelated." Morgan Stanley Bigman concurred: "Is there a bubble in commercial real estate? We would argue that there isn't."
Demographics are driving some of this demand. The Echo Boomers are turning 21 at an enormous rate (1 million per year for each and every year between now and 2014), and those young people are renting their first homes away from parents and college. At the same time, interest rates are rising (30-year, fixed-rate mortgage rates averaged 6.30% in mid-December compared with 5.68% a year earlier), and prospective buyers who might have purchased homes a few years ago now are staying in the rental market. Low interest rates created a group of home buyers who did not have the financial resources to own a home for the long term, and many are slowly returning to rental housing. The PMI Group reports that several housing markets stand a 50% chance or greater of registering falling prices in the next two years. Those markets include: Boston; Long Island, New York; Oakland, Calif.; San Diego; and Santa Ana, Calif. With prices falling, potential homeowners may opt to rent rather than invest in a declining market. Furthermore, any new supply of multifamily product is likely to be curtailed as construction costs increase due to the demand for steel and other commodities as part of the rebuilding in the Gulf region. The Class-A and B properties are likely to capture the homeowners turned renters, but C properties should also benefit as manufacturing jobs are transferred overseas and workers are forced to move down a notch on the housing ladder. A related category is mobile home parks, which give those who cannot afford a single-family home some of the features of home ownership.
The allure of medical office buildings ['MOBs'] hinges largely on predictable occupancy patterns. Doctors typically sign eight-year leases and have renewal rates of 90%. That figure compares favorably with the conventional office market where tenants today typically sign three- to five-year leases and have 60% renewal rates, according to Cain Brothers, a New York investment bank focused on the health care industry. Medical professionals tend to congregate and stay put because it's good for business. They can offer patients the convenience of one-stop shopping, and physicians within the building tend to refer clients to each other. Referral patterns are much more important to physicians than moving and maybe saving $2 per sq. ft. Medical office tenants also typically spend more money on high-end finishes than other tenants and often install expensive equipment, making it costly to pick up and move. That all adds up to steady long-term cash flow, rent stability and fewer tenant improvement costs through the life of the properties. In fact, medical office buildings are emerging as the new “recession proof” property category, a distinction once held by grocery-anchored shopping centers. Over the last two years, the average cap rates for medical office buildings have dropped 250 basis points to 7.3%, according to research and consulting firm Real Capital Analytics. That's a measure of the intense demand for the properties. LaSalle Investment Management was one of the first institutions to target MOBs when it launched its $100 million medical office fund in 2001, and in 2005 Heitman invested some $250 million in this property sector. A sign that major investors have identified MOBs is the surge in transaction volume in these products. Sales more than tripled between 2002 and 2004, jumping from $857 million to $2.6 billion, according to Real Capital Analytics. Deals through mid-December 2005 reached $2.1 billion, says RCA, and the prices hit $182 per sq. ft., a 28% jump from $142 per sq. ft. in 2002. According to estimates by the National Council of Real Estate Investment Fiduciaries (NCREIF), a Chicago-based association that tracks investment data from institutional members, tax-exempt funds hold some $508 million in MOB assets, compared with $104 million in mid-2004. Additionally, surveys such as Ernst & Young's 2005 Real Estate Private Equity Outlook suggest the enormous amount of capital pursuing conventional real estate is pushing money managers to consider alternative property types, such as MOBs and self-storage facilities. Next obvious question: Are the new investors driving up prices and paying too much for second-rate assets? Jean-Claude Saada, chairman and CEO of Dallas-based Cambridge Holdings, a firm that's been developing health care projects for 20 years, says yes. By his reckoning, many of the buildings trading hands lately are obsolete. They're aging and were not designed to accommodate the needs of high-tech medical groups. Also, medical groups tend to be larger, so spaces that were created for solo and small-group practices are not so easily filled. Despite all this, according to RCA, medical office buildings that are more than 15 years old have been selling at average cap rates of 7.3%, just 10 basis points higher than cap rates for buildings five years old or younger. “Unfortunately we're seeing a lot of crazy money overpaying for all the wrong stuff,” says Saada. “There's a lot of cash in the market, and not enough good solid projects.”
One factor driving the building boom is the creation of more outpatient facilities. In the hunt for new income streams, for example, hospitals are forming joint ventures with physicians to operate surgery centers and other outpatient services on campus or at satellite locations. Patients have spent nearly twice as much for outpatient care than they have for hospital care over the last decade, according to the Center for Studying Health System Change, a policy research organization. Regulatory shifts have actually primed the outpatient facility boom. To cut costs, the Centers for Medicare and Medicaid Services, the federal agency that pays health care providers, has pressured doctors to perform lower-risk procedures outside hospital settings. Many knee repairs, for example, used to require overnight stays in a hospital. Now they're done in outpatient facilities. “There are regulatory drivers that force these kinds of changes,” Venn says. “And we're going to continue to see growth in outpatient services.” The MOB market is ripe for investment. Hospitals own billions of dollars of facilities, and cash-strapped health care CFOs are becoming increasingly aware that they can capitalize the assets and plow the proceeds into new technology, services and equipment, says John Winer, a managing director with Ernst & Young's transaction real estate division, who advises health care systems. That wasn't always the case. “Years ago, it was challenging to raise capital for these properties,” Winer says. “But now they're understood by the investment community and are considered to be highly desirable.” LaSalle Investment Management had to thoroughly educate investors about the product when it launched its medical office fund a few years ago, says Steve Bolen, president of the fund. “MOBs weren't on investors' radar screens,” he says. “Now I think the properties are being acknowledged as simply a subset of conventional office buildings.” The Downside of MOBs There are some drawbacks to investing in medical properties. Health care system bureaucracies or government-approval processes sometimes slow projects. And leasing can drag on longer than in conventional office space, because developers must find a larger number of tenants to fill small spaces, typically 1,500 sq. ft. to 2,000 sq. ft., says John Wadsworth, vice president of Colliers Seeley International. Plus, potential tenants are tough to contact because they spend their days seeing patients, adds Wadsworth. MOBs also cost upwards of 20% more to build than conventional office buildings. Typically there are sinks in every patient room and toilets in every doctor's office, driving up the cost of plumbing and creating buildings that re-quire more maintenance. At the same time, he adds, doctors have become extremely sensitive to costs, since medical reimbursements have fallen and other costs have risen. Wide-ranging Medicare and Medicaid Stark laws, in conjunction with insurance rules, also add layers of complexity that can affect how buildings operate. If a hospital is leasing space in a MOB, for example, offering different incentives to different physician groups may violate Stark laws, which generally aim to prevent fraud and abuse related to Medicare and Medicaid payments. Thus, the regulations, combined with more long-term tenants, ultimately may restrict MOB owners from raising rents in response to a tight market, a problem conventional office landlords generally don't have. MOBs Reduce Portfolio Risk Overall, however, assigning MOBs to commercial portfolios is still regarded as a reduction in risk. Indeed, returns on medical offices are happily uncorrelated with the larger office market. A Cain Brothers study of San Francisco following the dot-com bust found that net effective rents grew to $34 per sq. ft. from $28 per sq. ft. between 1999 and 2004, while net effective rents for conventional office space fell to $25 per sq. ft. from $50 per sq. ft. Cash flows also took divergent routes over that same period: Medical office buildings enjoyed growth of 22%, while conventional offices plummeted nearly 80%. Additionally, areas with pent-up demand for MOBs have experienced solid rent growth. Case in point: In the Dallas suburb of Rockwall, PM Realty needed to achieve gross rents excluding electricity of some $24 per sq. ft. to justify development of a 90,000 sq. ft. MOB, which is about double the average market rate, according to Perkins. That compares with rents of $21.08 per sq. ft. for conventional Class-A office space in suburban Dallas, where vacancy rates are 23.4%, according to Grubb & Ellis. Nonetheless, the $15 million project, slated for a March opening, is 90% leased. Investors hope to see continued appreciation in the facilities, and evidence thus far indicates the properties are paying ample dividends. On the other hand, higher prices eventually will put a clamp on yields. Like most commercial real estate, however, the medical office building sector remains highly fragmented despite the growing interest of institutional investors. Regional and local players dominate the space, particularly when it comes to health care facilities located off hospital campuses. In fact, doctors often band together to own buildings, which creates an additional revenue stream — and often retirement savings — for physicians.
Most health care REITs share a resistance to real estate cycles. Demand for retail, industrial, office and multifamily properties may rise and fall with the economy, but occupancy in health care properties is closer aligned to trends in government reimbursement for medical expenses. When a shift in government policy cut reimbursements for nursing care in 1999, five of the nation's seven largest skilled nursing operators filed for bankruptcy, Doctrow says. “The government backed off, everybody came out of bankruptcy and the industry recovered, but that's still fresh in people's minds.” Health care REITs aren't entirely immune from real estate cycles. At greatest risk is private-pay seniors housing, which is driven by supply and demand and has fewer barriers to entry than other asset types in the health care sector. The seniors housing market is still recovering from an oversupply created by intensive construction in the 1990s. Occupancy hit bottom at 84.5% in 2001 and had only recovered to 88.5% as recently as midyear 2005 — well below the 95% occupancy rate in 1997, according to the National Investment Center for the Seniors Housing Industry. Falling Cap-rates In a commercial real estate market awash in excess liquidity, REITs are finding themselves outbid for acquisitions by non-traditional investors willing to accept lower initial returns. Capitalization rates for MOBs on hospital campuses have averaged between 8% and 9% historically, but are now in the 6% to 7% range, according to Bethany Mancini, an associate vice president at Nashville-based Healthcare Realty Trust. “There are still acquisitions to be made, but the accretions on new investments are much lower than in years past,” she says. “It's difficult to get much growth from external investments when you're not getting the capitalization rates you used to get.” Cap rates are higher in the higher-risk seniors housing property sector, but are still well below historical averages. The stabilized portfolios of independent living properties have traded in the range of 6% to 8% recently, which is down from 8% to 10% just one or two years ago, according to Ray Braun, who is the president of Health Care REIT. For assisted living, cap rates have fallen to between 6.5% and 8% vs. the previous 10% to 12%; cap rates on skilled nursing facilities now range from 8.5% to 9%, down from a 13% to 16% range. “Exit cap rates will likely be higher due to the historically low interest rate environment of the last few years,” Braun says. “Consequently, we view investing in stabilized, long-term-care assets at these cap rates as risky.” If interest rates rise this year, cap rates should follow suit as the buyer's cost of capital increases. But that poses a different problem: Health care REITs lose their luster when rising interest rates bring better returns from alternative investments. Case in point: The share prices of health care REITs fell in Q1-05 when concerns about a potential rise in interest rates sent investors scurrying to the broader equities market. “Health care REITs are most attractive when the economy is declining and interest rates are flat or down,” Doctrow says. “They're less attractive when the economy is improving and interest rates are rising.” But “While the stock price may not perform as well in a rising interest-rate environment, our earnings growth has been better in a rising interest rate environment because of the higher accretion, or returns, on new investments,” says Mancini of Healthcare Realty Trust. How do health care REITs mitigate their unique risks and increase revenue? One solution is to diversify leasing or lending to a variety of operators over a wide geographic region. Another common practice is to group properties under a single lease. Even if performance deteriorates at one facility, the tenant will keep up payments on a master lease rather than jeopardize the rest of its portfolio. It's also a smart practice to grow revenues by building rent increases into leases. Health Care REIT's leases typically increase rent by 20 to 25 basis points each year above the initial lease yield. Some health care REITs are stepping up construction to circumvent the difficulty of finding accretive acquisitions. Healthcare Realty Trust purchased a $130 million portfolio in the Dallas-Fort Worth area from Baylor Health Care System in 2004 and leased the acquired 20 buildings back to the seller. In 2005, the Healthcare Realty Trust developed two new medical office buildings for lease to Baylor, and it plans to expand its relationship with that health care system through more construction in 2006. “We invest with a long-term view,” Mancini says. “We may acquire a 20-facility portfolio at a marginally accretive cap rate, but we believe it has long-term potential for the development of new facilities.” Analysts say health care REITs suffered in 2005 because investors feared a spike in long-term interest rates would make other investments more attractive by comparison. Those concerns are abating, now that the Fed's measured increases are showing a governing influence over the economy. In raising the fed funds rate to 4.25% on Dec. 13, the Fed described inflation expectations as “contained.” That bodes well for health care REITs, which are more sensitive to changes in interest rates than mainstream REITs. “The general sense is that the economy is more likely to be a little slower [in 2006], with less concern about interest rates rising,” Doctrow says. Market fundamentals are solid, with a stable supply for acute-care and nursing facilities and the more volatile supply of seniors housing, at least for the moment, experiencing rising occupancy and climbing rental rates. In the long term, demand for health care properties should increase. Those born in the Roaring '20s are adding to the number of U.S. residents above the age of 85 at the rate of about 3% each year, and increasing the demand for skilled nursing, Doctrow says. The Baby Boomers are beginning to hit their mid-50s and will increase demand for the rest of the health care sector. The Different Types of Health Care REITs At least 14 REITS focus on health care. Their assets are typically concentrated in one or two property types. Nearly half of health care REITs own hospitals, surgery centers or medical professional buildings, also known as acute- care facilities. Most of the other REITs in this sector emphasize seniors housing, which can range from nursing homes to assisted-living communities. Life-science companies, which cater to pharmaceuticals and research rather than patient care, make up the remainder of the group. REITs are prohibited from providing health-care services directly except in special, temporary circumstances, such as a financial workout. Most health care REITs acquire properties from an owner/operator and then lease those assets back to the seller under a long-term lease, typically for 7 to 15 years on the initial term. Most leases require the tenant to operate, maintain and even replace the property, if necessary. Capital expenses may affect a tenant's ability to pay rent, but rarely will a REIT need to factor capital expenses into its leases. “They are more finance companies than true building operators in most cases,” says analyst Jerry Doctrow, managing director at St. Louis-based Stifel Nicolaus. Risks vary by property type, but changes in Medicare payments or state-level Medicaid reimbursements for care to the indigent can threaten a tenant's performance. The risk is pronounced for skilled nursing centers, which receive 60% to 70% of their income from Medicaid and 20% to 25% from Medicare, according to Philip Martin, a senior vice president at Stifel Nicolaus. A strength of the skilled nursing set is that high barriers to entry make overbuilding unlikely. States require a Certificate of Need to verify demand before a new nursing center can open. Likewise, the complicated nature of running a hospital is an effective curb against unneeded construction. The sector with the most to fear from overbuilding is private-pay seniors housing, which is largely free from government regulation and driven more by supply and demand forces, Martin says. “With private-pay senior living, you run the risk of overbuilding and falling prey to a real estate development cycle.”
By virtue of their sheer number, the 80-million-strong echo boomers are having a dramatic impact on the look and feel of student housing. These kids never had to share a bedroom with their brother or sister, much less some unknown freshman. They're also the first “wired” generation, having grown up with easy access to pcs and other electronic gadgets. Three new REITs aim to gain more market share. In April 2004, Austin-based American Campus Communities became the first REIT to focus on student housing when it filed a $253 million initial public offering. GMH Communities Trust followed suit in October 2004 with a $312 million IPO. Memphis-based Education Realty Trust was the third student-housing REIT to join the party with a $304 million IPO in January 2005. Brokers say the volume of student housing property trades doubled in 2005 over 2004 to close to $3 billion, with average pricing up 10%. Experts put the value of the U.S. student housing market at about $160 billion. “Interest in student housing properties is skyrocketing,” says Herb Chase, managing director of the multi-housing capital advisors group at Transwestern Commercial Services in Los Angeles. “Just a few years ago when we'd bring a property to market, we'd get about one-third the offers we'd get for a conventional multifamily property. Today, we're getting about 75%.” What's behind the change of heart? Growing familiarity with the new product type — and premium yields. Currently, cap rates are typically 50 to 100 basis points higher for student housing developments than traditional apartments. Specifically, cap rates range from 5% to 5.5% for student housing properties in California compared with cap rates of 4% to 5% for traditional multifamily properties throughout the state. In smaller markets nationally, cap rates for student housing are as high as 7% or 7.5%. But as student housing becomes more widely accepted by investors, expect that gap in cap rates to tighten. In fact, it already has done so. Eighteen to 24 months ago, the gap between traditional apartments and student housing ranged from 100 to 200 basis points. Buyers of student housing properties can expect to pay more than they would for traditional multifamily product — 10% to 25% more. In areas where land is in short supply, the premium can be as much as 50%. But they'll also collect more revenue, with rents for a three-bedroom, student-housing unit starting at $1,200 to $1,500 per month. The national average rent collected for a three-bedroom apartment is about $1,160, according to Dallas-based MP/F Research, which tracks the multihousing industry. Markets where land is in short supply — such as California, Washington, D.C., New York, Boston, Chicago, and Miami — are hot student-housing markets. Texas also is a favored market due to population and enrollment growth projections. The reason every investor isn't getting into student housing is that a lot of the major universities are in small, tertiary cities, Chase says. “Investors will buy in Atlanta, but they won't buy in Athens, Ga.,” he says. “Small towns are more likely to have plenty of land and are less likely to reject new development, which drives up the potential for oversupply.” How Student Housing is Different Unlike apartments, which are leased by the unit, student-housing projects are leased by the bed, with residents getting their own private bedroom and often a bathroom — with a lock and key — but sharing kitchen, dining and living-room space with as many as five other students. Most of the units are furnished, at least in the common areas, to make life easier during hectic end-of-summer transition periods. The leasing cycle in the student housing business poses a formidable challenge, with all tenants moving in and out during a brief period in August or September. In short, there's only one chance each year to lease up the property. If owners hit occupancy goals, they can sit back and relax. But if they miss the mark, they're stuck with those numbers for another 12 months. Conversely, at traditional apartments leases are staggered throughout the year. Student housing properties near larger Division I schools tend to lease earlier because they select incoming freshman classes earlier. It also costs more to operate and maintain student housing properties, due to added amenities, such as the resort-style pools, game rooms and free high-speed Internet and cable offered at most new projects. And student housing properties have higher turnover rates and mountains of paperwork — 300 units could mean anywhere from 600 to 1,800 or more lease agreements. The contracts typically are signed by a student's parents, who agree not only to pay the rent but also be held liable for their offspring's conduct. Despite the extra work involved, the outlook for the student-housing sector is strong. The highest birth rate ever occurred in 1990, so by 2008 we'll have the largest freshman class ever seen. The Evolution of Student Housing Most of the current on-campus dormitories were developed in the 1960s and 1970s. These dorms typically house four students in two-bedroom units with a shared living space. Some units also include a private bathroom or two, but in many dorms. Private developers started getting in on the action in the late 1990s, both by partnering with schools to develop on-campus dorms and by luring students off campus with a new version of student housing: apartment-style projects complete with swimming pools, game rooms, fitness facilities — and no resident advisors monitoring curfews. Some schools responded with their own apartment-style offerings. But there were drawbacks. Universities found the apartment-style projects were more expensive, both to build and to operate, with increased maintenance costs for the kitchens. The new trend in on-campus housing: modified dorms, with suites that house six to eight students. Each same-gender unit has four double-occupancy bedrooms, two toilet rooms, two shower rooms and a living area. As with most of the modified dorms, suites feature both a small refrigerator as well as a microwave oven. An estimated 90% of all off-campus student housing is built and owned by private companies. Larger schools are more likely to fund their own on-campus projects. Smaller colleges are more likely to do a joint venture with private developers. Both on- and off-campus student housing projects are bringing in retailers, every thing from coffeehouses and convenience stores to bookstores, photocopy service centers and clothing stores. To compete against the swanky off-campus offerings, universities tempt students with access to college intranets and proximity to classrooms, dining halls and other campus buildings. They also put a lot of emphasis on outdoor spaces. Courtyards help students come together and interact. Schools are installing wireless Internet connections in the new dorms and upgrading mechanical systems, which means cleaner air and better individual temperature controls. Interiors have higher finishes to discourage destruction. Some schools are blurring the line between living and learning by throwing classrooms into the mix, especially if a dorm is geared toward a specific student set, such as engineers or athletes. Ryan Reid, director of student housing for CB Richard Ellis in Dallas, says all types of buyers are getting into the student housing game. “Besides institutional capital, TIC funds and private investors looking for niche plays are chasing it as well, getting involved both on the development and acquisition side,” he says. Demographic trends point to strong future demand. The percentage of kids who attend college is on the rise, now standing at about 65%. Reid advises buyers to partner with an operator who understands student housing. “Operating the product type is not drastically different, but there are nuances, such as making sure it's staffed correctly by people who can deal with both students and parents, and understanding how to turn over a 300-unit property in three weeks,” Reid says. “Investors getting in now are still a little ahead of the curve,” Reid adds, “but interest in student housing is growing faster than it is for any other product type. It's an emerging niche.”
The upscale segment received a major vote of confidence from Emerging Trends 2006, an annual survey of about 400 industry professionals released late last fall by PricewaterhouseCoopers and the Urban Land Institute: “Investors predict more revenue growth from upscale lodging categories than any other property sector,” the report notes. It's the first time in the 27-year history of the survey that any segment of the hotel industry was rated as the top prospect for investment among real estate property categories. Smith Travel Research reports that revenue per available room (RevPAR)in both the luxury and upper-upscale segments increased an estimated 14% to 16% in November 2005 compared with November 2004. By this measure, the two segments are slightly ahead of the hotel industry as a whole, which boosted RevPAR 13% to 15% during the same period. Annual average occupancy also has been climbing steadily since hitting a low in 2001. Through the first 10 months of 2005, according to Smith Travel Research, luxury hotels averaged 71.6% occupancy, up from 69.2% during the same period in 2004. In the upper-upscale category, average occupancies increased from 70.9% to 71.6% during the same time frame. There are a dozen or so major brands in the top two niches. Four Seasons, InterContinental and Ritz-Carlton are among the most dominant in the luxury segment, while Marriott, Hilton and Hyatt are leaders of the upper-upscale segment. The business and leisure travelers who support these segments are back in greater numbers because the economy has improved and travel fears are fading. “The underlying fundamentals of the economy driving RevPAR and occupancy growth are household wealth and business income, both of which have been expanding in recent years,” says Ray Torto, principal and chief strategist at Torto Wheaton Research. According to Economy.com, corporate profits and household wealth have been consistently increasing each quarter on a year-over-year basis since Q1-03. “Historically, there's a strong correlation between increased income and increased RevPAR, especially for luxury and upscale brands, and we're definitely seeing it again,” says Torto. “Investors see the strong fundamentals, and believe there's going to be a disproportionate increase in profits in the top segments for the foreseeable future,” says Kevin Mallory, senior managing director and U.S. practice leader for CB Richard Ellis Hotels. “It isn't too hard to convince yourself that there will be significant revenue growth over the next three to five years.” Not only are the prospects for revenue growth encouraging, but limits to new supply also beckon. “Owners don't have to worry about too much [upscale] property coming into the market anytime soon, because barriers to entry are so high,” says Steve Rushmore, president of New York-based HVS International. In 2005, the total supply of rooms in the luxury segment increased by 654 rooms, or only about 0.8% of the total inventory of 76,730 rooms existing at the beginning of the year, according to Lodging Econometrics. The growth in 2004 was a little bigger, coming in at less than 1%. “It's simply difficult to find good sites,” Mallory notes, especially in larger markets. “A hotel is going to compete in a lot of cases with residential development, and residential developers have, for now, a better hand. The demand for condos is still strong enough that they're able to pay more for the sites than a hotel developer, and financing is easier because you can borrow against your sales,” adds Mallory. Clyde Guinn, senior vice president at hotel developer and manager Stanford Hotels Group, says that hesitancy among lenders to finance new upscale and luxury hotel projects has been a key factor in restraining development, and he anticipates continued reluctance on their part. “Without condos or a timeshare element, even in second-tier markets, you can't sell a luxury hotel development project to a bank,” Guinn says. Still, not everyone is convinced that the barriers will impede development significantly on a national scale. Debt financing is available, but in many cases developers must put between 30% and 40% equity into a hotel deal, says Elliot Eichner, co-founder and principal of Sonnenblick-Eichner Co., a Los Angeles-based real estate investment banking firm specializing in commercial real estate, including luxury hotels. “Not only that, construction costs are 15% to 20% higher than a year ago.” Amid rising development costs, investors can still buy top hotels more cheaply than they can be built. Indeed, domestic hotel sales in the luxury and upscale segments totaled $9.1 billion in the first 11 months of 2005, compared with sales of $5.1 billion for all of 2004, according to Real Capital Analytics. That's roughly an 80% increase even before end-of-year figures are tallied. With so much capital chasing hotel properties, the loan terms for borrowers have become more attractive. “Hotels — and that includes the top segments especially — have now evolved into a favored class in real estate, and its financing isn't going to be so different from other kinds of real estate,” says Eichner of Sonnenblick-Eichner Co. The acquirer of a shopping center today could reasonably expect to obtain a 10-year, fixed-rate loan at an interest rate ranging from 95 to 105 basis points over the 10-year Treasury yield. The interest rate on a 10-year loan for a luxury hotel might be approximately 115 basis points over the 10-year Treasury yield. “If you have any longevity in this business, you'd think, ‘My God, only a 10 basis-point difference between retail and a hotel?’” Eichner says. “The reason is that the hotel business is good, and most individual properties have a positive trend line.” Eichner is adamant that top-tier hotels are trading nowhere near replacement cost. “I have not seen one deal that has come close to replacement cost, not one,” he emphasizes. “And I don't anticipate that happening in the near future, or even the not-so-near future.” In an urban environment, a luxury hotel might cost $350,000 to $500,000 per room to build, Mallory says, “assuming you can compete for the land and raise the required capital.” That price compares to the average sale price of $207,000 per room in the luxury segment during the first 11 months of 2005, based on data from Real Capital Analytics. While there isn't exactly a torrent of new development just yet in the upscale and luxury segments, new product is in the construction pipeline. According to Lodging Econometrics, nationwide five luxury hotels totaling 1,238 rooms will open in 2006, and 12 properties totalling 2,294 rooms will open in 2007. Moreover, 18 other projects are being actively pursued by developers, representing another 6,159 rooms that might come on line in 2008 or later. The upper-upscale segment shows a similar rise in new openings. There are currently 50 hotels under construction in the upper-upscale sector, while 42 will start in the next 12 months, and another 25 are in the early planning stages.
A big part of the improvement will be related to new construction, which is expected to remain near historically low levels. The report said rising construction costs and the conversion of hotels into condos will prevent oversupply and overconstruction. At the same time, investor interest in the sector shows no signs of waning, which should keep property valuations high. "Last year saw a doubling of financing activity for hotel real estate in the commercial mortgage-backed securities sector, and we see another strong year ahead," said Michael Fishbin, national director of hospitality services for Ernst & Young Transaction Advisory Services. Of the $100 billion currently held by real estate private-equity funds, Fishbin estimates as much as $20 billion will be channeled into lodging this year. "We expect investor appetite for hotel deals to grow in 2006, especially in major markets where room rates have shown strength and occupancy rates have improved," such as Chicago, New York, Washington, San Francisco, Los Angeles, Boston, Miami and Phoenix, he said. Fishbin said he wouldn't be surprised if new hotel development activity picks up in 2006 - but he believes most will be presold before a shovel hits the ground. "Capital sources are circling the primary hotel markets in the U.S. now, looking for opportunities to own new hotels as soon as they are completed," he said. On 1-05 Equity Inns announced that it expects AFFO for Q4-05 to be in the range of $0.23 per share to $0.25 per share versus previous expectations of $0.17 per share to $0.19 per share. ENN expects net income applicable to common shareholders for Q4-05 to be in the range of $0.07 per share to $0.09 per share. The better than expected results are due primarily to ENN's quarterly RevPAR exceeding initial forecasts. A fourth quarter 2005 RevPAR increase in excess of 8.0% has surpassed the Company's prior forecasts due, in part, to higher than anticipated occupancies in the Company's Florida and Gulf Coast hotels following Hurricanes Katrina and Wilma. ENN estimates approximately $0.03 per share in AFFO is attributable to positive business related to the effects from the hurricane season. On 1-10 LaSalle Hotel Properties issued a fiscal 2006 outlook calling for a sharp increase in earnings over 2005 levels, aided by expected contributions from a planned acquisition, but its guidance for FFO missed analysts' expectations. LHO said net income is expected to range from 92 cents to $1.02 per share, versus a 2005 forecast of 59 cents to 62 cents per share. FFO is expected to rise to $2.50 to $2.60 per share, compared with an estimated $2.13 to $2.16 per share, for fiscal 2005. Analysts, as surveyed by Thomson Financial, are expecting FFO to come in at $2.70 per share for fiscal 2006 and $2.16 per share for 2005. The forecast includes a contribution from a planned acquisition of Le Parc Suite Hotel in West Hollywood, Calif., for $47 million that is expected to close this month. On 1-13 Macerich announced that it has priced a public offering of 9,523,810 newly issued shares of its common stock at an initial price to the public of $69.50 per share. On 1-10 BRE announced that it sees 06 FFO of $2.05 per share to $2.20 per share. Excluding two extraordinary income items expected to be recorded in 05, the projected range forecasts that 06 FFO growth could be flat to up about 8% from 05. On 1-12 A joint venture consisting of Toll Brothers, which is the managing member, Meritage Homes and Simon Property Group has purchased a 5,485-acre land parcel in northwest Phoenix from DaimlerChrysler Corporation for $312 million. Toll Brothers and Meritage Homes each plan to build a significant number of homes on the site. Simon Property Group, Inc. has the option to purchase a substantial portion of the commercial property. Other parcels may be sold to third parties. Initial plans call for a mixed-use master planned community, which will include approximately 4,840 acres of single-family homes and attached homes. Approximately 645 acres of commercial and retail development will include schools, community amenities and open space. Initial homes sales are tentatively scheduled to begin in 2009. On 1-13 Ashford Hospitality Trust (AHT) registered Friday to offer 9 million common shares. The Dallas real estate investment trust said in a filing with the Securities and Exchange Commission that it intends to use the proceeds from the offering to repay part or all of the $60 million outstanding balance on its credit facility as well as for general corporate purposes, which may include additional hotel investments. On 1-03 Reckson was upgraded by Stifel Nicolaus and Maguire was downgraded by Stifel Nicolaus. On 1-04 A.G. Edwards Starts General Growth Properties At Buy and A.G. Edwards Starts Simon Property At Buy. On 1-05 Camden Property was downgraded by Matrix Research. Trizec downgraded by Matrix Research. On 1-11 F. Billings Cut Regency To Market Perform From Outperform. On 1-11 AG Edwards Downgraded VTR from Buy to Hold. On 1-11 JP Morgan Upgraded ESS from Neutral to Overweight. On 1-13 UBS Downgraded EDR from Buy to Neutral. On 1-13 Banc of America Downgraded EOP from Neutral to Sell. On 1-17 Wachovia Ups DiamondRock To Outperform From Market Perform. On 1-19 Stifel Nicolaus Downgraded MLS from Buy to Hold. On 1-20, Prudential Cuts CarrAmerica To Underweight From Neutral, Ups Arden Realty To Neutral From Underweight, Raises Brandywine Realty To Overweight, Cuts Entertainment Properties To Neutral, Cuts Macerich To Neutral From Overweight, Raises Camden Property To Neutral From Underweight, Raises CBL To Overweight From Neutral, and Raises ProLogis To Overweight From Neutral. Prudential Initiated coverage of AIV and AVB at Underweight and Initiated coverage of DDR at Overweight. On 1-27 Goldman Cuts Apt Invest & Mgmt To Underperform from In-Line, Cuts Libery Property To In-Line From Outperform, Raises AvalonBay To In-Line From Underperf, Raises Prologis To Outperform From In-Line, Raises Simon Property To Outperform From In-Line, and Raises SL Green To In-Line From Underperform. On 1-13 UBS analyst Chris Pike slashed his earnings guidance for Education Realty Trust (EDR) in 2005 and 2006 and is predicting a dividend cut of as much as 30% by the third quarter. In a note, pike downgraded Education Realty to neutral from buy and slashed his price target to $6.50 from $13 over the company's weak earnings picture. Pike cut his 2005 funds from operations projection 38% to 44 cents, and chopped his 2006 estimate 25% to 99 cents a share. The earnings cuts were based on the company's "missed investment timing, higher-than-expected expenses and lower-than-anticipated investment volumes," he said. Also, Pike said the market isn't recognizing the value of the company's existing assets. He said the current stock price values the company's properties at $29,500 a bed, which is far below the $42,000 a bed that similar properties recently fetched when sold. "We believe that this underlying real-estate value will help support the shares until management can regain shareholder confidence through improved operations and prudential stewardship of investors' capital," Pike said. Update: Fifth Experiment in Stock Picking 1-27-06 The new year has started, and my portfolio still lacks the 10% weighting in hospitality [AHT and SHO are candidates], the 12% weighting in apartments [GCT? or buying of AVB/BRE/ESS - but at such low yields?] and the 6% weighting in health care [with purchases of VTR] that I want. And add industrial FPO to the menu. But with prices at an all time high, it is no time to buy. But it might be a good time to lighten up on offices [and sell CRE or some VNO?]. GGP is up 25% since my purchase in August - its valuation scares me. And I want to dump MLS. The NAREIT index is 25% weighted in office and industrial, but this portfolio is 42% in those categories. The NAREIT index is 25% weighted in retail, mall and free-standing, but this portfolio is 34% in those categories. So I am uncomfortable with this portfolio's weighting and the valuations of highly weighted ARE, GGP, OFC and VNO.
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