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The U.S. commercial real estate market has so far averted the catastrophe that many strategists were predicting last year. Even after sales of existing homes plummeted 27 percent to record lows in July, threatening further home-price declines, analysts see commercial real estate values stabilizing. Vacancies for apartment buildings, office complexes, retail mall, and self-storage facilities are no longer rising meaningfully, rents are no longer falling, and many Real Estate Investment Trusts, the main vehicle for individual investors to participate in the sector, continue to reduce their debt loads.
Equity investors are taking notice: FTSE NAREIT's All-REIT index, comprised of 148 publicly traded REITs, was up 11.7 percent year-to-date as of Aug. 26 while the Standard & Poor's 500-stock index was down 4.9 percent. Publicly traded REITs represent 15 percent of the total U.S. commercial real estate market. Equally striking is how much more confidence investors have put in U.S. mutual funds and exchange-traded funds that focus on real estate assets than they have in equity funds in general. Year-to-date through July, $1.42 billion flowed into U.S. real estate mutual funds, while $27.1 billion flowed out of U.S. equity funds, according to an Aug. 20 research note by Deutsche Bank Securities (DB).
This doesn't mean that there aren't plenty of commercial real estate loans in default. Fitch Ratings, in an Aug. 20 report, said that 43 percent of the 126 commercial mortgage-backed securities set to mature in September—representing $962 million in face value—are either delinquent or in foreclosure. (Commercial mortgage-backed securities are pools of loans that were bundled and sold to investors in tranches rated for their level of risk of default.)
Given that the value of many properties has fallen dramatically since commercial mortgages were taken out five years ago—the typical loan duration—and that most of these loans are interest-only, for which principal hasn't been paid down, most borrowers will be hard pressed to provide the additional equity required by banks in order to refinance them at considerably lower loan-to-value rates, says Jeremy Anagnos, co-portfolio manager of the American Beacon Global Real Estate Fund (ABEAX).
The REITs trading at the highest multiples are those with better-quality properties and stronger balance sheets. Investors must decide whether it's worth paying up for those stocks on a bet that they'll use their liquidity for growth, says Paul Adornato, an analyst at BMO Capital Markets. They may prefer to buy a cheaper REIT facing a high cost of capital on the belief that the value of their portfolios will appreciate as the broader economy recovers. If you're not expecting a quick recovery, you may prefer the higher-valued REITs, Adornato says.
Nearly all of the 15 REITs on Credit Sights' coverage list reported funds from operations (FFO) in the second quarter that exceeded analysts' consensus estimates. Roughly two-thirds of the companies increased their full-year FFO forecasts, according to an Aug. 16 report by the ratings provider. Credit Sights continues to recommend an overweight position in REITs' credit such as unsecured bonds "based on relative value compared to other investment grade sectors and in the context of stabilizing, if not improving, fundamentals and capital markets that remain accommodative to debt refinancing and other capital raising."
Anagnos, who says American Beacon has questioned the strength of the economic recovery from the start, suggests that investors stick to higher quality REITs with lower costs of capital. The lower the interest payments a REIT is making on outstanding debt, the more money it's likely to have to make acquisitions and expand its portfolio of assets, he says.
Developers Diversified Realty (DDR) agreed to pay an initial yield-to-maturity of 8.0 percent on $300 million of 10-year unsecured debt it sold during the week ended Aug. 13, while Simon Property Group's (SPG) $900 million offering of 11-year unsecured notes was not only $150 million bigger than targeted but priced at just 4.42 percent. The same week, the largest tranche of Vornado's $600 million offering of commercial mortgage-backed securities priced at 4.03 percent due to strong demand.
Dave Rodgers, an analyst at RBC Capital Markets, sees liquidity as a more important factor because it determines how much capital a company can afford to spend on acquisitions. Some companies have attractive balance sheets but not necessarily strong liquidity.
"AMB Property (AMB)—an industrial REIT—has good leverage, but its liquidity is not great because they have a lot of near-term maturities," Rodgers says. ProLogis' (PLD) leverage is "too high," he says, noting that it has "good" liquidity because most of its debt doesn't mature for a further 24 to 48 months.
Then there's Boston Properties (BXP), which is sitting on more than $1 billion in cash. Including untapped credit lines, the company currently has a total investment capacity of $2.5 billion to $2.8 billion, Rodgers adds.
REITs have a permanent place in the investment portfolios that Scarsdale (N.Y.)-based Palisades Hudson Asset Management manages for its clients because of the higher yields they offer vs. government bonds. On Aug. 26, the yield on the FTSE NAREIT All-REIT index was 4.74 percent, compared with 2.50 percent for the 10-year Treasury bond. "You can't fake dividends," says Jonathan Bergman, chief investment officer at Palisades Hudson.
Having shored up their balance sheets by paying down debt and raising cash through equity offerings in recent quarters, the larger equity REITs "will be pouncing on opportunities over the next three to four years" as more distressed properties come to market from private owners that don't have access to the capital markets and will be forced into foreclosure, he says.
Palisades Hudson prefers to invest in REITs via international mutual funds with a focus on developed economies such as North America, Western Europe, and Japan. Among those the firm uses are the Morgan Stanley Institutional U.S. Real Estate Fund (MSUSX) and the Morgan Stanley International Real Estate Fund (MSUAX).
REITs that primarily own apartment buildings are in a stronger position than those that concentrate on office, retail, and industrial properties. With home prices continuing to fall, and access to credit diminished, renting is the only option for many people who can't get mortgage loans or aren't willing to buy a house now. Occupancy rates for apartment buildings are currently running at 92 percent to 94 percent, compared with about 88 percent for warehouses and other industrial properties and 84 percent for office buildings, says Rodgers.
Retail properties may be the second-most-attractive asset class. Investors need to be cautious because data show lower retail sales and certain retailers are closing some stores, says Stan Ross, chairman of the board at the University of Southern California's Lusk Center for Real Estate. Office buildings would be his last choice, due to high vacancy rates and a weak job recovery forecast. "The only good news there is that no construction is going on," he says.
Credit Sights said it finds the biggest challenges in industrial properties because tenants are reluctant to commit to space and prefer to use just-in-time leasing strategies and unconventional inventory management—which is expensive and likely unsustainable.
The fact that the commercial real estate market hasn't crashed as expected is positive, but it also explains the scarcity of acquisition opportunities, which has limited REITs' ability to grow as the economy recovers, says Adornato. Banks and special servicers of commercial mortgage-backed securities have been too willing to extend maturities and pretend that property values haven't fallen because they're reluctant to liquidate properties at distressed prices and they don't want the market to discover the true value of their loans portfolios, he says.
Another reason acquisitions have been slow is that REITs are being outbid for properties in the top markets by private equity real estate funds, which have to invest their clients' money and are often willing to overpay for assets, says Brad Case, an economist at NAREIT.
Certainly, some REITs continue to buy attractive properties. Equity Residential (EQR), SL Green (SLG), and Simon Property Group have been the biggest acquirers so far, according to Credit Sights. Brandywine Realty Trust (BDN) is buying office buildings in downtown Philadelphia and Kilroy Realty (KRC) is acquiring properties on the West Coast, while Boston Properties recently bought a vacant office tower at 510 Madison Avenue in Manhattan.
First Potomac Realty Trust (FPO) has acquired $121 million in assets in and around Washington over the past year and has changed its focus from flexible space properties to multistory office buildings in the greater Washington market, where it expects lots of assets to be up for sale in the next couple of years. With $100 million of untapped capacity on its credit line and the ability to issue 5.2 million shares of equity, as well as a "proven ability to source off-market deals, and a stated desire to double the size of its portfolio, the REIT's external growth should be more than competitive with its peers over the next few years," Janney Capital Markets said in an Aug. 2 research note.
Real estate firms will have to be creative if they want to continue growing at a time when so many properties are tied up in securitized loans on which lenders are reluctant to foreclose, says Rodgers. With lenders and other holders of commercial real estate debt reluctant to negotiate, REITs are increasingly trying to do deals with equity investors in distressed properties.
BMO's Adornato advises individual investors to make sure that a REIT is flexible enough to be able to make money whether the economy is slow or growing. "If you can't find good properties to buy, you have to make hay with your existing portfolio, either by re-tenanting or redeveloping [space], or if you have the good fortune to be in a sector that's strong even in this weaker economy, like multi-family or self-storage," he says.