Investing

Commercial REITs: Investing in a Shaky Market


Anyone who's been paying attention to Wall Street investment strategists' forecasts for 2010 knows that a potential avalanche of commercial real estate foreclosures could hit the market—and the smartest thing to do is get out of the way. This would include steering clear of most of the real estate investment trusts, or REITs, in the commercial sector. These trusts hold a lot of the retail, office, and industrial properties that have fallen sharply in value and may find it hard to refinance the underlying loans that are set to mature in the next few years.

Add in the fact that shares of the publicly traded REITs that own roughly 15% to 20% of all commercial properties in the U.S. have appreciated nearly 100% since March and it's hard to find a compelling reason to buy any of these stocks right now. The MSCI U.S. REIT Index jumped 96.6% from Mar. 9 to Nov. 17.

Investors need to know, however, that the prospects for the public REITs are dramatically better than those of their privately held counterparts. That's because the public companies financed acquisitions at lower grades of leverage during the commercial real estate boom a few years ago, while private developers took out mortgages on properties at up to 90% loan-to-value ratios. The more highly leveraged players have been left with underwater investments following property value declines of 30% to 40%.

The question of survival for most of the 99 publicly traded REITs that BMO Capital Markets covers is largely off the table because these companies have proved that they can access the capital markets, says Paul Adornato, BMO's senior REIT analyst.

DDR's mortgage-backed securities win

This year, publicly traded REITs have raised over $20 billion through equity offerings and an additional $7 billion through unsecured debt offerings, according to John Wenker, co-manager of the First American Real Estate Securities Fund (FARCX).

In addition to better capital market conditions, the long-dormant commercial mortgage-backed securities (CMBS) market has begun to show new signs of life. On Nov. 16, Developers Diversified Realty (DDR) successfully sold $400 million in bonds guaranteed by 28 shopping malls in 19 states. Aided by the federal government's asset-backed securities loan facility (TALF), which lets investors borrow from the Federal Reserve to buy new CMBS, the offering was oversubscribed and priced at a lower premium than expected over comparable Treasury bonds.

The prospect of additional CMBS offerings under the TALF could help put a floor under commercial property values, reducing the flow of foreclosures to come.

"If the securitization market for commercial real estate starts to open up in return, it will be a dramatically positive catalyst for not only public real estate companies, but the [entire] commercial real estate sector," including privately held properties, says Wenker. Just how distressed the market gets remains to be seen over the next year or two and will depend largely on the state of the economy and the capital markets, he adds.

Adornato at BMO doubts the DDR deal will unleash a flood of CMBS deals, although two other trusts are exploring offerings of their own.

a big drop in maturing unsecured debt

Three weeks before DDR's breakthrough, Credit Sights predicted that the majority of REITs it covers will have enough cash and credit capacity to meet all unsecured debt obligations, at least through 2012.

Credit Sights noted that many REITs have used proceeds from equity offerings over the past three quarters to pay down maturing unsecured debt. "We are giving our companies credit that they can refinance their secured debt without having to kick in a significant amount of additional equity," or that they can mortgage unencumbered assets to raise cash to pay down secured debt that's maturing in the short term, certified financial advisor Craig Guttenplan wrote in an Oct. 25 report.

BMO has a neutral rating on REITs overall. That's based on how the high valuations compare not only with the March lows, but with historic levels. Adornato expects REITs to perform only as well as the stock market as a whole.

One group he sees as fairly cheap, however, are industrial REITs that own and operate warehouses used by distributors. The need for U.S. companies to replenish drawn-down inventories of goods—and an expected pickup in international trade as the economy recovers—will drive demand for these warehouses, he says.

A BMO favorite: Duke Reality

Although Adornato isn't optimistic about factory-sector fundamentals, he believes that the industrial real estate market could turn around quickly. "Industrial space tends to be less overbuilt than other property types that are more generic in nature and relatively quick to construct, like malls or office buildings," he says,

Among Adornato's favorites is Duke Realty (DRE), which owns warehouses and suburban office parks. Demand for office space will probably remain soft, but Adornato likes Duke's management, mix of tenants from diversified industries, and market strategy. The shares trade at 14 times estimated adjusted funds from operations (AFFO) in 2010, a nearly 23% discount to the overall REIT average of 18.1 times 2010 AFFO. (AFFO, a measure of operating profitability for REITs, is equivalent to free cash flow.)

First Potomac Realty Trust (FPO) is a small-cap company specializing in industrial space and real estate that can be adapted for either industrial or office use. With 60% of its properties located in the greater Washington metropolitan area, First Potomac benefits from economic stability around the capital, which is bolstered by the growth of government programs, Adornato says. The stock trades at 11.6 times estimated 2010 AFFO, a 36% discount to the average REIT.

DCT Industrial Trust (DCT), which has traded publicly for less than five years, has been overlooked by a lot of investors, according to Adornato. The stock is trading at 15.4 times estimated 2010 AFFO, a 15% discount.

One of the top five holdings in Wenker's fund is Public Storage (PSA), which benefits from diversity in its large national portfolio of self-storage properties. In addition to considering the company well-run, Wenker likes that Public Storage has financed acquisitions by issuing preferred shares in lieu of debt. Although the preferred stock carries a higher coupon than secured debt, it need never be paid back because it's perpetual, he says.

will U.S. consumer spending recover?

Wenker concedes, however, that unlike in previous recessions, self-storage has proved to be less resistant to this downturn.

Adornato says he's reluctant to recommend REITs that focus on retail properties because he's not certain that discretionary spending by U.S. consumers will return to pre-financial-crisis levels.

While many retailers have been adept at managing inventories and cutting costs, he expects to see a further wave of bankruptcies among weaker merchants after the holidays. Another concern is whether the smaller mom-and-pop retail tenants in shopping malls—think nail salons and pizzerias—have nearly depleted their personal savings to keep their businesses going during the recession. With few reserves left, Adornato asks, might they have to shut down?

Instead of the wave of commercial property liquidations that some economists anticipate—as followed the savings & loan debacle in the early 1990s—Adornato thinks liquidations will "probably be much more limited both in terms of volume and discounts."

Of the $300 billion worth of commercial mortgages slated to mature in the next two years, he believes roughly $75 billion of them, or 25%, will end up being liquidated.

For now, investors who expect bargains to gleam among the rubble once that happens might want to consider buying well-capitalized REITs long before the recovery takes shape.

Bogoslaw is a reporter for Bloomberg Businessweek's Finance channel.

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