Markets & Finance

The Rundown on REITs


Amid recent weakness in the group, some stocks are still good bets. S&P breaks down six key sectors and finds the best plays in each

From Standard & Poor's Equity Research"What do you think about REITs?" That's a question I have been asked fairly frequently over the past few weeks. Rightfully so, since this asset class, which skyrocketed in the past few years, now appears to have fallen on hard times. Year to date through July 6, the Standard & Poor's Composite 1500 index gained 8.5%, while the majority of the six real estate investment trust indexes declined from approximately 3% to 6.5%. This erosion in performance has caused many to ask: "Is this the beginning of the correction in real estate stocks?"

Subindustry

% Chg. YTD

S&P STARS

Div. Yld. (%)

Fund. Outlook

# of Cos.

S&P Composite 1500

8.5

3.7

1.7

NA

1500

Diversified REITs

(5.5)

3.0

3.8

0

5

Industrial REITs

(2.9)

4.0

3.3

+

3

Office REITs

(4.9)

3.2

3.6

+

6

Residential REITs

(5.3)

2.8

3.6

0

7

Retail REITs

(6.6)

4.3

3.9

+

12

Specialized REITs

(5.1)

3.3

4.0

+

12

Source: Standard & Poor's

There are 46 companies in the S&P 1500 that are assigned to six REIT subindustry indexes. S&P STARS (Stock Appreciation Ranking System) reflect our analysts' investment outlooks on individual securities (5 is highest and 1 is lowest), and offer an impression of each subindustry's investment prospects based on the market-weighted average of the 3 to 12 companies found in each group.

Our analysts also generate fundamental outlooks on each of the subindustry indexes found in the S&P 1500 based on economic, market, and legislative projections. Investment and fundamental outlooks could differ, however, depending on whether the share prices and valuations of the underlying issues properly reflect their fundamental outlooks. On the whole, based on both the average STARS and fundamental outlooks, S&P analysts are neutral to positive on both outlooks of each style of REIT.

Royal Shepard follows the Diversified, Office, and Residential REITS. Robert McMillan covers the Industrial and Retail REITs, while Jason Wiley covers the Specialized REITs. They reminded me that, in general, REITs have historically been economic laggards, depending in part on the timing of lease expirations. An expanding economy typically helps boost property revenue across the category.

In addition, many REITs aim to boost earnings via other means, such as merger and acquisition activity, refinancing debt and preferred issues, or by divesting non-core holdings to unlock potential capital gains. On the other hand, slower economic growth, due to higher interest rates and a drop in housing activity, could restrain demand for leased space.

In evaluating REIT securities, one should consider the dividend yield, long-term dividend growth rate, and payout ratio of funds from operations. Investors should also consider the anticipated direction of interest rates, fundamentals for the REIT's dominant property type, and net asset value (NAV) per share. One should also look at growth in same-store (those open at least a year) sales and net operating income, as well as rent growth and occupancy levels.

The following are the fundamental outlooks currently held by Roy, Bob and Jason, on the different classes of REITs found in the S&P 1500 index.

Diversified REITs

S&P has a neutral fundamental outlook on this group, which holds a mix of office, industrial, retail and, in some cases, residential properties. Accordingly, S&P expects earnings growth largely in line with the overall REIT average.

S&P expects diversified REITs with significant exposure to retail, industrial, health-care, or office properties to see growth, based on our view of above-average fundamentals. S&P favors regional and super-regional malls among retail assets. Increasing international trade, in particular, has boosted occupancy rates for industrial properties located in or near the nation's port facilities. S&P is also positive on REITs exposed to favorable trends in lodging. We are somewhat less enthusiastic on REITs holding significant exposure to multi-family residential properties, given our view that supply will increase and rental rate increases will start to moderate by 2007's second half. In addition, several of the subindustry's component companies are focused on long-term net leases, which shift the risk of rising operating expenses to the tenant but offer limited upside growth opportunities, in S&P's view.

The stock in this index with the highest STARS is PS Business Parks (PSB; 4 STARS; $65)

Industrial REITs

S&P has a positive fundamental outlook on the group. Industrial REITs have historically been economic laggards. In fact, we think the group is just now beginning to fully recover from the effects of the last recession, which prompted users of industrial real estate to jettison unnecessary space, causing rental rates to decline. It was only with the release of 2006 third-quarter results that we observed broad increases in rental rates for industrial space.

With real U.S. gross domestic product expected to rise moderately and increased demand for industrial space, we believe same-property revenue and funds from operations will likely be positive across the industry over the next 12 months.

Many industrial REITs posted first-quarter 2007 results that met or exceeded S&P's expectations. However, unlike in other recently passed quarters, growth was driven not only by occupancy gains, but improvements in rental rates as well. Overall, we believe industrial REITs should continue to see growth based on what we view as improving fundamentals. We expect REITs focused on supply-constrained markets and those whose properties are closely tied to global trade to improve the fastest among the sector. We look for less robust results from industrial REITs with relatively generic space in low-barrier-to-entry markets, but even these companies are showing some improvement.

In addition, S&P thinks many industrial REITs will continue to seek to boost earnings via other means, such as property acquisitions either directly or through co-investment arrangements, refinancing debt and preferred issues, or divesting non-core holdings.

Stocks in this index with the highest STARS are AMB Property (AMB; 4 STARS; $56), and Prologis (PLD; 4 STARS; $60).

Office REITs

S&P's fundamental outlook on the office REITs subindustry is positive, based on continuing U.S. employment growth. We also believe positive net absorption of office space will lead to moderately rising rental rates on average, and continued growth in cash flow from cyclical lows. The U.S. office market tends to track the overall economy on a lagging basis, reflecting an average lease term of 7-10 years. We believe the national vacancy rate was approaching 13% at the end of 2006, an improvement from about 17% in 2003.

Given a still-stable economic backdrop, S&P believes office leases will be renewed in 2007 at average rents above those already in place. We also believe a majority of office REITs are likely to report stronger earnings gains in 2007 reflecting the higher rates, increased occupancy, and limited new supply of office space in most markets. We think REITs positioned in more favorable regions such as New York City, Washington, D.C., and Southern California will outperform peers due to a combination of positive labor markets and office supply constraints. Slower population growth in Midwest markets has generally made these metropolitan areas less attractive. Finally, S&P thinks that recent mergers-and-acquisition activity has helped push stock prices to levels that fairly reflect the current outlook.

The stock in this index with the highest STARS is Mack-Cali Realty (CLI; 4 STARS; $45).

Residential REITs

S&P's fundamental outlook for the residential REITs subindustry is neutral. During the March quarter, we believe vacancy rates for rental apartments increased for the second consecutive reporting period, reflecting seasonality as well as renewed supply. In addition, we believe renters may be starting to resist rent increases that averaged 4%-6% in 2006. Also, recent weakness in real estate prices may have some renters considering home ownership as an alternative. Nonetheless, occupancy levels remain high by historical standards, and S&P expects solid earnings comparisons in the second quarter of 2007.

We see a few more challenges awaiting these companies later in 2007. The softening housing market has dramatically slowed the number of rental units converted into condominiums, and we think many previously converted units have begun to return to the rental market, thereby increasing supply in select markets. Moreover, S&P forecasts a slowing economy in the months ahead, largely induced by the housing slump and slower consumer spending. As a result, we think renters may be less willing to accept rent increases as the year progresses.

Long term, we think fundamentals for residential REITs are more positive. S&P forecasts a gradual decline in housing starts through 2008, as well as steady growth in household formation due to increased immigration and as "echo-boomers" enter the work force. Our forecast of the national rental vacancy rate in 2009 is 9.12%, down from 9.85% in 2005."

The stock in this index with the highest STARS is Essex Property Trust (ESS; 4 STARS; $120).

Retail REITs

S&P has a positive fundamental outlook on the retail REITs subindustry. With U.S. real gross domestic product continuing to rise, consumer spending increasing, and retailers expanding, we believe same-property revenue and net operating income will likely be positive across the industry over the next 12 months, although we expect to see differentiation among property types; we think regional and super-regional mall owners/managers will post the best performance. In addition, we think many retail REITs will continue to seek to boost earnings via other means, such as property acquisitions either directly or through co-investment arrangements, or refinancing debt and preferred issues.

Many of the retail REITs have generated first-quarter 2007 results that met or exceeded our estimates. Overall, S&P believes that retail REITs should continue to see growth based on what we view as strong fundamentals. We expect REITs focusing on regional and super-regional malls will benefit the most from healthy retail conditions, continued retailer expansion, and limited new shopping center development, especially in major metropolitan areas where available land is scarce. S&P thinks these types should be able to leverage trade area dominance and sizeable barriers to entry, which should help them generate higher rent growth on lease renewals and increased occupancy gains. We look for less robust results from community and strip-center malls, which lack the trade area dominance and substantial barriers to entry.

We believe concerns over potential continued increases in interest rates as well as technical trading patterns have hurt the group this year, despite our expectation for improving underlying fundamentals. We see attractive appreciation potential for this group over the next 12 months.

The stock in this index with the highest STARS is Simon Property Group (SPG; 5 STARS; $96).

Specialized REITs

S&P has a positive fundamental outlook on the specialized REITs subindustry. We believe the strong macro economy has generated increased demand for a number of the services provided by specialized REITs, including lodging, self storage, and timber. The growth in demand for products and services has been magnified by limited supply growth in a number of groups within the subindustry as cost of construction, land availability, and investor focus on other sectors have limited new projects. S&P sees health-care REITs as less affected by the general economy, with their growth influenced by trends in government reimbursement policies and population demographics. We believe stability in government policy and the aging baby boomer population are positive trends for health care REITs.

Longer term, we see the performance of the subindustry being driven by trends in the overall economy such as employment, energy, and commodity prices; the direction of interest rates; and government decisions on health-care reimbursement.

Recently, there has been significant consolidation within several of the subindustry's groups, which we believe is related to companies looking to accelerate their earnings growth. S&P expects the consolidation trend to continue, given the cost and time associated with developing new assets, the challenges of growing organically in the REIT structure, and increased interest in REITs by private equity investors.

Stocks in this index with the highest STARS are Medical Property Trust (MPW; 4 STARS; $14), Public Storage (PSA; 4 STARS; $80), and Sovran Self Storage (SSS; 4 STARS; $50). Our favorite non-index REIT is Health Care REIT (HCN; 5 STARS; $42).

So there you have it. Despite the slump in residential housing, as witnessed by the 25.5% year-to-date decline for the S&P Homebuilding subindustry index—on top of the 20.2% giveback in 2006—S&P believes the expected soft landing of the U.S. economy in 2007, and projected recovery in 2008, will offer fundamental (and in some cases investment) support in the quarters ahead. As a result, we are maintaining our neutral and positive fundamental outlooks on the six REIT groups in the S&P 1500 index.

Industry Momentum List Update

Here is this week's list of the industries in the S&P 1500 with Relative Strength Rankings of "5"

(price performances in the past 12 months that were among the top 10% of sub-industries in the S&P

1500), along with a stock with the highest S&P STARS (tie goes to the highest market value).

Subindustry

Company

S&P STARS Rank

Price (7/6/07)

Apparel, Accessories

Quiksilver (ZQK)

5

$15

Commercial Printing

R.R. Donnelley (RRD)

4

$44

Commodity Chemicals

Lyondell Chemical (LYO)

3

$40

Computer Hardware

Apple (AAPL)

4

$132

Construction & Engineering

Jacobs Engineering (JEC)

5

$60

Construction Materials

Vulcan Materials (VMC)

2

$116

Diversified Metals & Mining

Freeport-McMoRan Copper (FCX)

3

$88

Fertilizers & Agr. Chem.

Monsanto (MON)

3

$67


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