by Barry Vinocur
Real estate investment trusts are on a tear. At our press deadline, the Morgan Stanley REIT Index (ticker RMS) had finished up 17 of the last 19 trading sessions, with only two down days in the month of August, through August 24. Year-to-date (again, through August 24), the widely followed benchmark had posted a 14.4 percent total return. Keeping in mind that the Morgan Stanley REIT Index delivered a 26.8 percent total return last year, property-linked stocks have now made up much of the ground they ceded during the two-year-long bear market for the stocks in 1998 and 1999.
In 2000, it was the large blue-chip REITs that led the way. This year, the rally in REIT shares has been driven largely by small-cap, higher-yielding names. Market veterans have endlessly debated in recent months whether the shift to the “high yielders” was driven by investors’ thirst for yield, or whether after the sharp run-up in big-cap prices in 2000, the smaller-cap, high-yielding names simply looked more attractive on a relative valuation basis.
Whichever camp you’re in, there’s no question that investors, reeling from the dot-com collapse and the continued shakeout in the tech sector, have shifted their focus—for now, at least.
In a recent article in The Wall Street Journal (“Dividends, Not Growth, May Be Wave of the Future”), Jonathan Clements wrote, “If the 1990s were about clocking capital gains, I suspect the current decade will belong to yield investors. The reason: Stocks may return just 8 percent a year and possibly less, so why not skip some of the uncertainty and claim your reward in cash?”
Jeremy Siegel, a finance professor at the University of Pennsylvania’s Wharton School who achieved financial cult status after the publication of his book, Stocks for the Long Run, bolstered Clements’ case. “A little more than a year ago,” he told Clements, “people laughed at dividends. In the future, I believe that more attention will be paid to dividends and current earnings and less to growth.”
Investors are likely to pay even more attention to dividends as concern about “quality of earnings” moves to the fore. In another recent piece in The Wall Street Journal (“Companies Pollute Earnings Reports, Leaving P/E Ratios Hard to Calculate”), Jonathan Weil wrote, “Few investors know it, but the U.S. stock market today is, by one way of looking at it, the most expensive it has ever been.”
How could that be? “In recent years, P/E ratios have become increasingly polluted,” Weil explains. “The ‘E’ in P/E used to refer simply to earnings as reported under generally accepted accounting principles, or GAAP. That’s what it means when the historical average is cited. But in First Call’s figure, the ‘E’ relates to something fuzzier, called ‘operating earnings.’ And that can mean just about whatever a company wants it to mean.”
“Based on earnings as reported under GAAP, the S&P 500 actually finished [the week ended August 17] with a P/E ratio of 36.7, according to a Wall Street Journal analysis. That is higher than any other P/E previously recorded for the index.”
This suggests, Weil added, that the overall stock market could be further from recovery than many suppose. “I don’t think most people realize that the market is as overvalued as it is,” David Blitzer, chief investment strategist at S&P, told Weil. “There probably are a lot of people who would sell some stock if they realized how overvalued the numbers are saying the market is.”
All of this, fans of property-linked stocks argue, bodes well for REITs and other real estate stocks. With the Fed slashing short-term rates (seven cuts since the beginning of 2001, with an eighth possible this year), yields on cash instruments, such as money markets and certificates of deposit, are downright puny. Add to that general concerns about earnings and it’s not surprising that investors are focusing on yield.
Real estate isn’t, of course, immune to the economic slowdown’s impact. In fact, earnings growth for property-linked stocks is declining. But, and it’s a very important “but,” property-linked stocks, in general, are still posting positive earnings growth, and barring an economic meltdown far worse than now anticipated, it’s unlikely that would change. Factor REITs’ juicy dividend yields (the average dividend yield for the 109 companies that currently comprise the Morgan Stanley REIT Index was 6.6 percent in late August) and low payout ratios (see “Rock Solid: The REIT Dividend Story” on page 20) into the mix, and it’s not hard to understand why net inflows into real estate mutual funds have risen sharply, of late.
Second Quarter Earnings Recap
Property-linked stocks (including four non-REIT real estate operating companies—Security Capital Group, TrizecHahn, Brookfield Properties, and Catellus Develop-ment—delivered 4.8 percent year-over-year FFO growth in the second quarter of 2001.
Of the 102 companies tracked by our sister publication, Realty Stock Review, all but 12 (see table on page 36) met or beat Street consensus (as reported to First Call) for 2Q01. Not all subsectors fared as well, however. Hardest hit were healthcare and lodging, which saw their earnings decline by 9.1 percent and 6.7 percent, respectively. Industrial REITs fared better; the nine companies that comprise this subsector saw their earnings grow by a healthy 10.7 percent. The average FFO for the four self-storage REITs grew by 10.2 percent. The office/industrial subsector also posted strong numbers, as did opportunity/diversified, and office.
A number of companies took technology-related writedowns/writeoffs (not reflected in our Earnings Track table, see page 35) in the second quarter. The magnitude of those one-time charges varied considerably, from $0.01 per share at Equity Office Properties to $0.81 per share at General Growth Properties. Realty Stock Review excluded those writeoffs from its tally for several reasons, principally to preserve the long-term value of its Earnings Track feature. “Quarter-over-quarter and year-over-year comparisons would be impacted significantly were the one-time charges reflected in Earnings Track,” the newsletter’s editors wrote recently. “Since the focus of Earnings Track is to capture longer-term operating trends, we noted the writedowns/writeoffs, but backed them out of the numbers.”
In a recent note on second quarter earnings, Larry Raiman and his fellow analysts at Credit Suisse First Boston (CSFB) wrote that second quarter results confirmed their previously stated belief that the pace of earnings growth will continue to slow from cyclically high levels.
“We say that because real estate is a lagging indicator of economic conditions,” the CSFB analysts explained. “The most recent bout of job layoffs has been hitting corporate America for some time now—but not REITs, thanks to their long lease durations. With sublet space on the rise and new development taking longer to be absorbed, organic growth rates for many REITs will likely decline—and bring down earnings results as well. In turn, the pace of REIT earnings growth should come down from the 8.0 percent level achieved in first quarter 2001 to the 5 percent to 7 percent level in 2001 and 2002.”
How Stocks Fared in the Second Quarter
For the record, the Morgan Stanley REIT Index set a series of all-time highs as the second quarter drew to a close. Though the widely followed total return (that is, it includes dividends), market-cap-weighted benchmark closed the quarter at 403.99, analysts and investors were quick to note that on a price-only basis, it still hadn’t recovered back to the levels seen in late 1997.
Unlike the first quarter, however, when, despite finishing barely in the red, RMS smoked all comers except for the Russell 2000 Value Index, four of the six benchmarks that were dusted by REITs in the first three months (see table below) staged strong rallies of their own in the second quarter and finished ahead of the Morgan Stanley REIT Index. Most notable, perhaps, was the Nasdaq, which continued its 2000 freefall in the first quarter (down 25.5 percent) only to rebound in the second three months of 2001 (up 17.6 percent).
Looking at the year-to-date period through August 24, REITs ruled, besting all comers. It’s worth noting that utilities, which managed to outdistance REITs last year (one of the best years for property-linked stocks, ever), turned in their second straight quarter of negative returns in 2Q01. Year-to-date (through August 24), the Standard & Poor’s Utility Index was solidly in the red, with a negative 17.8 percent total return.
A Closer Look
More interesting than the “tote board” is what happened to REIT returns during the second quarter. Specifically, from the end of the first quarter through April 11, the Morgan Stanley REIT Index was down, posting a negative 2.3 percent total return. From its 355.97 close on April 11 through its June 29 close (403.99), the widely followed benchmark chalked up a whopping 13.5 percent total return—260 basis points better than its return for the full quarter.
As noted, it has been primarily the small-cap, high-yielding REITs that have burned up the track this year. One way to get a handle on the magnitude of the outperformance by the smaller-cap names is to contrast the performance of the Morgan Stanley REIT Index with Cohen & Steers Realty Majors (ticker RMP). The Cohen & Steers index includes 30 large-cap REITs and, like the Morgan Stanley REIT Index, it’s a market-cap, total return (it includes dividends) index. In contrast to the Morgan Stanley index, Cohen & Steers Realty Majors includes healthcare REITs.
Our comparison of the two indices found that the Cohen & Steers index finished the first quarter with a negative 2.6 percent total return vs. the Morgan Stanley benchmark’s negative 0.5 percent total return. However, from the end of the first quarter through April 11, the two benchmarks marched pretty much in lockstep. The Morgan Stanley index outdistanced the large-cap benchmark in the second quarter, but only by 0.5 percent. Looking at the first half of this year, the Morgan Stanley REIT Index posted a 10.4 percent total return vs. the Cohen & Steers index’s 7.5 percent total return.
Though it’s an educated guess, we believe the sharp REIT turnaround beginning on April 12 was tied, at least in part, to an April presentation to S&P’s Index Committee outlining the case for including REITs in the Standard & Poor’s 500-Stock Index (see Newsline on page 6). A measure of support for that thesis comes from looking at how the two indices fared when Andrew Bary noted in “The Trader” column in Barron’s on June 11 that the S&P Index Committee was considering adding REITs to its flagship index. The Morgan Stanley REIT Index chalked up a 0.9 percent gain that day; the Cohen & Steers benchmark had a 1.1 percent gain.
In a recent issue, Realty Stock Review's editors provided their take on the market for property-linked stocks. Here's a recap:
For some time now, they wrote, we have focused on the flow of funds into and out of the sector because time and again we have seen how dramatically fund flows can impact this relatively illiquid market niche. The problem with talking about fund flows is that once you venture beyond inflows and outflows from mutual funds, there’s not much data that one can rely on.
Looking at the data from AMG Data Services (basically, the “gold standard” when it comes to tracking mutual fund flows) in Arcata, California, we weren’t blown away by the flows into dedicated real estate funds last year (roughly $525 million). However, in recent weeks, funds flows have ticked up rather dramatically. Through the week ended August 22, AMG reported net inflows into real estate funds totaled approximately $460 million, this year.
If mutual funds flows aren’t behind the bull market for property-linked stocks, what is? Though mutual funds played an important role in the mid-1990s REIT bull market, their impact is at the margins. Second, flows into and out of real estate funds are only a tiny part of the story. For instance, during a recent conversation with Tim Pire, one of the head honchos at Heitman/PRA Securities in Chicago, he remarked that though they hadn’t seen major inflows into their mutual fund last year or this year, they had seen “significant” inflows via Merrill Lynch Consults, a wrap account program sponsored by Merrill Lynch.
Another factor: In late May, Cohen & Steers Capital Management raised roughly $375 million (including the exercise of the underwriters’ overallotment option) for Cohen & Steers Advantage Income Realty Fund (ticker RLF), a new closed-end fund. The fund’s yield, (currently 8.4 percent) coupled with monthly dividends, no doubt helped sell it. The fund had the ability to add leverage, which it did, and that brought its total assets to roughly $500 million.
Two other factors to be taken into account are reports from a number of sources that institutions have RFPs (requests for proposals) for real estate securities managers in the market for up to $2 billion. And, there are reports that as much as another $1 billion is in the “shadow” RFP pipeline (that is, RFPs that will be put into the market late this year or early in 2002). Though dedicated managers of real estate securities portfolios stress that a lot could happen between now and when those funds might be committed, the potential inclusion of REITs in the S&P 500, coupled with the stocks’ strong performance since mid-March of last year, has put smiles on their faces.
No discussion of fund flows would be complete without at least noting the impact nondedicated REIT investors have had on the stocks over the years. The initial public offering boom that resulted in the dawn of the modern REIT era (late 1992 through roughly mid-1994) was fueled, in large part, by general equity fund managers, especially equity-income fund managers. Not surprisingly, general equity fund managers are once again embracing REITs.
Why are they chasing REITs? First, REITs have been a favorite safe haven for a long list of general equity managers during periods of turmoil in the broader market. Based on its conversations with those managers, Realty Stock Review long ago concluded that the list of draws includes very attractive dividend yields, with solid cash flow coverage; generally, stable and growing cash flows (even if declining, a bit); as well as the fact that managers can often juice their performance by adding REITs, because of the sector’s relative illiquidity.
Finally, the Standard & Poor’s Index Committee’s deliberations on adding REITs to the S&P 500 hasn’t escaped the eye of general equity fund managers.
Subsector Recap
Which subsectors were the winners and losers in the second quarter? Which ones did the best and worst in the first half of 2001? (Download Earnings Track for Second Quarter 2001.)
Regional malls led the pack in the second quarter, with a 17.6 percent total return. The self-storage REITs finished in the No. 2 spot, chalking up a 14.7 percent total return. Rounding out the list of the top five subsector performers were factory outlets, up 13.3 percent; hotels, up 13.1 percent; and healthcare (not included in the Morgan Stanley REIT Index), up 12.3 percent.
Posting returns that failed to keep pace with the Morgan Stanley REIT Index in the second three months of 2001 were manufactured housing, posting a 6.6 percent total return; apartments, with a 9.2 percent total return; strip centers, with a 10.3 percent total return; and office and industrial, with a 10.4 percent total return.
Through the first six months of this year, the hands-down winner was healthcare REITs, which delivered an eye-popping 38.6 percent total return. Sliding into the No. 2 spot
was regional mall REITs, which posted a 27.6 percent total return. In the show position was net lease, with a 27.1 percent total return. Finishing in the fourth and fifth slots were factory outlets, with a 26.0 percent total return, and self-storage, with a 25.4 percent total return.
Only three subsectors failed to keep pace with the broader REIT market (as measured by the Morgan Stanley REIT Index) in the first half of 2001. Those were apartments, with a 5.2 percent total return; office and industrial, with a 5.4 percent total return; and manufactured housing, with a 5.5 percent total return.
Fund Performance, a Shocker
Hard though it may be to fathom, during the first six months of this year, only 10 real estate funds (Realty Stock Review tracks five dozen such funds) posted a total return that matched or beat the Morgan Stanley REIT Index’s. (A table showing how real estate funds performed in the second quarter of 2001 is available as a WebXtra on our website at www.property-mag.com.)
The top five performers during the first six months of 2001 were: Spirit of America, with a 26.7 percent total return; Stratton Monthly Dividend REIT Shares, with a 23.0 percent total return; Kensington Strategic Realty, with a 22.8 percent total return (see Property, January/February 2001, page 20); Alpine U.S. Real Estate Equity, with an 18.6 percent total return; and FBR Realty Fund, with a 16.9 percent total return.
Looking Ahead
The gut question for investors is whether the eye-popping performance of property-linked stocks over roughly the past 18 months can continue. By some measures the stocks appear, if not fairly valued, close to it. Looking at two of the best valuation metrics—forward adjusted funds from operations, or AFFO, multiples (a graph that shows the current as well as the historic AFFO multiples is available as a WebXtra on our website at www.property-mag.com) and premiums/discounts to net asset value (see graph at the bottom of page 75)—one cannot argue any longer that the stocks are cheap. Neither, however, do they appear to be overvalued.
Playing the devil’s advocate, one could argue that softening real estate fundamentals (likely to get softer unless the economy turns around sooner than expected) will continue taking their toll. If that doesn’t send stock prices down, at the very least it will doom them to trade in a narrow range around their current values for some time.
Of course, one also can argue that investors’ current preoccupation with yield, coupled with a broader market that shows no sign of turning around anytime soon, and the fact that though slowing, REIT earnings growth rates are solidly in the black (generally) could take the stocks still higher.
As one portfolio manager who specializes in real estate stocks told us recently, “I am not suggesting that it’s ‘different this time,’ that would be foolhardy. However, it’s possible that investors may be willing to pay a modest premium for stocks that should be able to deliver high single-digit to low double-digit total returns, especially when a very large chunk of that return is coming from dividends that are backed by very solid cash flows.”
