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  Thinking the Unthinkable Is the REIT market experiencing one of its periodic lulls, often followed by a strong run, or is the market conveying a far more ominous message? by Barry Vinocur |
In a recent research note, Lee Schalop, J.P. Morgan's REIT analyst, pointed out that while a lack of investor focus has impacted the performance of REITs this year, the bigger issue is deteriorating fundamentals. "Historically, the market has been an accurate predictor, and with new supply expected to exceed demand for apartments, retail, industrial, and office in 1999 for the first time in eight years, fundamentals have become significantly less attractive," Schalop wrote.
As a result, Schalop says he expects real estate stocks to remain in the doldrums unless investors become defensive, even though certain characteristics of real estate stocks remain attractive, including 6% yields and good FFO growth—12% in 1998 and 10% in 1999.
Six days after J.P. Morgan's Lee Schalop issued his report, Burl East and his colleagues at Everen Securities in Chicago provided their take on the sector's woes. It was very different from Schalop's, as well as from the view of Donaldson, Lufkin & Jenrette's Larry Raiman, who, along with his colleagues, got off the first salvo in the current round of soul searching back on February 12.
"Real estate stocks have underperformed the broader indexes so far this year by a very material margin, reducing greatly the prospects that they will outperform or even catch up through the remaining 5-1/2 months," East and his colleagues wrote. The Everen analysts noted that "typical" performance in an up market for REITs (defined as the cyclical rebound) is about 15% to 20%. "Returns so far in this cycle, which commenced in 1992-1993 have been about 20%," they wrote.
Like others, East and his colleagues underscored how "cheap" REITs are today. "These stocks are as cheap relative to the market as they have ever been. Compared to the S&P 500, real estate stocks typically trade at about a 4x to 6x discount to the market (that is, if the S&P 500 trades at 15x, REITs trade at 10x). The raw multiple difference has doubled to 12x over the past 14 months," they pointed out.
One issue raised by the Everen analysts that hasn't received as much attention as some other reasons for the market's woes is what's happening to REIT dividend yields. After noting the trend in recent years for REITs to significantly reduce their payout ratios from 95% of FFO in the early 1990s to current levels, which are approaching 65% of FFO, the analysts posit that the result of the collective decision to lower payout ratios and thereby reduce the dividend yield to investors relative to the cash flow generated has "resulted in income oriented investors becoming less interested in these stocks."
Finally, East and his colleagues note that only five times in this decade has the S&P 500 outperformed NAREIT four consecutive months. "We have just passed the fourth consecutive month of REIT underperformance. If history holds, REITs should turn around."
The View at Prudential
REIT earnings, they point out, are being driven by a combination of three factors: (1) the supply-demand equation for most REIT sectors appear to be favorable; (2) interest-rate trends are allowing REITs to access debt capital at a lower cost and on more favorable terms; and (3) external growth opportunities continue to exist in most sectors, and, in fact, are tending to outpace expectations.
"As long as these trends remain in place, earnings growth for equity REITs should remain fairly strong, allowing companies to report results that exceed expectations and result in additional positive estimate revisions (see table above)," the Prudential analysts wrote.
Seven sectors delivered double-digit per-share FFO growth in the first quarter of 1998, Sullivan and his colleagues noted. For the fourth consecutive quarter, the office, hotel, and industrial sectors were at the head of the pack. (Collectively, these three sectors account for 42% of the equity REIT market's capitalization.) Retail and residential were in the middle of the pack (together they account for roughly 40% of the equity REIT market's capitalization), delivering growth ranging from 10% to 12.5%, slightly below the overall average. At the bottom of the pack, in terms of growth and positive surprise, were several sectors that between them account for approximately 18% of the equity REIT market's capitalization, the Prudential analysts noted. Healthcare had the lowest annual growth rate as well as the "dubious distinction" of posting a negative 0.5% earnings surprise. The factory outlet sector also posted a negative surprise and an annual growth rate of less than 5%. "And the self-storage sector reported per-share growth of only 3.3% and the largest negative surprise of any sector of 1.5%," Sullivan and his colleagues reported. The bottom line, according to the Prudential team: "We see no decline in earnings growth in 1999." For four consecutive quarters, per-share FFO results have come in solidly in the double-digit level with positive surprise for the industry at a 1.4% to 1.5% level, which indicates a reported quarterly growth rate 10% above expectations, they added. "It is interesting to note that as of May 21, the composite of consensus estimates for per-share growth for 1999 was 12.2% on a market-cap weighted basis and 10.2% on an equal-weighted basis. That level of expectation is higher than the 12-month forward estimates at midyear 1997. At June 30, 1997, consensus estimates for 1998 were only 10.1% and 9.3%, respectively. So while we understand the generalized commentary in the industry as to ‘where we are in the property cycle,' the fact is when one assembles a composite of all of the equity REITs, earnings expectations are expanding, not contracting." Sullivan and his colleagues concluded by stating, "We believe that those observers who underpin a less bullish case on REIT performance, in whole or in part, on per-share FFO growth rates declining below 10% are likely to be surprised. Our data suggest strength, not weakness, in the future direction of per-share growth rates." | |||||||||||||||||||||||||||||||||||
So, is the market sending a message that perhaps is being drowned out by wishful thinking on the part of analysts, investors, and others? Clearly, as Schalop and others have pointed out, real estate markets pretty much across the board—and for all property types—not only are in equilibrium, but have been in equilibrium for perhaps the past six months to a year. It's also true that, though not yet widespread, there's reason to express concern about the specter of overbuilding for selected property types in some markets.
Reading Tea Leaves
Several things keep Realty Stock Review (Property's sister publication) from agreeing that the market is foretelling the future rather than suffering by comparison to the broader market's performance, etc..
First, though RSR agrees that a general slowdown in FFO growth is inevitable—and to some extent is already occurring—corporate earnings elsewhere in the market have already begun to decline. As a result, investors will increasingly place more emphasis on stability of income. At the same time that change is taking place, investors will also be taking note of the fact that an ever increasing number of REITs will be increasing their dividends quite substantially as their payout ratios bump up against what they are required to pay out in order to preserve their REIT status.
Second, there's merit to the case being put forth by Boston Properties' Mort Zuckerman (see his article "A Second American Century," in the May/June issue of Foreign Affairs) and others that structural changes in the American economy are likely to have a salutary effect on the supply/demand equation for commercial properties, especially office properties.
Third, the benefits of industry-wide consolidation are likely to be greater than some market observers are willing to concede. Though the focus remains on near-term accretion in earnings, Realty Stock Review believes that over time investors will accept that the biggest bang from consolidation may not be seen for 18 to 24 months after an acquisition or merger. (The 1996 merger of Simon Property Group and DeBartolo Realty Corp. is a case in point.)
Furthermore, though there will undoubtedly be some managements who will resist the consolidation trend—even if it means relegating their companies to neuro-vegetative wreck status—they will find it more difficult to do so. As the ownership of property-linked stocks broadens well beyond the "usual suspects," RSR expects shareholders to turn up the heat on managements who fail to perform up to reasonable expectations.
Fourth, though it remains to be proven beyond a reasonable doubt, a growing body of anecdotal evidence supports the thesis that public market discipline will help to prevent the sort of excesses that commercial real estate has had to cope with in the past. That doesn't mean the term overbuilding will cease to be in our vocabulary, or that property prices may not be bid up from time to time to uneconomic levels, or that some managements won't continue to sell "undervalued" equity. Rather, it means only that there will be a moderation of the peaks and valleys in the real estate cycle, and that enough managements will "get it" and accept, if not embrace, that market discipline.
Finally, even if some of these assumptions turn out to be incorrect, a wild card may benefit many REITs. Keep in mind that not only has a great deal of money been raised for real estate opportunity funds, but a lot of money is still being raised for those funds. Opportunity funds promise investors hefty returns, on the order of 20% to 30% per year. To have any chance of achieving those returns in today's market, the funds have to take on a good deal of risk, most notably highly leveraging their acquisitions. If real estate fundamentals are deteriorating as J.P. Morgan's Schalop and others suggest, then REITs may find themselves in the catbird's seat as anxious investors pressure those running the opportunity funds to sell properties.
Darwin and REITs
To take advantage of opportunities in today's market—or tomorrow's—REITs must have ready access to equity capital. The number of companies that are able to access equity on demand is already shrinking, and that process will only accelerate over time. To some extent that will serve as a natural selection process—if not for which REITs survive, certainly for which companies will make it onto the short list of companies that will emerge as powerhouses in the 21st century.