  Oasis or Mirage? Brokerage firm analysts argue the correction in REIT prices is over. Are they right or was the recent rally only a bounce magnified by the stocks' relative illiquidity? by Barry Vinocur |
Most analysts and veteran REIT investors argued the September rally marked the end of the nearly year-long bear market for REITs. (Most refused to characterize the slump as a bear market, preferring to label the 24.5% decline in the Morgan Stanley index from October 6 of last year through September 11 of this year as a correction.) However, with the benefit of hindsight that seems unlikely. Though the rally was dramatic, there's not only been no follow through, but also—and perhaps most important—analysis of the rally data show that the stocks rose on what most investors now concede was very modest volume. Rather than an end of the bear market for REITs, the rally underscored that despite very significant growth in recent years, the REIT market is still plagued by relative illiquidity. (To see how more than 100 property-linked stocks have fared over the past year, see the tables below.)
Not surprisingly, a number of brokerage firm analysts see it differently. In rapid-fire succession, they argued that REITs had turned the corner. One of the first Wall Street analysts to make the case that the REIT correction had run its course was Lehman Brothers' Steve Hash. His group put out a September 21 note that bore the headline "1998 REIT Correction is Over" and stated that the shares had fallen to a point where they represented fair value.
The morning after the Lehman Brothers' analysts made their call, Donaldson, Lufkin & Jenrette's Larry Raiman added his voice to the chorus. (Raiman, you recall, unnerved investors when he downgraded REITs across the board back on February 12. See Property, July/August 1998, p. 18.) Raiman and his group said they upgraded REITs from "market performer" to "outperform" because a catalyst had emerged that could support real estate values. The catalyst, according to the DLJ analysts, was the severe tightening of money flows to the real estate business. They predicted that reasonably priced REIT shares could rise 15% or more in value as long as there is no flood of new stock offerings.
Raiman cautioned his firm's clients against reading into his note that he believed fundamental trends for real estate will rebound strongly or permanently. "We don't," he wrote. "Instead, we believe fundamental trends can now sit comfortably in equilibrium, and newly restricted money flows should preclude severe excesses. We are thus making more of a trading call on REITs than a fundamental call on the real estate business."
Raiman cited four factors as being responsible for his group's more "favorable investment thesis." First and foremost, "the catalyst we have been looking for … has emerged over the past couple of weeks." That catalyst was the severe credit tightening in the CMBS (commercial mortgage-backed securities) market. (See table on page 32.) "Acting as a prolific source of funds to the real estate business, all sorts of borrowers, public and private alike, tapped into an aggressive lending source for existing assets and new development opportunities. Now that aggressive lending in the CMBS business is no longer evident, and REIT funding has slowed, the shutdown of Wall Street's $100 billion-plus annual money machine for real estate should put a screeching halt to capital flows to public and private operators and developers," Raiman and his colleagues emphasized.
The DLJ analysts also argued that the ramifications of credit tightening are "rather significant" and will act as a catalyst for better operating trends and share-price performance for REITs. "Without aggressive capital, rampant new construction and supply additions should be unlikely, thereby laying the groundwork for sustained same-store growth trends (presuming the economy remains status quo). Also, without aggressive capital, asset values should come down, and acquisition opportunities for REITs should once again present themselves."
As a result, Raiman and his colleagues predicted, "The fundamental operating environment for REITs may turn more favorable and serve to sustain trendline earnings." REIT earnings, they added, should stabilize in the 7% to 8% range, well below levels we've seen in recent history but still rather respectable and in line with current industry multiples. Moreover, the DLJ analysts contended that with REITs so deep in the hole, it would take one if not two legs up before equity issuance materializes again, suggesting the REIT stocks need to rise 15% to 20% before investors would feel good about equity offerings.
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Third, the DLJ analysts underscored, "the market" historically has been remarkably prescient when it comes to earnings trends and changes in private-market asset valuations. "As growth was accelerating throughout the years 1994-97, share prices responded by trading up as much as 20% per annum; as growth has been slowing in 1998, REIT share prices have responded by trading down by about 15%. When cap rates were declining for the extended period from 1997-98, share prices responded with strong gains. In 1998, REIT share prices have turned the other way. Does that mean asset values may soon turn down as well? We think so," Raiman wrote. "With capital in short supply and a large number of properties on the market, the likelihood that property prices will decline over the next 12 to 18 months is quite high."
Last, the DLJ analysts noted that REIT valuation levels were more reasonable now. "Even after recent price increases, the REIT group's FFO/FAD (funds from operations/funds available for distribution) multiples have compressed by about 24% since mid-February, mostly as a result of price declines. We now calculate that the group is trading at a 10% free cash flow yield (or at 9.9 times FAD multiple), which is high enough to lay the groundwork for midteens total returns."
What happens to REIT earnings growth is far from a foregone conclusion, however. On October 1, for instance, Eric Hemel, who heads the REIT research effort at Merrill Lynch & Co., and his colleagues reduced their 1999 REIT earnings estimates across the board. Pointing out that their previous estimates "implicitly reflected an extrapolation of recent GDP and employment growth rates into the indefinite future," they reduced their 1999 estimates by between 1% and 3% to reflect 2% rather than 3.4% real GDP growth, 1999 over 1998.
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Hemel and his colleagues, emphasizing that they weren't changing their general recommendation to overweight REITs in a U.S. equity portfolio, wrote, "On average, REIT earnings shortfalls resulting from an economic slowdown should pale in comparison to the earnings shortfalls across the U.S. corporate economy." According to Hemel and his colleagues, if the 2% GDP forecast proves correct, "Merrill Lynch's economists believe that individual analyst estimates for S&P 500 companies will need to decrease by 16% between now and 1999 year end."
Whatever happens on the earnings front, there's no question that real estate prices have come down rather sharply over the past several months. Though industry veterans emphasize that transactions in many sectors of the commercial real estate market have all but dried up, most say prices have fallen by 5% to 10%, depending on the sector. For instance, industry veterans report that cap rates for office buildings have risen by 50 to 75 basis points, perhaps as much as 100 basis points.
As a result of the increase in cap rates and September's short-lived REIT rally, Green Street Advisors, a Newport Beach, California buy-side research boutique specializing in property-linked stocks, calculates that at the end of September the average real estate stock in its coverage universe was changing hands at a 1% premium to its net asset value (see graph at the bottom of page 73). That compares to a nearly 8% discount at the end of August—and a premium of roughly 20% at the beginning of 1998.
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