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Cover Story REITs Behaving Badly Two years into a bear market, investors are wondering when REITs will rebound. by Barry Vinocur |
Last year, investors lived through a market slide the likes of which hadn't been seen in roughly a quarter of a century. The Morgan Stanley REIT Index finished deep in the loss column, with a negative total return of nearly 17 percent. Because the Morgan Stanley index is a total return index (it includes dividends) the carnage was worse than it looked. On a price-only basis, REITs were down roughly 25 percent last year.
1999 didn't get off to a great start either, but there was hope. Real estate fundamentals were still strong, and investors drew solace from the knowledge that only once in the past roughly three decades had REITs posted back-to-back years of negative total returns. By the spring of this year, investors were at a psychological low point. One industry veteran lamented that the REIT market was the equivalent of "death by a thousand cuts." On March 23, the Morgan Stanley REIT Index finished the day at 280.54. The index was within shouting distance of 273.03, the bear market low (set back on October 8 of last year). Investors wondered whether REITs would ever rebound.
What happened next was, well, amazing. In early April, in rapid fire succession, Warren Buffett announced he had made sizable personal investments in two REITs: Tanger Factory Outlet Centers and Town & Country Trust. On the heels of that news, several institutional buy programs were launched. Suddenly, REITs were alive and kickin'. Industry veterans were quick to proclaim that the bear market was over. REITs were "cheap," and, though it had taken a while, investors recognized that fact and the stocks were back. Though no one predicted REITs would return to the lofty valuations seen in late 1997, everyone figured that REITs would again deliver total returns in the range of 15 percent, which REIT investors had come to accept as the rule over the past roughly three decades.
Not so fast. After peaking at 328.31 on May 12, the Morgan Stanley index started to backslide. As we went to press, the index was quoted (albeit, intraday) at 280.30, below its March 23 close and heading toward its bear market low of 273.03. Put simply, as of late October (see tables on pages 15 and 16), the Morgan Stanley index was in the red, down roughly 7 percent this year. Back out dividends and the stocks are down roughly 14 percent this year.
To be fair, no one expected REITs would deliver the returns that they had in the mid-1990s. Total returns north of 35 percent, well, those were a "moment in time." Nevertheless, the economy was strong, a brief whiff of overbuilding in early 1998 was in check, and real estate fundamentals were surprisingly strong for the later stages of a real estate cycle. Investors were left wondering, "What in the heck is wrong with REITs?"
Sources of the Pain
A number of analysts and investors have produced laundry lists of reasons why REITs are languishing. Tony Davis, an analyst at Warburg Dillon Read, put forth his list in a recent note to his firm's clients.
Davis wrote that the underperformance by REITs can be attributed to both general market and industry-specific factors. "From a broader perspective, any stock without a ‘.com' behind its name has been at a distinct disadvantage in terms of appealing to investors this year," he observed. Focusing on REIT-specific factors, Davis pointed out that the inevitable deceleration in FFO (funds from operations, the REIT equivalent of earnings) growth from an "in your dreams" 14.8 percent pace during 1997-98 to a more sustainable 10 percent this year has undoubtedly cost the industry some supporters.
Beyond this, Davis suggested, three other developments have had a negative influence on REIT stocks this year. First, a hoped-for relaxation of restrictive federal REIT regulations has failed to occur. (As we went to press, it looked like the legislation might become law this year.) On April 29, legislation to modernize the REIT industry was introduced in the House Ways and Means Committee. On May 17, an identical bill was unveiled in the Senate Finance Committee.
As initially drafted, the REIT Modernization Act would enable REITs to own 100 percent of the stock of taxable REIT subsidiaries (TRSs), which could account for up to 25 percent of a REIT's assets and up to 25 percent of its gross income. (Final legislation will probably reduce the number to no more than 20 percent.) A TRS could generate earnings by providing such previously restricted, "noncustomary" services as concierge, maid, valet parking, message, document and parcel delivery, mall management, development, and landscaping to both third parties and tenants.
Interest deductions on debt extended to a TRS by third parties and guaranteed by the REIT or extended directly from the REIT would be allowed. However, if the TRS's debt exceeded equity by 1.5 times, if its income fell below two times interest expense, or if the rate of interest paid did not reasonably approximate market rates, then interest deductibility would be disallowed. Several safe harbors from the 100 percent excise tax proposed by the Clinton administration to prevent unfair REIT-TRS dealings would be provided in the areas of interparty rental rates and overhead cost allocation. Further, a TRS would be permitted to lease lodging and health care facilities as long as such facilities were operated by independent contractors and no organized gambling occurred.
An important provision of the REIT Modernization Act is that the dividend payout required to retain tax exempt status would be reduced from 95 percent to 90 percent of ordinary taxable net income. For an industry that today finds itself virtually denied access to the capital markets, this would be a welcome development, Davis observed.
Another emerging investor concern impacting office and multifamily REITs has been telecommunications access. Under the leadership of Chairman William Kennard, the Federal Communications Commission has pursued an aggressive agenda over the past year or so to broaden the availability of competitive telecommunications services. During the last few months, this accommodative posture has prompted several wireless telecommunications providers to lobby the FCC, Congress, and state legislatures in the pursuit of "nondiscriminatory" access. In effect, these providers seek to bypass the lease process to gain mandated access to privately owned office and apartment buildings without providing fully negotiated, market-based compensation to the owners.
On June 29, Senator Ted Stevens (R-Alaska), chairman of the Senate Appropriations Committee, introduced S. 1301, which would require owners of any building with a federal government tenant to permit free access to all telecommunications providers on a nondiscriminatory basis. A similar bill, H.R. 2891, has been introduced in the House and is sponsored by Rep. Tom Davis (R-Va.).
While three of the five FCC commissioners have expressed concerns regarding the potential for the "taking" of personal property, the FCC issued a Notice of Proposed Rulemaking (NPRM) on July 7, asking for comments on forced access. This issue has quickly progressed to the point that the Building Owners of America,
NAREIT (National Association of Real Estate Investment Trusts), and eight other organizations collectively referring to themselves as the Real Access Alliance have had to scramble to address it.
A final constraint for REIT stocks, Warburg Dillon Read's Davis noted, has been the uncertainty caused by proposed changes to funds from operations, the industry's supplemental performance measurement. Prompting this reassessment have been the liberties taken by certain REITs in the treatment of dead deal costs, charges related to debt repayments, the unwinding of derivatives positions, employee severance expenses, and other unusual items. These abuses have occurred because FFO is not GAAP-compliant and is therefore not an audited measurement standard.
Since mid-June, NAREIT members and other interested parties have commented on the appropriate definition of FFO. These comments have been under review by NAREIT's 16-member Best Financial Practices Council. The critical issues being debated involve the treatment of nonrecurring items, gains and losses from property sales, and the appropriate method for calculating depreciation.
Davis pointed out that as of the date of his note (late September), no formal consensus regarding a revised FFO definition had yet evolved.
Looking Ahead
Though some analysts and investors continue to argue that REITs are "cheap" and suggest that the only thing standing in the way of a rebound is some as-yet-unidentified catalyst, not everyone shares that view. In fact, in recent weeks a number of analysts and investors have suggested that rather than being "cheap," REITs are appropriately valued (or nearly so) by today's market. The large gap between REIT net asset values (see graph on page 74 and the tables beginning on page 66) and REIT prices is more likely to be closed by a substantial lowering of NAVs over the next three to six months than by a substantial move up in REIT prices. (NAV, in most instances, is a lagging rather than a leading indicator since analysts and investors don't change NAVs until there's ample evidence that property cap rates have moved up or down.)
In a recent note to their firm's clients, Jonathan Litt and his colleagues at PaineWebber suggested there may not be as much wrong with REITs as many people believe. "For the better part of the past seven quarters, we and many real estate commentators have been trumpeting the great value REITs represent due to the discount the shares trade [as compared with] their net asset value."
In their note, the PaineWebber analysts reported on a recent conversation with an investor who argued that the cap rates being used by Wall Street REIT analysts were too low. In fact, the investor argued, REITs may even be trading at a premium to NAV.
The simplicity of his argument, Litt and his colleagues wrote, is appealing. "Dumb money has earned its reputation for buying real estate just prior to a downward revaluation."
The argument follows, Litt and his colleagues continued, that the stock market is smarter than the private real estate market and that the private real estate market will eventually succumb to the public market's view.