Dow Jones Property: Analytic Viewpoint

A Neural Disconnect
Most REITs are trading at discounts to their net asset values. Dividends are more conservative than in the past and growing at a healthy clip. REIT earnings growth should outpace estimates for the S&P 500 next year. So what’s wrong with this picture?

by Barry Vinocur

By any number of valuation yardsticks, REITs appear more attractively valued today than at any time since the real estate crash of 1990. Despite that fact, investors seem unimpressed. As of early September, equity REITs, by far the single-largest category of property linked stocks, were on track to post one of their worst years ever. The decoupling of REIT pricing from any number of other objective valuation tools, including assessments of real estate fundamentals, has led Property’s sister publication, Realty Stock Review, to term the current situation a neural disconnect.

How do REITs stack up vs. the most commonly employed valuation tools? Where are we in the real estate cycle? Why haven’t REIT dividend yields acted as a “shock absorber” as so many industry veterans had expected? Most important, has the dramatic drop in REIT prices this year created a buying opportunity, or is it the harbinger of even tougher times ahead?

As noted, REITs appear more attractively valued relative to the broader market today than at any time since the early 1990s. But REITs long ago proved that they are a leading indicator of what’s taking place in property markets, nationwide. Just as REIT prices fell in advance of the widespread recognition of the real estate crash of the early 1990s, REIT prices rebounded—and dramatically—well ahead of the realization that real estate was on the verge of a powerful recovery cycle.

Assessing Real Estate Fundamentals
Is the sharp falloff in REIT prices a harbinger of deteriorating real estate fundamentals, as some analysts have suggested? No one argues that real estate fundamentals across the board are as positive today as they were several years ago. In fact, by most accounts, most property sectors as well as most property markets are (and have been for some time) in equilibrium. At the same time, property fundamentals appear quite healthy.

In a recent letter to its clients, Heitman/PRA Securities Advisors, a Chicago-based firm that invests in real estate stocks on behalf of institutions and individual investors, remarked that though REIT earnings growth is slowing, real estate fundamentals looked okay. “Given many investors’ past experiences with private real estate cycles, there is no shortage of skeptics who believe it won’t be any different this time around.” Despite those concerns, the letter went on to say, “our analysis suggests real estate space markets remain generally healthy.”

The letter continued, “no matter what data we use to assess real estate fundamentals, we come to the conclusion that the markets are in good shape. Although the excess or abnormal risk-adjusted opportunities of the past several years appear to be diminishing, real cap rates, as measured by the spread over inflation even for office properties, are at 10-year highs. With cap rates on office properties averaging around 8.8% and the 10-year Treasury around 5.6% (all data is as of the end of the second quarter, unless otherwise noted), the implied risk premium on office real estate is in excess of 300 basis points. The average spread over the past 12 years has been just 140 basis points.” Justi-fication for that large a spread, the Heitman/ PRA letter concluded, cannot be found in the space markets.

Here’s Heitman/PRA’s assessment of the four major property sectors—apartments, office, industrial, and retail.

Multifamily—In the apartment sector, conditions remain generally healthy with rent growth exceeding inflation across local markets. The national vacancy rate, as reported by Dallas-based M/PF Research, was 5.1% at the end of this year’s first quarter, down 30 basis points from the same quarter in 1997. New supply has crept up in aggregate and increased spectacularly in some markets (e.g., Houston), but a major and prolonged national oversupply is unlikely. Individual companies could experience some margin pressure as higher costs, particularly for labor, influence expense growth.

Office—For the office sector we expect net absorption in the 50 largest markets to exceed 75 million square feet in 1998, with new deliveries less than 60 million square feet. The national vacancy rate as measured by Torto Wheaton Research (TWR) was 9.5% at the end of the first quarter of this year [see pages 41-46 for another view on office market fundamentals], and it is projected to fall to 9.2% by year end. At the end of the first quarter of 1998, 33 of the 53 metropolitan markets tracked by TWR had a vacancy rate of less than 10%, and 10 markets were under 7%. Rent growth reflects this current strength. Construction is increasing but not at an alarming rate. Assuming that demand falls to just 45 million square feet next year (vs. 75 million square feet this year), the expected supply of 70 million square feet in 1999 would push the national vacancy rate to approximately 9.8% by the end of next year.

Industrial—The industrial sector is healthy with a national vacancy below 8%, supply lagging demand in each year since 1992, and rent growth well ahead of inflation [see pages 41-46 for another view on industrial market fundamentals]. For 1998, the supply of new industrial space is projected to decline by 13% over 1997, according to TWR data.

Retail—Market rents at class-A malls continue to rise and class-B malls continue to gain occupancy. Only six new traditional enclosed regional malls opened last year, down from a peak of 26 in 1989. Strip center fundamentals are improving with rents up 6% over 1997. Only class-C malls struggle, while power centers show some pockets of weakness.

REITs vs. the Usual Valuation Tools
When REITs were trading at nearly a 25% premium to the best estimates of their so-called net asset values late last year, a number of analysts and investors suggested that NAVs weren’t terribly helpful as a valuation tool. But as REIT prices plummeted, and with most companies trading at discounts to their NAVs (see graph on page 73) for the first time since early 1995, NAVs have taken on new relevance. Though hardly unexpected, the focus on NAV—as investors, no doubt, soon will discover—cuts both ways.

As property cap rates fall, NAVs rise and vice versa. As you might expect, it takes a while before the most recent data on property pricing gets reflected in NAVs. In fact, over the past six to eight weeks, there have been anecdotal reports that property values were coming under some pressure. As that data makes its way into the hands of analysts and investors, NAVs will begin decreasing. Several industry veterans recently told Property they believe cap rates have risen by at least 50 basis points over the past two months. Once that’s reflected in NAV data, they suggested REITs may no longer be trading at significant discounts to their NAVs. One veteran market observer expects that REITs, on average, will be trading roughly at NAV by mid-October—assuming there’s no significant change in prices.

As documented elsewhere in this issue as of the end of August, REITs looked “cheap” relative to the broader market, based on price to multiples of their adjusted funds from operations, for instance. In fact, as of September 9, the REIT analysis group at Merrill Lynch & Co. reported that based on either “top-down” or “bottom-up” earnings estimates, REITs appeared cheaper (relative to the S&P 500) than at any time since the group began compiling data roughly four years ago. Nevertheless, most analysts and investors, as noted, expect REIT earnings growth to slow in the coming years. Some estimates call for a slowdown in FFO growth (’99 vs. ’98) on the order of 350 to 400 basis points. Of course, those same analysts and investors are quick to point out that the outlook for S&P 500 earnings growth is less rosy.

There’s been a good deal of emphasis recently on the spread between REIT adjusted-funds-from-operations yields and Treasury yields, specifically the 10-year Treasury (see graph on page 73). Again, according to the Merrill Lynch analysts, as of September 9, the spread between REIT AFFO yields and the yield on the 10-year Treasury was 531 basis points. Not only is that more than 300 basis points higher than the historic average (1993-1998), but it also was higher than at any time during that period. The previous record was 426 basis points in December 1995. A number of investors and analysts have pointed out that the following year (that is, 1996) REITs posted one of their best years ever.

Though noteworthy, it’s important to keep in mind that as dramatic as the spread between REIT AFFO yields and the 10-year Treasury was in early September, the “bond rally” that has been a hot topic of conversation lately really has been a Treasury bond rally (reflecting, perhaps, increasing and widespread global financial concerns). Moreover, in August, investors in bonds other than Treasurys experienced widespread losses. According to a recent New York Times article, only two non-Treasury sectors of the bond market posted gains in August. Municipal bonds rose 1.9% and the highest-rated corporate bonds rose 0.5%. In sharp contrast, Treasury bonds advanced 2.2%.