Dow Jones Property: Market Insight

REIT Market Melt Down
1998 is likely to be the worst year for REITs since the sector rebounded in the early 1990s. What happens next will be driven by technical factors rather than property fundamentals, however.

by Barry Vinocur

The list of reasons why REITs have performed so poorly this year is long. It includes everything from REITs are suffering because diversified money managers dumped them early this year when large caps soared to REITs were beaten up because of a severe supply/demand imbalance (that is, record equity issuance by property companies late last year and early this year far outstripped demand for those shares).

None of those reasons—no matter how valid—changes the fact that REITs are trapped in a downdraft the likes of which hasn’t been seen since the bull market for the stocks began in the early 1990s. In fact, you have to go back to 1990 to find a year in which REITs performed as poorly as they are on track to perform this year.

No sector of the REIT market has escaped the carnage. As of the end of August, the average company followed by Realty Stock Review (Property’s sister publication) was off its 52-week high by 25.8%. (As of September 10, the Morgan Stanley REIT Index had dropped an additional 4.5% from its August close.) Not only was every one of the 12 sectors tracked by the newsletter in the red for the trailing 12-month period through August 31 (see table at the top of page 32), but every one of the 125 companies in its Side-by-Side analysis table (see tables that begin on page 64) also was in the red.

Hardest hit of the 12 sectors tracked by Realty Stock Review has been lodging. As of the end of August, the 10 hotel REITs in that group were off their respective 52-week highs (on average) by nearly 45%. Hardest hit among the hotel REITs was Patriot American Hospitality, which was down nearly 62% from its 52-week high. Also down sharply was Starwood Hotels & Resorts—the largest hotel and gaming company in the world and by far the largest REIT. Starwood, which recently said it would convert from a REIT to a C corporation (see page 6) was down more than 40% from $61.50 per share (its 52-week high) as of the end of August. (Since then, Starwood has fallen further.) Also hard hit in the lodging sector have been Sunstone Hotel Investors, FelCor Lodging, Boykin Lodging, and Innkeepers USA. As of the end of August, each was off its respective 52-week high by at least 45%.

The list of reasons why lodging REITs have been so hard hit this year—like the list for the industry as a whole—is a long one. However, most of those reasons emanate from a widespread concern about overbuilding in the sector and declining fundamentals. In the case of Patriot and Starwood, the uncertainty that arose early this year when the Clinton administration proposed freezing the ability of so-called paired share REITs (Patriot and Starwood are two of the industry’s five paired share entities) to own and operate properties within the unique structure has also been a factor. Lost in the “panic” over deteriorating fundamentals and concern over pending legislation targeting the paired share REITs (that legislation was included in the IRS Restructuring Bill, which now has been passed by Congress and signed by President Clinton) has been any real differentiation between, for example, REITs that focus principally, if not exclusively, on luxury or upscale properties, such as a Starwood and a Patriot, and those that focus on the limited-service end of the spectrum. It’s the midscale to limited-service end of the spectrum that is most vulnerable to economic vagaries, including those REITs who are in a market segment with few, if any, meaningful barriers to entry.

Also especially hard hit this year have been office REITs. Like the lodging REITs, office REITs had been an industry leader in each of the past two years. Again, there’s a long list of reasons why office REITs were off their respective 52-week highs, through the end of August, by nearly 30%. Chief among those reasons, however, have been concerns about new construction, as well as worries about REITs, in particular, overpaying for properties. As is the case for lodging REITs, investors have painted the entire sector with a very broad brush. For instance, though new construction is an issue, it’s more likely to affect suburban office properties than so-called CBD (central business district) buildings.

Search for a Catalyst
No longer willing to continue calling what was taking place in the REIT market a correction, Realty Stock Review declared in early August that it was a bear market for REITs. Acknowledging that to qualify as a bear market the Morgan Stanley REIT Index would need to be down by 20% or more (it was down roughly 12% at the time), the newsletter stated that it regarded that definition as being too stringent. First, because the Morgan Stanley REIT Index is a total return index (that is, dividends are taken into account), the companies that comprise it (see page 77) were down more than the index suggests. Second, looking at the companies in its Side-by-Side table and seeing how far off their respective 52-week highs they were at the time, Realty Stock Review stated, “We don’t believe a credible case can be made that this isn’t a bear market for REITs.”

Calling it a bear market sounds ominous, but what does it really mean? First, if you look at the historical returns for equity REITs over roughly the past quarter century (see table on page xx), you’ll note that only once did equity REITs post back-to-back years with negative total returns. Any doubt over whether or not it was a bear market has since been eliminated. The Morgan Stanley index fell by nearly an additional 11% from July 31 through September 9. Realty Stock Review added that this drop, by itself, doesn’t say anything about how long the downturn might last. The newsletter pointed out that, in its view, real estate stocks could continue to move sideways or down for another three to six months—possibly longer. Realty Stock Review also cited a number of reasons for its pessimistic outlook.

Funds Flows—Though a number of institutions and value investors reportedly are taking a hard look at jumping into the market for property-linked stocks, they are concerned by a number of factors (more on those in a bit) that could drive prices still lower. For REITs to move higher and sustain that move, several things have to happen. Among the most important of those is a substantial increase in the flow of funds into the sector. At the same time, dedicated real estate funds—for the most part—are continuing to experience outflows. Realty Stock Review noted that, though interesting, positive flows into dedicated real estate funds won’t sustain a recovery in prices, though they may serve as a leading indicator of inflows from other sources.

Performance and Valuation Review Sectors Ranked by Percentage Change From LTM High December 31, 1997 – August 31, 1998
Sector	Pct. Price Change from LTM High	Pct. Price Change from LTM Low	Y-T-D Total Return	Trailing 12-Mo. Tot.Return	Trailing 3-Yr. Tot.Return	Aug. '98 Tot. Return	Div. Yld. 8/31/98	1999(E) P/AFFO	1999(E) AFFO Payout Ratio	Prem./ (Disc) NAV 8/31/98
Lodging	(44.4%)	2.2%	(18.5%)	(34.0%)	(27.5%)	(18.5%)	10.8%	6.3	66.3%	(38.6%)
Office	(29.6%)	2.2%	(21.2%)	(11.9%)	19.7%	(10.5%)	6.8%	10.3	68.7%	(9.6%)
Net-Lease	(29.2%)	1.3%	(9.3%)	(21.9%)	(13.8%)	(9.3%)	8.6%	8.3	70.7%	-
Healthcare	(29.0%)	2.0%	(10.4%)	(20.3%)	(10.8%)	(10.4%)	10.0%	8.3	81.3%	-
Factory Outlets	(27.7%)	3.0%	(13.8%)	(12.5%)	(8.5%)	(13.8%)	7.4%	7.4	75.2%	(5.0%)
Self-Storage	(25.7%)	1.5%	(8.8%)	(18.3%)	(13.1%)	(8.8%)	7.6%	9.0	67.0%	(11.0%)
Industrial	(24.8%)	2.5%	(7.2%)	(17.5%)	(5.5%)	(7.2%)	7.0%	9.9	68.6%	0.7%
Shopping Centers	(22.8%)	3.9%	(12.8%)	(5.6%)	9.8%	(8.0%)	8.9%	9.1	78.3%	(0.8%)
Apartments	(20.8%)	1.9%	(12.2%)	(3.1%)	13.7%	(7.2%)	8.0%	9.6	75.4%	(6.6%)
Diversified	(20.1%)	4.1%	(5.9%)	(9.2%)	(1.6%)	(5.9%)	6.8%	10.7	71.9%	0.0%
Regional Malls	(20.0%)	5.9%	(6.1%)	(7.7%)	(1.4%)	(6.1%)	7.9%	10.3	78.7%	(0.1%)
Manufactured Homes	(15.9%)	1.1%	(5.5%)	(9.8%)	(1.0%)	(5.5%)	6.4%	11.3	71.7%	8.7%
Average	(25.8%)	2.6%	(11.0%)	(14.3%)	(3.3%)	(9.3%)	8.0%	9.2	72.8%	(6.2%)
Note: P/AFFO is calculated using '99(E)AFFO

Supply/Demand Imbalance—Though the REIT market is substantially more liquid than it was, say, five years ago, liquidity is still very much an issue. Inextricably tied to the general topic of liquidity is the specific issue of what happens when prices begin to recover. Money managers, notably nondedicated REIT investors, say they believe that if REITs were to rally, companies would rush to issue equity. This concern is so great that buy-side firms believe it will be impossible to sustain a rally for the foreseeable future.

Capital Crunch—It’s unlikely that any REIT could—or would be foolhardy enough to try to—do a public equity offering now. That said, a number of companies are talking about (or recently sold) small amounts of equity in private deals. Though making blanket statements is always dicey, buy-siders say that selling equity right now is a mistake. Spreads in the corporate debt market have widened recently, so that’s not a terribly attractive option either. The preferred market isn’t much better, as most companies have had considerable trouble doing deals even in the $100 million range. As a result, more companies are talking about doing secured financings. And joint ventures continue to be a hot topic, though buy-siders, analysts, and the rating agencies continue to express concern over deals of the off-balance sheet variety.

Annual Total Returns
(Equity REITs)

1972 8.0% 1981 6.0% 1990 (15.4%)
1973 (15.5%) 1982 21.6% 1991 35.7%
1974 (21.4%) 1983 30.6% 1992 14.6%
1975 19.3% 1984 20.9% 1993 19.7%
1976 47.6% 1985 19.1% 1994 3.2%
1977 22.4% 1986 19.2% 1995 15.3%
1978 10.3% 1987 (3.6%) 1996 35.3%
1979 35.9% 1988 13.5% 1997 20.3%
1980 24.4% 1989 8.8% 1998(1) (23.4%)
Notes: (1) 1998 year-to-date return is through September 10.
(2) With the exception of the 1998 year-to-date return,
which is for the Morgan Stanley REIT Index, the other
annual total returns are for the NAREIT Equity REIT Index.
Source: NAREIT and Realty Stock Review

One option is increasing leverage. There’s already evidence that companies are heading in that direction, though the increases are far from worrisome at this point in time. What is worrisome are comments by some CEOs suggesting that by increasing leverage they’ll goose FFO and that in turn should translate into a higher stock price. Leverage does increase return on equity, but 40 years ago, Franco Modigliani and Merton Miller showed that increasing leverage doesn’t increase firm value (a Nobel Prize winning finding). Put another way, increasing leverage won’t translate into a higher stock price, except over the longer term as ROE hopefully increases.

There are catalysts that might trigger substantial inflows into the sector. For instance, there’s already evidence that capitalization rates are starting to trend upward. For now, the change is small and there’s enough liquidity in real estate markets that it’s unlikely cap rates will perform an abrupt about-face and head north (substantially) overnight. At the same time, the slump in REIT prices is already having an impact on the supply side of the real estate equation. For instance, the supply of debt capital, though hardly in short supply, has been affected. And a number of Wall Street firms active in the rapidly growing market for commercial mortgage-backed securities (CMBS) have reportedly pulled back.

Changing Strategy
Despite the recent downturn, as well as an inability to put its finger on the catalyst that would turn the REIT market around, Realty Stock Review recently stated it regarded what was taking place as a “neural disconnect” between stock prices, underlying value, and property fundamentals. Though in the later stages of the real estate recovery, the newsletter maintained that property fundamentals were still quite strong. Moreover, the newsletter argued that with most REITs trading at or below estimates of their net asset value, it was becoming increasingly difficult to view what was taking place as anything but an overreaction. This conclusion led Realty Stock Review to advocate that investors dollar-cost-average into companies with the most talented (and deepest) management teams, as well as companies with sufficient balance sheet flexibility to take advantage of any opportunities that might arise in the near term.

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