Parting Shot
The Best Offense Is a Good Defense
Sector weighting is key in a market slowdown.

by Gregory J. Whyte

We can no longer suggest real estate fundamentals are improving, although they could remain solid. While we are aware of what happened to REITs when growth rates began sliding in late 1997 (despite the prospect at the time that REITs would grow at twice the S&P 500’s growth rate), the question remains: What is the growth and return outlook for the overall market?

Under most scenarios, lower-beta REITs might well be a decent place to hide. To that end, we have evaluated five different GDP, Fed ease, and market performance scenarios (see table).

We believe the most likely scenario is some variation of No. 3. And, if you held our head under water and forced a call, we believe REITs will likely post 9 percent to 12 percent total returns, with roughly 5 percent price appreciation and a roughly 7 percent yield in 2001. We further believe that the current high, single-digit consensus growth rates for REITs may end up being too high (due to softer economic conditions), and the current multiple valuations might contract slightly.

Graph Assessing the five scenarios outlined, we believe REITs are likely to post relative outperformance in all cases except the extremes. If the market snaps back sharply in 2001 (Scenario No. 5), there is a good chance of solid absolute returns, but other, more cyclically sensitive market sectors are likely to perform more strongly. Under that scenario, we believe some of the nondedicated "growth and income" and "value" money may be pulled out of the REIT group. In a hard landing (Scenario No. 1), we believe REITs would not be immune to tenant failures and defaults. This type of slowdown also might force some companies to postpone/delay development projects. With inves-tors believing that REIT earnings are somewhat defensive, any material knock to earnings could hit valuations more sharply.

In an attempt to differentiate between the valuations on the varying asset classes, we examined both the average FFO/share growth for the different asset classes since the first quarter of 1995 and the multiples on which the subsectors have traded vs. the balance of the REIT sector.

In targeting a 9 to 12 percent total return for REITs in 2001, we still believe investors should continue to be more overweighted in certain sectors. We believe the defensive qualities associated with longer-term leases and higher barriers to new construction levels will hold firm for the downtown office subsector, although we believe some stocks might, in fact, be sensitive to slightly softer regional economic conditions, namely regions with significant exposure to high-technology tenants. We also believe that unless the U.S. economy slows to a hard-landing pace, the industrial REIT names will likely hold up better, but being exposed to higher barrier-to-entry markets will be even more important here. While some multi-family names may already be priced for perfection, the slowdown of new-home purchases might see continued strong demand for rental units. Only if the economy slows such that new household formation turns negative (i.e., singles move back with parents, etc.) will demand likely drop off materially.