Point of View
War, Recession, & REITs
Though we remain bullish on real estate investment trusts, the onset of war and recession causes us to adopt a more defensive posture.

by David Shulman, Stuart Axelrod, and David Harris

In what now seems years ago, we wrote on September 10 that REITs were shifting from being analyst stocks to portfolio manager stocks. We noted that real estate fundamentals were weak and getting weaker, but because REITs still offered positive earnings growth along with high dividend yields, they would, by default, become portfolio manager favorites. Moreover, the inclusion of several REITs in the Standard & Poor’s 500-Stock Index [see “REITs Join the Club” on page 20] appeared to be just around the corner.

We never said, however, that REITs would not go down in a bear market. What we said was that should the broader market get pummeled, REITs would decline with a lower beta. This is precisely what occurred between September 10 and September 28 when the S&P 500 declined by 4.7 percent, while the Morgan Stanley REIT Index declined by 1.4 percent, indicating a beta of 0.3. The beta would be far lower if we excluded the decidedly weak hotel REITs.

However, the world has changed. Our nation is at war and the economy is in recession. Moreover, REITs are no longer as relatively cheap to the rest of the market as they were three weeks ago.

A Changed World
It’s against that backdrop that we are making some adjustments to our view of the REIT market. First, in this dramatically changed environment, six macro-assumptions (see sidebar on page 59) will drive our thinking vis-à-vis REITs. Second, in our September 10 note, we cautioned that our 7.9 percent average growth estimate (that is, earnings estimates for 2002 vs. this year) for our coverage universe was too high.

We are now acting on that earlier caution, as well as figuring the dramatically changed environment into the mix. As a result, we are cutting our projection for year-over-year FFO growth (again, estimates for 2002 vs. this year) by roughly 40 percent, from 7.9 percent to 4.8 percent. (See table on page 57 for revised estimates of individual companies.)

A Cyclical Business
Too many analysts have forgotten that real estate is a cyclical business and that leverage—even at “only” 50 percent—can be vicious on the downside. Moreover, we will soon learn just how risky new development can be. The full onset of recession will, for the most part, decrease occupancies, lower rents (or drastically cut anticipated growth rates), and increase the cost of tenant improvements. Concessions will appear in many markets.

We are making these cuts now because if we wait for official guidance from REIT managements, it will be too late. Frankly, we are in uncharted territory, so managements’ crystal balls could be just as foggy as ours.

Save for the New York City metro area, office leasing all but stopped during the last three weeks of September. Moreover, the previously tight apartment market will soften as tenants find themselves in more roommate situations and young people move back in with their parents (hardly a satisfying alternative for all parties concerned).


In spite of those “negatives,” the fact remains that REITs’ funds from operations are likely to be higher in 2002, albeit with some of the growth coming from lower interest rates and off-income-statement concessions. We wonder how many other sectors can predict higher earnings in 2002 with reasonable confidence!

Should our assumptions prove too pessimistic, we will gladly increase our estimates. However, we caution that this is the first down cycle in the tenant market since the dawn of the modern REIT era (circa 1992-1993). Managements will truly be tested, both operationally and financially.

Making Changes
Because we were so physically close to what happened on September 11, we were reluctant to make any immediate changes in investment ratings. After three weeks, we are making those changes.

In the environment we envision, stability of income will become the primary investor criterion. As investors turn more cautious, we believe our prior target of 450 to 460 for the Morgan Stanley REIT Index [on October 1, the benchmark closed at 393.25] by the middle of next year was too aggressive. Therefore, we are lowering it to 430 to 440. Yes, that still means a return of about 10 percent from here.

Put simply, we still like the group because of its defensive nature. On a more micro-basis, however, development returns will be discounted and the more cyclical sectors of the real estate market will lag. As noted in our September 21 research note, the industrial sector is more vulnerable to a long-lasting cyclical downturn than most investors realize. Short lease terms and tenant bankruptcies are a prescription for lower earnings. Suburban office markets suffer from similar attributes. In addition, high-end, high-rise residential markets are vulnerable to both an economic contraction and tenant fears of terrorism.

Six Macro-Assumptions
1. The war against terrorism will be a long and shadowy one; victory could very well be achieved before we really know it.

2. We pray that we are wrong; however, we probably have not seen the last high-profile act of terrorism.

3. The start of the war has exacerbated all of the negative conditions extant in the economy prior to September 11. We are assuming that the U.S. economy is now in a recession that will last through the second quarter of next year. Although it may look like a “V” on the way down, the recovery could be more muted.

4. Because terrorism will exact a tax on the economy by creating friction between economic agents, GDP growth will not fully translate into profit growth. Simply put, the hassle costs of doing business will go up.

5. The Fed will respond by continuing its active rate cutting policy with the Fed funds rate going to 2 percent or lower. Long rates could be stickier as the budget surplus melts away to near zero, or possibly a deficit in fiscal 2002.

6. Although dividend yield will become increasingly important to investors, the old-fashioned notion of preservation of capital would initially delay an all-out scramble for yield.

The recession we are in will likely cast a pall over the entire consumer-driven mall group as percentage rents decline, specialty leasing loses its robustness, and tenants fail. Moreover, the very expensive cities of New York, Washington, D.C., Boston, San Francisco, and Los Angeles, which represented the core of the late 1990s’ real estate boom, are the most target-rich environments for terrorism. We suspect the suburban markets of those cities might benefit at the expense of the urban core as firms diversify their operation centers.

Make no mistake: The surge in urban America in the 1990s came first and foremost out of a sense of renewed personal security in those environments. Much of that sense of safety is gone. This is yet another way terrorism exacts a tax on the economy.

Rating Changes
Following on the thinking set forth in our recent downgrades of Liberty Property Trust and Catellus Development, we are now downgrading AMB Property Corp. from a Strong Buy to a Buy and CenterPoint Properties from a Buy to a Market Perform.

Our thinking, again, is that investors do not yet fully appreciate the implications of a recession on the industrial sector. Leasing dramatically weakens. To be sure, supply is in check, but tenant demand falls away. AMB’s focus on “High Throughput Distribution” (HTD) facilities at airports will bear the full brunt of the “terrorism tax” as commerce physically slows for much-needed inspections. As for CenterPoint, we are concerned that the more risk-averse investment climate will make investors wary of its high multiple and development exposure. In a sense, CenterPoint would be penalized for its past success.

We also are downgrading two office companies, Boston Properties and SL Green, from a Strong Buy to a Buy. Boston Properties was perfectly positioned for the late 1990s’ real estate bull market; we do not see investors paying up for this fine company over the near term. Indeed, the value of its high-profile central business district office assets (Embarcadero Center in San Francisco; Pru Center in Boston; and CitiCorp in New York City) may have been somewhat impaired. SL Green’s shares have run up by 43 percent since February 2000, reflecting the tightening New York City office market. We think the price already reflects the change in supply dynamics. However, the demand shoe has yet to drop as New York City and other financial centers brace themselves for the inevitable layoffs that are about to come.

We also are downgrading General Growth Properties from a Strong Buy to a Buy. We do not believe investors will pay up for mall companies as consumer spending wanes. Moreover, General Growth’s largest asset is the Ala Moana Mall in Honolulu, which is now being hit hard by the drop-off in tourism. Our downgrade of Archstone Communities from a Strong Buy to a Buy results from our view that an urban high-rise presence has been temporarily devalued. (We were big fans of Archstone’s proposed merger with Charles E. Smith Residential; Smith focuses on urban high-rise multifamily properties.)

Lest you think otherwise, we are not negative across the board. We are upgrading two companies from a Buy to a Strong Buy—Kimco Realty Corp. and Equity Residential. Why? Both companies offer portfolio managers a safe haven in a very stormy stock market. Both have strong balance sheets and offer the prospect of cash flow stability.

Equity Residential is the leading apartment REIT serving the middle of the market. Kimco has an A credit rating with a proven management team that has the ability to take advantage of restructuring retail leases. Kimco’s recent Ward’s transaction [see “Why Shareholders Love Milton Cooper,” Property, Sept./Oct. 2001, page 12] will generate about 10 percent of the company’s funds from operations over the coming 12 months.

We also are upgrading Mack-Cali Realty and Simon Property Group from Market Performers to Buys. Mack-Cali’s New Jersey presence [see “Aftershock” on page 12] is benefiting from the lack of supply in Manhattan, and the company has the potential to start another tower in Jersey City. That said, we note that if lower Manhattan wanes as a financial center, the New Jersey waterfront would be devalued. With regard to Simon, the selling may have been overdone, and its near 8 percent dividend yield will likely support the shares.

David Shulman heads the REIT Research Team at Lehman Brothers. Stuart Axelrod and David Harris are REIT analysts. This is an edited version of a research note published by Lehman Brothers on October 2.

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