Real Estate Investment Trusts
The U.S. Real Estate Investment Trust (REIT) industry registered a strong recovery and year-end performance in 2009. The FTSE NAREIT Equity REIT Index reported total returns of 27.99% in 2009, vs. a 26.46% and 18.82% gain for the S&P 500 and the Dow Jones Industrials, respectively.
The strong performance of the FTSE NAREIT Equity Index was primarily attributed to the influx of fresh capital through secondary equity offerings and asset sales. REITs and REOCs (Real Estate Operating Companies) raised nearly $38 billion in 2009 in an industry-wide push to recapitalize balance sheets, and over 90 secondary equity offerings were issued in addition to 37 unsecured debt offerings.
During the fourth quarter of 2009, total returns for the FTSE NAREIT Equity Index was 9.39%, vs. a 5.5% and 7.5% gain for the S&P 500 and the Dow Jones Industrials, respectively. So far in 2010, equity REITs are up 2.13% (total return FTSE NAREIT Equity REIT Index as on Jan 19, 2010); the strong performing sectors have been Lodging/Resorts (7.88%), Industrial/Office (3.01%), Specialty (2.93%), and Health Care (2.80%).
The U.S. housing market is expected to mark the beginning of the bottom of the market in 2010, with subsidized mortgage rates, tax credits, increased FHA (Federal Housing Administration) lending and a government-sponsored slow down in distressed liquidations.
OPPORTUNITIES
Many REITs are still trading at discounts to NAV (net asset value), traditionally a good “buy” signal. Over the past 7 or so years, REITs had traded near or in excess of NAV.
With dividend cuts and share price gains, the average yield for equity REITs during fourth quarter 2009 was 3.7%, compared to 3.8% for the 10-year Treasury, as most companies have been raising cash through asset sales and equity financing to pay down debt.
The credit freeze will have a positive effect on commercial real estate down the road; new office, apartment and retail construction has slowed considerably, which will benefit owners in a couple of years. Many companies that we cover have stopped all-new construction.
In this environment, we like well-capitalized companies that have adequate liquidity and manageable near-term debt maturities. Currently, we are bullish on American Capital Agency Corp. (AGNC), a mortgage REIT that invests exclusively in agency securities for which the principal and interest payments are guaranteed by U.S. government agencies like Ginnie Mae, Fannie Mae (FNM) and Freddie Mac (FRE). The company declared a fourth quarter dividend of $1.40 per share. American Capital is one of only a few companies to have increased its dividend during the economic downturn.
Another stock worth mentioning is Vornado Realty Trust (VNO), the largest publicly traded office REIT in the New York region, concentrating on Class A office properties. The core properties of Vornado are still performing at a high level, maintaining strong occupancies and increasing rents in most property formats. We believe this puts the company well ahead of many competitors, and warrants upside potential.
We would also like to mention Simon Property Group Inc. (SPG), the largest publicly traded retail real estate company in North America, with assets in almost all retail distribution channels. The geographic and product diversity of the company insulates it from market volatility to a great extent and provides a steady source of income. Furthermore, Simon Property’s international presence gives it a more sustainable long-term growth story than its domestically focused peers.
WEAKNESSES
REITs still depend on access to capital to fund growth, and with the credit markets still not fully back to normal, it is difficult to raise money for new developments/acquisitions. In this scenario, most REITs are raising capital through property level debt, dividend reductions and equity offerings.
Although both debt and equity financings provide the much-needed cash infusion, they could potentially burden an already leveraged balance sheet and/or dilute earnings. Property level debt is also harder to obtain and more expensive as commercial real estate prices remain under pressure.
Fundamentals are declining in many suburban office markets as corporate expansion continues to slow. More and more corporations are putting off leasing decisions until the economy recovers. Recent employment trends are also not encouraging as the U.S. economy continues to shed jobs at a rapid pace.
Year-to-date, the U.S. has lost about 7.6 million jobs since the start of recession in December 2007. The national unemployment rate has surged to 10.0%. As the U.S. economy struggles with the economic downturn, REITs will have trouble holding tenants and leasing new space.
Given the market uncertainties, we are bearish on Developers Diversified Realty Corporation (DDR), which is primarily engaged in owning and leasing shopping centers across the U.S., Puerto Rico, Brazil, Russia and Canada. The current recession has led to increased tenant bankruptcies, which in turn have led to a decline in occupancy and an increase in vacancy rates. The possibility of store closings at many Developers Diversified centers further adds uncertainty to the earnings, and it might have to re-let large “big-box” spaces at significantly lower rents in a very tough leasing environment.
We would also avoid Regency Centers Corporation (REG), a self-administered and self-managed real estate investment trust (REIT), that owns, operates and develops grocery-anchored retail shopping centers in the U.S. We think the company will have a difficult time continuing to raise rents in a faltering economy, and expect flat rental rates and negative same-store revenue growth in 2009. Furthermore, the company has an active development pipeline which increases operational risks in the current credit-constrained market, exposing it to rising construction costs, entitlement delays, and lease-up risk.
