Time to Invest in REITs?

Real Estate Investment Trusts are designed to give investors an opportunity to invest in real estate, which over the long-term has performed pretty well as an asset class, the last year notwithstanding. Last week (2/2 - 2/6) even saw a pretty nice move in the REIT market, below the returns of the Nasdaq (QQQQ) and S&P 500 (SPY), but slightly above the DJIA (DIA).

Source: Wall Street Journal

Of course, the days of easy credit, structured real estate products freeing up capital, and rampant building may be over, most likely taking with them above average returns. Nonetheless, there may still be some opportunities in REITs as the housing mess unfolds and sorts itself out, and the Treasury department finally starts addressing the housing issue (see WSJ article regarding a proposed loan modification program - details later). Note: Citigroup (C) and JP Morgan (JPM) have agreed to a foreclosure moratorium for 90 days (see WSJ article), in anticipation that additional details of the Treasury plan will be available within the next three months.

For those considering investments in REITs, it is important to remember that not all REITs are created equal, nor are they all the same, but instead come in many flavors. Reported data for REITs is also different. Instead of sales, REITs report rental income as revenue. An advantage for REITs is that much of this income is relatively consistent given that long-term leases are often in place. Obviously, when dealing with rental income, the higher the occupancy rate, and the easier the ability to raise rates, and the higher the reported revenue. While the ability to raise rates is probably not currently in the cards for most REITs, some may begin to see an increase in occupancy rates, or at least a level of stability not seen in all markets (more on this later).

Valuation of REITs is a little more difficult, or at least different, compared to traditional equity valuation. While Book Value per Share can be used, in active markets such ratios can produce extreme values. A common approach that is often used instead begins with using Funds from Operations per Share, which includes net income, along with depreciation and amortization, minus any gains or losses from any asset sales. It is worth noting that both depreciation and interest rise significantly with increased financing, with REITs often having debt-to-equity ratios above 50 percent.

Even with a valuation approach in hand, and data one can trust, it must be remembered that not all REITs are likely to benefit in each unique market. One strategy which individual investors are utilizing in the current market is to purchase unfinished homes, often at a steep discount after builders either choose, or were forced, to move on (see SeekingAlpha article). After investing a little more money to finish the home, such properties are being rented out. Even in poor real estate markets, such as Florida and California, the rental market is doing well, and offering such rental opportunities - after all, as the thinking goes, people need to live somewhere. While individual investors may not be able to make the same large investments, there are various REITs that invest in residential rental real estate. Some of those listed in the aforementioned article include CMG Realty (CGMRX), Third Avenue Real Estate Value (TAREX), Avalon Bay Communities (AVB), Essex Property Trust (ESS), and Camden Property Trust (CPT), yet most of these REITs have their own issues and require additional due diligence.

To support the rental argument, the Real Estate Channel (see article) has recently stressed how "apartments continue to be the product of choice in national investment circles," while Apartment Investment & Management announced in its latest conference call that "the multi-family investment market continues to be relatively liquid." Yet, not everything is rosy, as others feel that Apartment REITs are susceptible to the downturn, no matter how they might be positioned to other REITs (see InvestmentNews article). Other REITs, like commercial REITs, may also not do as well, and are being recommended as good shorts, even at these depressed levels (see SeekingAlpha article). Like just about everything else in the market right now - enter at your own risk. Trying to catch a bottom, especially after a relief rally and a detail-free plan from Treasury, is always risky.

Comments

[Steve in TN:]

Even though Mr. Khan's job application, above, is not relevant to this article on REITs, it shows the problems many qualified individuals are having during this economic downturn. Some may get mad at him for posting his resume' on this site - I, personally, wish him all the possible luck in finding a good job.

Feb 15 08:47 AM

[CWest:]

Commercial real estate is spring loaded for a rebound. Two important items I rarely see in any article addressing commercial . [Also absent the above article:]
1./ Many REITS are trading below replacement cost. That is to say, if a building costs $200 sqft to construct and it is selling for $170 sqft - that building is spring loaded for a rebound.

2./ New construction, for reasons of unavailable financing and risk-fear, have un-preleased new construction at virtually zero. There is just no new construction starting.

Shorts in this environment are taking large risk indeed.

fcw

Feb 15 09:51 AM

[Downturn:]

CWest, there was overbuilding in CRE during the last 5 years. That, coupled with reduced consumption that will be the norm in the next couple of years paints a different picture.

Feb 15 10:23 AM

[surgcare:]

Dear CWEST , I have some land in New Orleans ,would you be intersted in buying .

Feb 15 10:37 AM

[VA Homeowner:]

can't agree with you here... residential REITs face significant headwinds in 2009 and 2010. While it is true that you will see REITs increase their occupancy, this will happen at the expense of rental rates, i.e. rental revenue will go down in the near term. Unemployment is one of the single biggest drivers for REITs and with the unemployment rate expected to go up to 9%, this can only lead to higher delinquencies and vacancies.

Additionally, IRS recently made changes to allow REITs to pay dividends out in additional shares. This would presumably allow the REIT to conserve capital, but would also dilute shares. The major (and well-capitalized) REITs have committed to continuing dividend payments in cash but I seriously doubt this will be the case for all of them. As you referenced Apartment Investment & Management (AIMCO), they recently cut their dividend in a bid to conserve cash for upcoming debt payments.

Finally, real estate values may still have room to go down, especially for apartment buildings and communities. Can you realistically say that any building bought within the past 3-4 years is worth more today than at purchase price? Investment in REITs have had a proven track record but I would wait a bit longer before jumping in...

Feb 15 12:14 PM

[ChipSeal:]

The tri-headed debt monster says commercial real estate (CRE) values are stratospherically high.

First head: Most regional and community banks made Fanny/Freddy loans for origination fees but have few residential loans on their books. So they are over-weighted with CRE loans, many that are in trouble as business suffers, and they MUST repair their balance sheets. Therefore, most of them are unable to lend.

Second head: The deteriorating business environment is making many CREs too risky to lend to. Some are in imminent danger of violating current loan covenants. Warren Buffet is lending- but only if he can get 10-15% in a 4% world.

Third head: Those that are credit worthy to lend to are not yet willing to borrow. With CRE values continuing to plunge and vacancy rate rising, why borrow now when better bargains are ahead?

Keep your powder dry. CRE has two or three more legs to go down. And then it will lag behind the market for years as the tremendous present overcapacity gets drawn down.

Feb 15 12:53 PM

[the ilster:]

This is a massive deflating bubble. I wouldnt touch real estate at all.

Short IYR

Feb 15 01:33 PM

[Rob Viglione:]

I wrote an article on 12/27/08 about commercial real estate developers lining up at the TARP trough, warning "that thousands of office complexes, hotels, shopping centers and other commercial buildings are headed into defaults, foreclosures and bankruptcies.” Something about $530 billion commercial mortgages coming due in 2009 for which financing is unavailable.

Unless these peachy fellows secure a half trillion from the federal government they are not likely to be attractive investments.

www.thefreedomfactory..../

Feb 15 08:27 PM

[reitmedia:]

Not only are REITs oversold, but many are getting much more creative with incremental revenue which means even more revenue on the flip-side of this current downturn.

Here are two examples, that I've covered recently...

www.reitmedia.com/reit.../

www.reitmedia.com/reit.../

Feb 15 09:25 PM

[Periphanto:]

REIT's are going to start to show trouble. In California, recently many of the names mentioned and more are going from 96% occupancy to now in upper 80's. Many people are losing their jobs and simply leaving California. In attempts to bring up occupancy levels rents are dropping to attract the few in the market. There is a storm being waged as we speak and the numbers will start to show soon. Many people are living with family again. The days of rising rents are over as I see it. REIT's carefully selected may be a great time to Short!

Feb 16 12:31 PM