Is the Time Ripe for REITs?

A couple of days ago one of my Urban Digs readers pointed out an interesting article from the Financial Times. The article notes that REIT prices in the U.K. have declined significantly below their net asset values and that these declines have exceeded the price declines of the underlying real estate that REITs own. The article touched off some reflection on my part regarding the "REIT indicator".

First a little history: There was a flurry of activity in the late 90s when many REITs came public. After a while the Street worried that the capital they raised would be used to overbuild new properties and the REIT stocks tanked. This also coincided with the Asia crisis and some interruptions in capital market liquidity (yes this is not the first time that the CMBS market has gone kablooey). Further, Internet stocks were just starting to become all the rage, temporarily distracting folks from the value of big fat dividends. A big correction in REITs left valuations quite low.

Taking their signal from the Street, REIT managements pulled back on the development reigns and didn't significantly overbuild. This set up a major buying opportunity in the late 90s. For about six years thereafter my father in law thanked me for the heads up I gave him to this opportunity. Being an income seeking investor, he loved the dividend increases he got and didn't mind the capital appreciation of the shares either, though he had no plans to sell them. Fast forward to today. My father in law won't speak to me! (Just kidding). He has actually hung in there and continued to clip his dividend coupons (until some recent dividend policy changes I will discuss shortly).

As most people know, REIT stocks were shellacked as the markets began to anticipate the seriousness of the commercial real estate debacle that is now unfolding (View image). Recall, however, that as stocks, REIT shares tend to anticipate the future. I commented on the REIT indicator back in January of 2008. At the time, REIT stocks had begun to trade at significant discounts to their net asset values (NAVs). That is, the market caps of the companies began to fall well below the value of the properties they owned, less the debt on those properties (as well as corporate debt). The REIT indicator says that when this happens, the commercial real estate market is about to catch down to REIT prices. In the latest instance one can only say the REIT indicator was spot on in predicting a downturn in the commercial real estate cycle.

The REITs had a bit of an uptick late last year when many of them decided to pay their dividends in stock rather than cash (and the IRS deemed this strategy to be kosher). This demonstrated that liquidity risk was on the minds of investors as the shares appreciated despite the unappetizing prospect that this income instrument was going to pay in stock not cash. It probably helped that many folks were short the stocks and hoping they would go to zero. The efforts made by REIT managements to conserve cash pushed out that prospect at the very least, thus boosting REIT shares.

Lately REIT stocks have perked up again, particularly those that have been able to issue new equity. Stocks like Kimco Realty (KIM), Simon Property Group (SPG) and AMB Property (AMB) have issued shares in order to give themselves breathing room relative to upcoming debt maturities. The table below (click to enlarge) shows the REITs with the biggest debt maturities over the next couple of years, courtesy of an article that was published late last year by Commercial Real Estate News. These REITs were under some of the greatest price pressure and had large short positions because there was the potential that they would not be able to roll over maturing debt and end up defaulting.

This had little to do with the actual debt service capacity of the REITs in several cases. As noted in my recent piece Loan Extensions - Bridge to Nowhere, it appears that General Growth Properties (GGP), which was apparently able to service its debt, went under for just this reason.

Last Wednesday, the Wall Street Journal ran a piece about how the U.S. vehicle of Israeli real estate investor, Chaim Katzman, Equity One, is apparently making aggressive moves towards shopping center REIT Ramco-Gershenson. In the article Rich Moore, analyst at RBC Capital, opines that according to his estimates an acquirer who took the company over at today's prices would be paying only a 12.7% cap rate for the underlying properties.

Now, according to Ramco's most recent 10K, the firm owned 89 properties, 86 of which were community shopping centers, 39% of which were in Michigan. Its key anchor tenants included (19) TJ Maxx (TJX) at 3.6% of rents, (12) Publix (PUSH.OB) at 2.9%, (4) Home Depot (HD) at 2.1%, (5) Wal Mart (WMT) at 2.1% and (12) Office Max (OMX) at 2%. Anchor tenants constituted 51% of rents and Non-Anchors 49.3%. National chains were 68.4% and local retailers constituted 18.2%. All in all, not the best mix of assets (with the significant Michigan exposure), but not the worst either and likely pretty reasonably priced for whatever risk lies ahead at a 12.7% cap rate.

Interestingly, from what I hear shopping centers are selling today at cap rates around 7 - 8%, with PricewaterhouseCoopers Korpacz real estate investor survey reporting Q1 2009 cap rates for strip shopping centers at 7.63% up 14 basis points, with national power centers at 7.98% up 41 basis points. They project a rise of 25 to 125 basis points over the next 6 months for these assets. On that basis, Katzman's play seems to make some sense and depressed REIT shares may start to become attractive to other investors.

If there were a way to short commercial real estate and go long REITs, I think you could make some real low risk money. This may actually be possible in Europe where there is a more active real estate derivatives market that I believe trades based on appraised values of a basket of buildings. Perhaps some Seeking Alpha reading macro hedge fund guys can tell us if this trade is actually feasible or could even be pulled off some other way.

Comments

[flleasing:]

I would be careful going long reit stocks. Being in the markets I see declining rents, declining occupancy levels and higher cap rates. This is a perfect storm that will continue until we have an absolute bloodletting in this industry. If Kimco or DDR bought a property during the past few years with $1,000,000 in income at a 6% cap rate they paid $16,700,000. If they financed 50% of the cost they would have $8.35 million in debt and $8.35 million in equity. In the current market assume a 10% loss of income for vacancy and collections and you now have $900,000 in net income. If cap rates have or do move from 6% to 9% then the new valuation for this property is $10,000,000. this means the reit has lost $5,500,000 in equity. Now the banker is looking at a loan with $1,700,000 in equity and $8,350,000 in debt. If cap rates move to 10% all the equity is lost. So, while the property is probably still cash flow positive, not even a big stupid bank would refinance it at the same terms.

Apr 28 11:02 AM

[Obi-Wan:]

"...not even a big stupid bank would refinance it at the same terms"

Well, those banks kinda did this on the residential side a while back now didn't they?? :)

Apr 28 03:10 PM