Outlook for REITs Is Solid: Multifamily and Office Especially Strong

by: Brad Case

An article published today by Paul Bubny in GlobeSt.com summarizes strong recent operating results by several REITs and suggests a strong outlook going forward for the whole industry:

Vornado Realty Trust's financial results marked the latest in a series of strong quarterly showings by major REITs...(and) provided further evidence of recovery across commercial real estate. REIT stocks, which cratered in early 2009 following the capital market's collapse, are attracting investors once again thanks to an improving industry outlook as well as high dividend yields and strong quarterly earnings.

In addition to Vornado (NYSE:VNO) the article focuses on strong earnings reports by LaSalle Hotel Properties (NYSE:LHO) in hotels, Pennsylvania REIT (NYSE:PEI) in retail, and SL Green Realty (NYSE:SLG) in office.

The article quotes Jeffrey Rogers, president and COO of Integra Realty Resources, as saying

2010 proved to be a great year for REITs overall, and I predict the same for 2011 with maybe slight corrections in the first two quarters.

(Equity REITs gained 27.95% during 2010, and 4.1% during January 2011.)

According to the article, Rogers believes that multifamily and office will "lead the way."

The multifamily residential space encompasses 15 apartment REITs--Equity Residential (NYSE:EQR), AvalonBay Communities (NYSE:AVB), UDR (NYSE:UDR), Camden Property Trust (NYSE:CPT), Essex Property Trust (NYSE:ESS), Apartment Investment & Management (NYSE:AIV), BRE Properties (NYSE:BRE), Mid-America Apartment Communities (NYSE:MAA), American Campus Communities (NYSE:ACC), Home Properties (NYSE:HME), Post Properties (NYSE:PPS), Colonial Properties Trust (NYSE:CLP), Associated Estates Realty (NYSE:AEC), Education Realty Trust (NYSE:EDR), and Campus Crest Communities (NYSE:CCG)--plus three manufactured housing REITs: Equity Lifestyle Properties (NYSE:ELS), Sun Communities (NYSE:SUI), and UMH Properties (NYSEMKT:UMH).

In its 2011 Outlook for U.S. equity REITs, Fitch Ratings maintains a "stable" outlook for multifamily REITs, although with (in my own opinion) a perceptible lean toward "positive."

The stable outlook is driven by property fundamentals that have begun showing signs of improvement, as well as solid liquidity and capital markets access. These credit strengths are offset by elevated leverage in the multifamily sector relative to other property types, but appropriate for current ratings.

The outlook for property market fundamentals for multifamily REITs in 2011 is positive. According to Property and Portfolio Research, vacancy rates decreased in all of the 54 largest U.S. markets...(while) rent growth in the third quarter was positive for the second consecutive quarter. The recovery has been weighted toward higher quality properties, as many class B and C renters have traded up in quality due to lower rents and higher concessions during the downturn.

Fitch expects multifamily fundamentals to continue to improve despite weaker overall economic growth, driven primarily by limited new supply, continued hurdles for new homebuyers, and demographics enlarging the renter base.

Overall, NOI growth in 2011 is expected to be positive, although it will lag other positive fundamental trends such as asking rents and vacancies.

Multifamily REITs have had access to a variety of capital sources following improvement in the debt and equity markets. Additionally, the multifamily sector continues to have the added advantage of access to mortgage capital from the GSEs, despite their financial woes.

Five multifamily REITs are in Fitch's coverage universe: EQR, CPT, BRE, HME, and CPT.

As for the office space, there are 18 publicly traded office REITs: Boston Properties (NYSE:BXP), SL Green (SLG), Alexandria Real Estate Equities (NYSE:ARE), Mack-Cali Realty (NYSE:CLI), Piedmont Office Realty Trust (NYSE:PDM), Corporate Office Properties Trust (NYSE:OFC), BioMed Realty Trust (NYSE:BMR), Highwoods Properties (NYSE:HIW), Douglas Emmett (NYSE:DEI), Kilroy Realty (NYSE:KRC), CommonWealth REIT (NYSE:CWH), Brandywine Realty Trust (NYSE:BDN), Franklin Street Properties (NYSEMKT:FSP), Government Properties Income Trust (NYSE:GOV), Parkway Properties (NYSE:PKY), Hudson Pacific Properties (NYSE:HPP), MPG Office Trust (NYSE:MPG-OLD), and Pacific Office Properties Trust (PCE).

In its 2011 Outlook for U.S. equity REITs, Fitch Ratings maintains a "stable" outlook for office REITs, although it points out a significant difference in operating fundamentals between CBD and suburban office properties.

Fitch's office REIT outlook for 2011 is stable based on the sector's continued access to capital and improvements in liquidity. Further, improved balance sheets to some extent will offset challenging, but moderating, property market fundamentals.

That said, there is a clear bifurcation in property fundamentals between CBD and suburban office. Net effective rents and occupancy levels in most CBD markets appear to be bottoming, whereas properties in most suburban markets face continued weakness.

Fitch's outlook for office property market fundamentals is mixed, driven by high vacancy rates and a protracted high unemployment rate. Office fundamentals are expected to inflect positively in 2011 with positive rent growth and a vacancy rate decline according to Property & Portfolio Research. However, despite these improvements, NOI is expected to fall. On the positive side, construction remains muted.

While the operating environment for office REITs remains challenging, most office REITs will fare better than the market average due to higher-quality portfolios and strong management and leasing teams, thereby allowing REITs to benefit from tenants trading up to better space. As of 9/30/10, Fitch's universe of office REITs had average occupancy or 90.8%, compared to 80.5% for the PPR 54-market average.

That is a critical factor: even in a time of general weakness in operating fundamentals, that doesn't mean equally weak fundamentals for everybody; REITs historically have provided much stronger returns to their investors than have other real estate investment managers, and a good part of the reason (in my opinion) is simply that they are better at managing their assets.

The stable outlook is also supported by the flexibility public REITs have due to their multiple sources of liquidity to be acquisitive nad fund tenant improvements and leasing commissions to fill vacant space, compared to more financial restricted private players.

In terms of access to capital,

The debt and equity markets remain open for REITs in general, and office companies have taken advantage of this to improve liquidity and flexibility by issuing low-cost, longer term debt and tendering for near-term maturities, improving debt maturity schedules.

Fitch would turn more positive on the sector if property fundamentals improve materially over the near term. Conversely, should property fundamentals materially deteriorate further, issuers increase leverage or the capital markets become inhospitable, Fitch would take a more negative view on the sector.

Nine REITs are in Fitch's coverage universe for the office space: BXP, SLG, CLI, HIW, and BDN plus Liberty Property Trust (LRY) and PS Business Parks (PSB), which NAREIT considers "mixed" office/industrial REITs; Vornado Realty Trust (VNO), which NAREIT considers a diversified REIT; and Reckson Operating Partnership LP.

Incidentally, I wrote back in December about Fitch's 2011 Outlook for REITs.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: I am long Vanguard REIT Index Fund and ING Global Real Estate Fund.

Disclaimer: The opinions expressed in this post are my own and do not necessarily reflect those of the National Association of Real Estate Investment Trusts ((NAREIT)). Neither I nor NAREIT are acting as an investment advisor, investment fiduciary, broker, dealer or other market participant, nor is any offer or solicitation to buy or sell any security investment being made. This information is solely educational in nature and not intended to serve as the primary basis for any investment decision.

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