In 2007, the bull market in REITs finally slowed down, and REIT indexes are down virtually across the board. With myriad issues hanging like the sword of Damocles over the sector -- interest rates, securitization, a credit crunch, and the ghastly specter of recession -- now seemed like the perfect time to get an expert's outlook for 2008. The following is a recount of a phone conversation I had with Paul McDowell, CEO of CapLease (NYSE: LSE ) , a net leased REIT -- where the lessee pays for expenses like utilities, insurance, tax, and repairs -- that focuses on commercial real estate.
Emil Lee: How bad is it right now in the securitization markets?
Paul McDowell: One of the things we discovered in 1998, after Russia's debt defaulted, is that there is an interconnectedness that shows up in ways that people don't expect.
What should have been a very contained problem in subprime mortgages has spread beyond a few people missing their mortgage payments to large sections of the commercial real markets dependent on securitization for funding -- such as CMBS [commercial mortgage backed securities] conduits, mezzanine loans, and CDO financing -- from capital providers like Bank of America (NYSE: BAC ) , and Wachovia, and so on. Those markets should not have been impacted by the subprime debacle.
What we found is that a problem centered in the subprime space has leaked into all aspects of asset securitization and that those markets have ceased to function, at least temporarily.
Lee: So where do we go from here?
McDowell: There's an absolutely enormous leverage unwinding that needs to take place, where assets find their appropriate prices. That's been going on since June of last year, and then accelerated dramatically over the course of the summer and last fall.
No one wants to buy a bond for $0.90 today that's worth $0.85 tomorrow. For the past four or five years, we've seen the opposite: Prices kept getting tighter and tighter spreads, and a bond bought today was instantly worth more tomorrow. Today the opposite is true; a bond bought today is worth less tomorrow, and until that psychology turns around, you'll see ongoing pressure.
Lee: In your opinion, is the current credit crunch worse than the one in 1998?
McDowell: Absolutely, absolutely worse. In 1998, it was external events -- first it was Thailand, then Russia defaulting, then bad directional bets at Long-Term Capital Management.
[This time], we sort of did this to ourselves. Wall Street mismanaged the securitization of subprime assets, much like the savings-and-loan crisis of the early '90s. This type of internal crisis takes longer to work out and could push this economy into a recession.
Lee: When do you think we'll hit bottom?
McDowell: I would hope that once we get through the fourth quarter, and all the money-center banks continue to [write down assets] -- they will do so to such ridiculous levels that valuation questions go away. Then, in 2008, you'll first see stability return, and then momentum. The wild card is the U.S. economy, which could have a very significant impact on U.S. commercial real estate.
As consumer spending drops, retail real estate could suffer, and then you'd have the problems of delinquency and default spilling into commercial real estate. Right now, it feels like the economy will kind of muddle through, if not do well, and commercial real estate will hold up through this cycle.
Lee: What REIT sectors should investors keep an eye out for?
McDowell: Well, my view, of course, is biased by my company. When markets enter this level of stagnation, then companies, such as net lease companies, with long-term fixed rate leases and very high quality tenants, provide stable cash flows and dividends. That includes CapLease, Realty Income (NYSE: O ) , National Retail Properties (NYSE: NNN ) , and Lexington Realty Trust (NYSE: LXP ) .
Lee: Who are your biggest tenants?
McDowell: We have an extremely transparent portfolio. You find them in our 10-Q or 10-K. Our biggest tenant is the U.S. government, and our next biggest is Nestle, which is rated triple-A. Some of our other tenants include Tiffany's, Lowe's, and Allstate -- so big, very large, and very profitable companies.
Lee: Are there any other REIT sectors investors should be attracted to?
McDowell: Investors should be attracted to stability. Some of the mall companies that have got big class A malls (including General Growth Properties (NYSE: GGP ) ) will weather downturns well. Also, I'd look at some of the very big and very diversified REITs like Vornado (NYSE: VNO ) .
Lee: So investors should look for REITs where, at the time of origination, most of the variables like funding costs, cash flows, and credit quality are already in place and very secure?
McDowell: Right. We don't finance an asset today and hope to sell it later for more. We're a long-term fixed-rate investor.
According to news reports, super investor David Einhorn advised investors to tread cautiously, noting "You don't have to be a hero." With that in mind, I think it'd be wise to take Paul's advice and look for REITs where dividends and cash flows are secured by long-term, fixed-rate contracts with high-credit-quality tenants like the U.S. government and Fortune 500 companies.