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What Recession?

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By Reitnut
November 20, 2001

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Robfinkii states:

Not sure I agree that we are already coming up the other side, but I do expect that this will not be as deep or long a recession as is widely feared.

I agree. Here are a few more thoughts for what they're worth (probably nothing):

It's obvious by now that investors are convinced that an economic recovery by next spring is well in hand. This past week provided yet more evidence that the "market" is now discounting such a rebound. The yield on the 2-year T-note, just in this past week alone, rose from 2.43% to 3.07% (a huge price movement for such short-term securities); yields on longer-term maturities i.e., the 10-year T-note, spiked by a similar amount and caused a loss to holders of almost 0.5%, or 12% of their expected annual income. Cyclical and economically sensitive stocks such as homebuilders, retailers and such have levitated. The S&P Retail index (RLX) soared over 26% from its bottom on September 21. The Morgan Stanley Consumer Cyclical index (CMR) is up 11.7% from the same date. The Amex's Airline index (XAL) bottomed one day earlier, on September 20, at 63.06, and has spiked 28.8% through last Friday.

And, of course, we're seeing the same things in our world. Last week the most economically sensitive stocks, the hotel REITs, levitated: Meristar, +20.7%, Innkeepers, +13.0%, non-REIT Starwood, +11.4% and HMT, +10.9% (the RMS, during the same period, was up "just" 3.1%). And the apartment REIT stocks, which are showing themselves to be rather economy-dependent and whose FFOs are expected to rise by an average of only 2-3% next year, have suddenly become popular with investors; my own informal index consisting of an unweighted group of 17 apartment REITs rose 2.9% last week, beating all sectors other than offices (averaging +3.1%) and hotels (averaging +10.5%).

You'd expect the healthcare REITs to falter in a rising economic climate, as interest rates begin to reverse and move upwards; they did. HCP, HCN, HR and NHP all failed to keep up with the RMS last week, and three of the four finished the week in negative territory. Manufactured home REITs are also very defensive. Last week CPJ, MHC and SUI all lagged the RMS badly, with only SUI up (barely). Where else can we find very defensive REITs? Oh, yeah, neighborhood shopping centers. While most of these stocks were positive on the week, only KIM, FRT and JDN managed to beat the RMS while REG, WRI, PNP, IRT, NXL and DDR did not.

Is this price action a sign of a major trend reversal? Will investors be selling defense and going long offense? Will the healthcare, manufactured home and strip center REITs now begin a long trend of underperformance following their outperformance so far this year? Is it up, up and away for the hotels, offices, apartments and malls, all of which are more dependent upon healthy economic conditions?

My guess is that much will depend upon the STRENGTH of the recovery. It has rarely been smart to bet against a major trend reversal in the market, particularly during the depths of recession; the market almost always moves higher, discounting recovery, before we see improvements in the economic statistics. So I do think that we will get a recovery, particularly if we can prevent further terrorist attacks here in the US and if the war on terrorism doesn't sour on us. But the key to predicting which REIT stocks (and which sectors) will perform best over the next 12-18 months will be the nature and shape of the recovery.

A strong recovery would particularly favor hotels (for obvious reasons), apartments, offices and malls. In the apartment sector, an interesting question is whether owners of A-/B+ assets would fare better than B-/C+ properties in a strong recovery, i.e., do we buy Summit or Aimco? A strong economy, although goosing employment income, also causes rising home prices and interest rates, which could make luxury homes unaffordable or unattractive for many, and encourage the rental of upscale apartment units. But lower-quality assets would also benefit from rising occupancy rates in a strong recovery. A dampening effect on rebounding apartment REIT stock prices would be a resurgence in new apartment permits and starts; to the extent this happens, investors would need to be particularly careful about Southeastern/Southwestern apartment REITs where the barriers to entry and land prices are much lower. Houston could quickly lose its investment esteem when permits crank back up.

In any event, apartment REIT stocks would probably do just tolerably well in a weak recovery, as occupancy rates would likely hold or move up a bit, but rent increases would be puny � and development opportunities would be few. Manufactured home community stocks would probably just plod along regardless of how strong the recovery, but bad debt, occupancy and development issues would be much less of a concern, and so the risk premium for these guys would shrink � causing modestly higher stock prices. A weak recovery would particularly benefit this sector.

In retail, a modest recovery would favor virtually all the neighborhood shopping centers, but particularly those who develop, e.g., FRT, REG and WRI, as well as those mall REITs that don't develop extensively, e.g., SPG, MAC and even GGP. But a stronger recovery would be best for TCO, RSE, MLS and CPG, who specialize in upscale assets and who have extensive development pipelines. Big-box asset owners (e.g., DDR) would probably fare best during a modest recovery, taking advantage of price-consciousness among consumers. In a strong recovery, the relatively modest FFO growth rates of the strip center REITs might not compare well with the more levered and economically-sensitive mall REITs and thus probably wouldn't perform as well; however, some of the mall REITs have significant unhedged exposure to rising interest rates, and that could offset some of their perceived beauty.

In the office/industrial sectors, a strong recovery would favor the guys who either have substantial development pipelines in place, as a % of total asset value (e.g., BXP, KRC, HIW, CLI and DRE in offices, PLD, CNT and LRY in industrials), as well as others who are very proficient in development (e.g., CUZ, CRE and PP). It would also help those who specialize in 3rd party development (e.g., DRE, PLD, FR, etc.) On the other hand, a weaker recovery would offer fewer new development opportunities and thus tend to create better relative stock price performance for those REITs with less development orientation (e.g., EOP). A very mild recovery would also keep interest rates in check, thus favoring the high-yielders such as GL, BDN, etc.

Healthcare REITs are not apt to perform very well in a strong recovery, assuming that interest rates soar in that type of an environment. Today Nationwide Health shares yield 9.3%; if they were re-priced to yield 10.3%, this would result in a price decline of 9.7%, almost wiping out an entire year of yield. A modest recovery would probably mean better price performance for these REITs, but still perhaps underperform vs. the RMS index. Of course, a strong recovery would also tend to cause greater inflationary expectations and rising long-term interest rates, thus negatively impacting REIT preferred stocks � particularly the higher quality issues where "economy risk" was not priced in.

Storage? Hmmm�these companies have shown themselves to be recession-resistant, but are now priced to reflect those attributes. They are up an average of 38% in price this year, and all but SHU are trading at NAV premiums. My guess is that these stocks will underperform during a significant economic recovery, although SUS' exit from the scene could create some scarcity value in this suddenly popular sector. That said, I don't think that these stocks are grossly over-priced at the moment, and would look to buy more on any modest price dips.

Finally, I know that you will not take these speculations and suppositions too seriously; no one is able to predict the kind of economy we'll have next year, including of course this lowly poster. This is particularly so when there are so many unknowns and uncertainties out there, and consumer and business psychology is more important than ever. However, I thought that these ruminations might be interesting, particularly as the market seems to have made up its mind on the subject. The problem, of course, is that Mr. Market could change his mind and suddenly tell us, "Ha, ha, I was only joking." He sure made a mess of it in '99 and into 2000 when the likes of Priceline, Yahoo, Amazon and all the other Profitless Wonders were priced as though the "New Economy" was here to stay, no one would need offices or stores and real estate would become largely irrelevant.

As always, the most conservative REIT investment strategy is to be widely diversified, not only by property type and sector but also by business strategy and investment characteristics, perhaps shifting emphasis from time to time, depending upon how active we want to be in managing our portfolios.

Ralph

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