POST OF THE DAY
Real Estate & REITs
Woes Still Haunt the Office Sector

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By Reitnut
October 21, 2002

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We've spent a lot of time on broad industry issues in recent posts, so how about a change of pace? Can we talk a bit about one particular REIT, and how it currently views the office markets?

Prentiss Properties (PP) is an office REIT that's moderately smaller in equity market cap than most of its more well-known office peers, i.e., $1.3B vs. $1.6B for Arden, $1.4B for Highwoods and, of course, much greater than that for EOP ($$12.3B), Vornado ($5.3B) and Boston ($4.5B). Yet, surprisingly, it has (according to Green Street) delivered the highest total return in the office sector during the three years ending August 2002. The reason, I suspect, is that management has done a very good job in capital allocation (PP was one of the first to cut back substantially on its development pipeline), has earned high marks for return on invested capital and has garnered an excellent reputation for "telling it like it is" with respect to office market conditions.

PP was the first office REIT to release earnings for Q3 and, for that reason and perhaps due to management's reputation as a straight shooter, the conference call drew a wide audience among the analysts. What PP said on the conference call has convinced me that the turnaround in the office sector is still likely to be a number of quarters, perhaps even years, away. Here are some of the highlights (or "lowlights") of the call. As I don't know how many of you own PP (we own it, but it's a small position for us), this summary will focus more on industry-wide conditions than company-specific issues.

The environment out there is "not very good...no signs of an immediate turnaround." Business is still sagging and deteriorating. "We had hoped for the beginnings of a turnaround after Labor Day, but so far we haven't seen it." GDP growth is less important to us than job growth, and so far we've not seen any of the latter. Speaking to an increasing worry in the office markets, management noted the underutilization of existing space; many lessees are willing to renew, but want less space than they presently have. They normally receive tenant requests to "downsize" the leased space upon renewal; they do not know if the frequency of this is increasing or holding steady. Another significant concern is tenant credit quality, though this is hard to quantify. (Last quarter we saw several office REITs express concern over some tenants, including WorldCom and others).

Capital expenditures are rising (no surprise there), and the gap between FFO and AFFO is widening. In Q3, cap ex was $2.44 sq/ft vs. $2.07 sq/ft, on average, for the first nine months of '02. There is intense pressure to find tenants, and very often PP had thought it had a new tenant, only to find that the tenant's existing lessor had lured it back with very generous terms. There are lots of commissions, TI's and even existing lease buy-outs that are being offered to prospective tenants in virtually all of PP's markets.

Prentiss reduced guidance for 2003, based on more negative assumptions for occupancy and rental rates. It now believes that rents will continue to sag for another 2-3 quarters, as well as further occupancy declines (100-150 bps) that they believe will bottom out in Q3 of next year. Rental rate growth won't resume, at least of reasonable size, for quite some time (management projects eventual rental growth of only 1-2%, beginning in'04), and pricing flexibility of owners won't return for some time. "We have two full years of plenty of available space ahead of us."

The company also believes that we've not yet seen significant reductions in FFO this year for most office REITs, due to certain FFO-goosing transactions, such as lease termination fees, lower interest rates and preferred stock repurchases. Next year, management believes, declining rents, increasing vacancies, flattish interest rates and the inability to continue to capitalize development costs will take their toll. PP's same-store NOI growth for 2003 will probably be negative but, thanks to its modest amount of lease expirations over the next 4 quarters, the decline will be in the modest 2-3% range. Some of this impact on FFO could be offset by a modest volume of acquisitions, particularly if cap rates move up a bit.

On the subject of cap rates and office property prices: They have not seen any abatement of interest on the part of pension funds to buy office properties. Deal flow has moderately increased in volume, and the market is very competitive � even somewhat aggressive. "Offers that we made, and thought somewhat aggressive, turned out to be too low," and "there is still lots of money out there looking for office assets." However, Mike Prentiss noted, there is a bifurcated market for properties. Those assets that are fully leased to good tenant credits are fetching very high prices, but all other properties are just not trading � so it's hard to get a handle on the pricing for assets with some warts on them. He adds that the "opportunity" funds are NOT doing what they advertise; they are merely buying well-leased buildings at high prices, and goosing their returns with 80-90% leverage. These guys are keeping prices higher than we think they should be, given the uncertainties out there.

With respect to specific markets, only DC (including No. Virginia), Southern California and Sacramento are not doing all that badly. Chicago feels as though it's bottomed, but the rest of PP's markets are in tough shape. The "oil belt" has been the most challenged of their markets, including Dallas, Austin and Denver, while the West Coast is holding up best. (PP's principal markets include DC/No. Virginia, Chicago, Dallas, Austin, No. Calif and So. Calif).

All of these negatives have caused Green St. to reduce its AFFO forecasts to $2.61 in '02, $2.57 next year and a modest 2.6% increase to $2.64 in 2004. Other analysts will cut their numbers this week. If there is any silver lining in this inclement weather, it's the sustainability of the $2.24 dividend. The company spent quite a bit of time on the dividend in the conference call, and suggested that occupancy would have to drop to 87% (after assuming a further increase in cap ex) before free cash flow would drop below the dividend rate. Office occupancy at the end of Q3 was 92%. At a closing price on Friday of $26.14, the current dividend yield is 8.6%.

Do you buy this stock at the present price? Certainly the dividend yield is excellent, and well above that of the typical REIT. And it is also likely sustainable, absent a serious downturn in the economy and a major new round of job cuts. However, the low earnings growth visibility for the next two years may discourage all but the most patient (or yield-hungry) of investors. And, unlike many of its peers, the current NAV discount (5% to 10%, depending upon whose numbers you're looking at) is somewhat less than that of its peers � though perhaps justified.

The bottom line, for me anyway, is that this management has, for the past few years, done a very good job running this company and communicating with investors; while early actions following the IPO were more questionable, more recently it has taken actions to reduce risk well ahead of the crowd, and has been pretty careful about its allocation of capital. I think Prentiss remains a solid holding, particularly for those looking for above-average yield, but the stock could be dead in the water for a while with respect to price appreciation. But, then again, we might say the same thing for most of Reitdom for the next 12 months or longer. For what it's worth, I like this company � and the current stock price � and am holding on to my personal position and may add more if the stock drops a bit more. These are, of course, just one guy's thoughts � for what they may be worth.

Ralph


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