Real Estate & REITs
The Essential REIT

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By Reitnut
June 2, 2004

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Well, better late than never...this is part I of the most recent "Essential REIT" ...part II will be a REIT quiz:


The Essential REIT
Formerly known as
May 26, 2004

"There is nothing more frightful than ignorance in action." --
Johann Wolfgang von Goethe

"Life is a long lesson in humility" �
James M. Barrie

"A fanatic is one who can't change his mind and won't change the subject"- Winston Churchill

1. "The Last Shall Be First" � But for How Long?

Three weeks ago, at the end of the last issue of The Essential REIT, I threatened to tackle several REIT investment issues that, had I done so, would have expanded this bizarre little publication to well over five pages; and five pages, given my loyal readers' tolerance for pain, has always been more than enough. But now let's plod on, shall we?

One question I asked myself � but did not answer � was: "Should I move more of my REIT holdings from retail to the apartment sector? That's what the sell-siders have suggested that I do." This question, which Green Street Advisors has called "The Trade," isn't new to Reitdom. Indeed, because we veteran investors know that all investment performance reverts to the mean, we have been wondering when the apartment REITs, those 87-pound weaklings of Reitland, would finally get up off their butts, brush the sand out of their trunks and beat the crap out of those tormenting, muscle-bound beach bullies (aka the retail REITs).

87-pound weaklings indeed! The "residential" sector of the NAREIT index, which is dominated by the apartment guys (as of May 1, the manufactured home communities were only 6.7% of NAREIT's "residential" sector), has, in recent years, been as weak as ABC's Nielsen ratings. They have badly lagged REIT industry performance in each of past three years (though they did much better in the previous two).

2003 2002 2001 2000 1999
NAREIT Equity Index 37.1% 3.8% 13.9% 26.4% -4.6%
Residential REITs 25.9% -6.0% 9.0% 34.3% 9.5%
Retail REITs 46.8% 21.1% 30.4% 18.0% -11.8%

Therefore, just as we all know that investments revert to that golden mean (as the retail REITs did in 2001 vs. all other sectors), we know that residential will, once again, outperform retail, right? Indeed, no less an illustrious personage than Sam Zell recently noted that, "Usually, in recoveries, apartments are first. I wouldn't expect it to be any different this time, and so I would suggest that the basic fundamentals of the apartment business are likely to improve significantly over the next 18 months."

And, if recent trading activity is an indicator, this reversion to the mean has already begun. As I write, the total return of the NAREIT equity index, year-to-date through May 21, is �3.44%. The residential sector, having lagged through the first quarter, has been shooting the lights out recently and is now well ahead of the index, with an average total return of -1.65% and outperforming the index by 179 bps. (Retail continues to perform reasonably well on a YTD basis after its strong Q1; at -2.83%, it's pretty much in line with the NAREIT equity index, but has been particularly weak since April 1).

Certainly there is good reason � aside from reversion to the mean principles � for the performance of the apartment stocks to perk up. The troubles in the apartment sector have persisted for so long and become so well known that they have been likened to another hackneyed expression, "a Perfect Storm." Even REIT newbies know that: (a) apartment dwellers have been finding it easier to buy a home (new or used) than to buy a microwave oven, (b) job losses over the past couple of years have cut heavily into occupancy rates and induced across-the-board concessions from all apartment owners, and (c) due to the insatiable demand for apartment properties from everyone who has realized (finally) that he/it is under-weighted in commercial real estate, merchant builders have been churning out new apartment units as if they were microchips, resulting in no drop-off in supply despite weak tenant demand. Rising interest rates, accompanied by strong job growth, will cause that Perfect Storm to leave our shores and head for Nova Scotia.

So what should we REIT investors do? Should we bail out of retail REITs and pour our resources into the residential sector? This strategy has been advocated by many performance-minded characters who aren't content with REIT-like returns, and feel the competitive need to do even better. They suggest that, in retail, it is now "as good as it gets," and claim:

(a) That the consumer is over-burdened with debt and, given the abatement of the purse-opening effects of last year's tax cuts, will be forced to reduce their retail spending;
(b) That rising interest rates, spiking gasoline prices, the grim news from Iraq trumpeted every day by frantic anchormen, and another in-your-face presidential election campaign will turn the consumer into a sour-faced, closed-fisted wretch and/or couch potato, unwilling to spend time at the local mall or even the neighborhood shopping center;
(c) That retail REITs, particularly the malls, are more exposed to rising interest rates than are other REITs, due to higher leverage and a bit more variable-rate debt; and
(d) That even if the retail sector of the economy holds up, the cash flow growth of the apartment guys will be accelerating, while retail property owners' growth will be abating � and today's market couldn't care less about values or profit levels, having eyes only for earnings momentum.

None of these claims are unreasonable, and might possibly be true. And, speaking of momentum, the apartment stocks are already demonstrating that lovely characteristic. So what are we waiting for? Hop aboard � the train's leaving the station �retail is so ten minutes ago!

But, unfortunately, the world ain't that simple. Although it seems clear to almost everyone that market conditions are about to improve for apartment owners while retail owners aren't likely to see accelerating growth rates, I have some issues concerning the extent of the apartment sector recovery, whether its earnings growth will catch up to that of retail property owners, and with respect to current valuations.

We do know that mortgage rates are up, and that job growth has been improving. This, of course, will help apartment owners. But we don't know by how much mortgage rates will rise. So far, they're up about 75 bps, to 6.3%, on average. But will that discourage those who regard home ownership as something akin to euphoric bliss? For a $250,000 mortgage, and assuming a buyer in the 33% tax bracket, the mortgage payments, at 6.3%, will be only $100/month higher, after taxes. Cut out two movies per month with the family and you've almost made up for it.

This extra burden may not discourage enough buyers to make a difference, particularly as many of them don't seem to have any fear or loathing of variable-rate loans (judging by recent statistics showing that mortgages of the floating rate kind have become increasingly popular with "What, Me Worry?" home buyers). My guess is that, while certainly beneficial, today's somewhat higher mortgage rates won't help the apartment owners a lot unless they spike significantly higher � to, say, well over 7%. Can that happen? Sure � but that's certainly nothing that we can put in the bank.

Let's now talk about AFFO growth rates. We remain in murky waters here. About all we know for sure is that many apartment markets seem to be in a sort of "bottoming process" (though the cynics might claim that the markets have sunken slowly to the bottom of the Mississippi River and will have a hard time extracting themselves therefrom). Many markets remain weak and still show no real signs of improvement. Take a look at EQR's results for Q1; Atlanta, Dallas and Houston, among the "usual suspects," each suffered NOI declines of over 8%. But let's be optimistic and assume that NOIs and FFOs for most apartment REITs will flatten by Q4. We still must guess at the extent of the improvement in NOIs for 2005, which is when most expect the apartment REITs to generate some very strong growth rates.

But 2005 is still quite a ways off, and crystal balls are opaque. What will the US economy look like then? Will interest rates (and mortgage rates) be higher or lower? If flat or lower, why won't the American public continue to favor owning at the expense of renting? Will the politicians continue to encourage the expansion of "affordable" home ownership to every nook and cranny of every US city? Even now, thanks to Aunt Fannie and Uncle Freddie, quasi-bankrupts can get zero-down mortgages just for the asking. Will Iraqi and terrorism issues, higher gasoline and natural gas prices and other uncertainties derail the strengthening economy and cause job growth to flatten, thus causing abatement in household formations? Will developers continue to be besieged with buyers for newly completed communities, and thus continue to put sticks in the ground at perhaps even an accelerating pace despite somewhat higher interest rates? These are all questions to which I have no answers, but they tend to suggest, to your humble author at least, that loading up on apartment REITs may not be the slam-dunk that has been suggested.

Finally let's talk about valuations. According to the estimate of Green Street Advisors, cap rates on apartment properties have dropped 200 bps over the past two years; this is a larger drop than in most other sectors. Indeed, the spread between apartment cap rates and Baa bonds has been narrower in the apartment sector than in others. This seems to be a pretty good argument for the proposition that a recovery in the apartment sector has already been priced into apartment assets. One quarter ago, Green Street made the point that investors were dubious of the sustainability of these low apartment cap rates, as the apartment REIT stocks were trading at much smaller NAV premiums than were being awarded to non-apartment REIT stocks at that time (8.4% NAV premium vs. 16.1% NAV premium).

That, however, has changed dramatically due to the outperformance by the apartment REIT stocks in Q2 of this year. Apartment REIT stocks are now trading at an average NAV premium of about 2%, compared with 3% for other REIT sectors, and perhaps there is more upside risk in apartment cap rates than in other sectors. Where are the bargains? Sure, apartment REIT stocks could continue to outperform even from today's pricing levels. However, further meaningful outperformance would seem to require that a large slice of prospective homebuyers be kicked out of the market, while job growth would have to remain very strong well into the future � and, perhaps, new apartment supply would have to be ratcheted back at least modestly. Apartment owners could possibly generate higher NOI growth rates than in other real estate sectors beginning late this year, but that may not be sustainable beyond a 12-month period � and, more important, current cap rates and apartment REIT stock prices may already discount those prospects.

On April 2, a "window of opportunity" to allocate more assets into the residential sector of Reitdom opened up, but that window closed faster than an Anchorage sunset in December. The sector now seems fairly valued to me; however, while I wouldn't bulk up on residential REITs beyond one's benchmark weighting, I don't think that performance-driven REIT investors (who seem to be more prevalent than cicadas these days) ought to risk being substantially underweighted in them either. As long as we see interest rates trending up, on both the long and short ends of the yield curve, and as long as we are enjoying job creation numbers that make President Bush smile from ear to ear, i.e., something like 325K+ per month, then prospects will, indeed, improve for owners of residential real estate, and they will no longer be 87-pound weaklings that the REIT industry will be ashamed of.

But let's be careful out there: The recently improved stock price performance in this sector has a lot to do with the economic statistics that have poured out of Washington governmental agencies during the past two months, along with the sharp jump in interest rates. Should we see any signs of these new trends reversing � or even flattening � the same guys who couldn't get enough apartment REIT shares since April 1 may decide that they have too many � and may commence to barf them quicker than Sammy can snag an errant tennis ball. And, meanwhile, despite some longer-term concerns, I see nothing preventing the retail REITs from growing AFFOs at 6-7% for at least another 12-18 months. Apartments may indeed outperform going forward, but perhaps it's fair to question whether moving out of retail and heavily into apartments at the present time makes a lot of sense when risk is accounted for. As is usually the case, balance is golden.

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