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Real Estate Inv. Trusts: REITs
Yesterday's Trashing

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By Reitnut
February 24, 2005

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Just a few comments about yesterday's trashing of REIT stocks (the RMS fell 2.6%, and was never able to stage a meaningful recovery, closing just six pennies off its low). It's always dangerous to try to explain market moves, particularly those of the short-term variety, but I think the explanation for yesterday's misery is fairly obvious.

One observer mentioned a "perfect storm" of negative news, and I think he was right on target. We suffered a 5.8% spike in oil prices (March delivery), along with an announcement that South Korea's central bank, with $200 billion in reserves, would be looking to diversify its holdings beyond the US dollar and dollar-denominated bonds. This, of course, reminded US investors that, due to massive trade and budget deficits, the health of our bond markets is largely dependent upon the kindness of strangers. And, of course, the 10-year T-note chimed in with its own version of the Bronx Cheer, closing at a yield of 4.28%, a level not seen since January 10.

Today it's not necessary to short individual REIT stocks to make a bearish call on our industry. As we all know, there are numerous other and more efficient choices, including iShares and other ETFs, which can be shorted in massive amounts and without waiting for upticks. And this is, I believe, what happened yesterday. It is no coincidence that almost every large-cap REIT stock declined by an amount of between 2% and 3%. Thus the decline has the fingerprints of "market basket sellers" all over it (the smaller cap REITs declined very little yesterday).

But this begs the question. Why did the hedgies and traders decide to make a bearish bet on REITs? A couple of reasons. First, interest rates. It is telling that "interest-rate sensitive" non-REIT groups such as utilities, homebuilders and banks all took substantial hits in the market Tuesday (e.g., is it just a coincidence that the Dow Jones Utility index fell 2.68% yesterday, a decline virtually identical to that of the REIT stocks?). It is also noteworthy that the healthcare REITs, which have traditionally been more interest-rate sensitive (for obvious reasons), fell more than their peers (healthcares were down 3.4% yesterday).

Another reason for yesterday's bearishness may have been the fear of permanently higher gasoline bills, resulting from the spike in oil prices. This, of course, would negatively impact consumers, and possibly bring about a slowdown in consumer spending. Consumer spending patterns could also be disrupted by a spike in interest rates, due to higher credit card interest charges, increasing payments on variable-rate home mortgage loans and even a "negative wealth effect" should rising rates cause a decline in the prices of single-family residences.

So, these are certainly things to worry about. However, Wall Street likes to predict the future every day, but gets it right only sometimes. Also, one frigid day, of course, doesn't make a nuclear winter. But I have cautioned at the end of last year that a big spike in interest rates would inflict pain upon REIT investors, and it seems that the 10-year doesn't even have to get to 5% for that to happen; indeed, the mere perception of a 5% yield is enough to send shivers down the spines of hair-trigger REIT investors (or, perhaps more accurately, hedge funds and traders).

Of course, nobody can predict short-term directions in stock or bond prices, and I have no intention of trying to do so. But we are two months into 2005, and thus far it's been a rocky year (total return, YTD, -6.2% for equity REITs, per NAREIT). Results for '05 may even stay negative, depending upon the behavior of interest rates and the US economy. But I cannot predict interest rates any better than the economists or market players, and I certainly am not going to predict whether yesterday's price action was a one-day wonder, or portents of more difficult days ahead. (As I write (10 am PDT), the RMS is virtually flat on the day).

Thus I continue to focus on the longer term, including the internal performance of individual REIT stocks (and, I will add, some REITs are doing quite well, based upon the results of this quarter's earnings season). Meanwhile, if we can assume no significant spike in cap rates (see my prior post), REIT NAV premiums have shrunk to about 2-3%, making the stocks cheap (on an NAV basis) for the first time in a couple of years -- but which is not to say that they cannot become even cheaper.

As always, and speaking from experience, I suggest it's imperative to keep our perspective, know why we own REIT stocks and keep our allocations filled. And what is the "proper" allocation? Pardon me while I don this suit of armor, mount my trusty steed and go off in search of the Holy Grail.

Ralph


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