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By Reitnut
February 9, 2007

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It would be easy, looking at the price action of REIT stocks on Wednesday (when some retail REITs generated the return equivalent of almost two years in dividends in a single day), to come to the conclusion that those buying REIT stocks this week are cavorting in La-La Land.

And perhaps they are. The movement in REIT stocks these days certainly does reflect at least a modest amount of "heavy breathing." But perhaps there is also a bit of "method" in their madness.

The Blackstone/Vornado bidding war for EOP has turned more than a few heads, and has caused serious investors to revisit their cap rate assumptions when looking at their valuation models. Blackstone is far from an investment weirdo; they have a reputation of being a very savvy investor, not prone to overpaying for their acquisitions. And, of course, the very same can be said for Steve Roth. Accordingly, investors have marked down the cap rates used to value office REITs, causing these stocks to levitate.

But this realization hasn't, until very recently, filtered into other real estate sectors. Of course, cap rates for apartment assets have dropped significantly, commencing a few years ago, but sizeable cap rate compression has generally been limited to apartments and, now, to offices. Can investors be wondering whether retail real estate deserves the same treatment? Would that explain the 3-4% spikes in retail REITs such as GGP, MAC and SPG?

It sure could. Green Street's estimated NAV for, say, Macerich, is at $85.50, and is based upon company-average cap rates of 6% (nominal) and 5.3% (economic). So, the stock, at $102.20 as I write, is trading at an NAV premium of 19.5%. That would make MAC more than a tad expensive. But what if we adjust the cap rates we assign to MAC? The price paid for EOP's assets by Blackstone, at $55.50 per share, translates into cap rates for EOP's assets of 5.3% (nominal) and 4.4% (economic). And certainly not all of EOP's assets are located in hot markets such as Manhattan.

So would it be outrageous to think that Macerich's high-quality malls would trade, if exposed to the market, at an economic cap rate of 4.8%, which is 40 bps higher than that of EOP? After all, there is a lot of built-in NOI growth in the portfolio, malls are one of the most stable of all property types, and competition from new developments is very, very modest.

Applying an economic cap rate of 4.8% (rather than the 5.3% now being used by Green Street) would result in an NAV estimate for Macerich, using all of Green Street's other assumptions for the values of its assets and liabilities, of $102.69 -- suggesting that MAC's stock is now trading at an NAV discount. And this, of course, allows us to conclude that MAC stock isn't overvalued after all. A similar exercise could be used for other retail REITs with property of high quality in protected markets.

So it's certainly possible to conclude that REIT stocks are overvalued at the present time, and investors' emotions can justifiably be described as frothy; a couple of down-days should certainly be expected. However, if serious investors are today willing to accept initial returns of 4.4% on good quality commercial real estate assets and believe that internal rates of return on these assets over a period of a few years will be acceptable (perhaps something like 7.5% unlevered, as Blackstone and Vornado were apparently willing to do), well, perhaps today's buyers of the shares of the retail REITs with the best quality assets are not so crazy after all.

Anyway, something to think about before dumping all of our REIT shares.

Ralph


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