The Essential REIT
Real Estate Inv. Trusts: REITs

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By Reitnut
March 28, 2007

Posts selected for this feature rarely stand alone. They are usually a part of an ongoing thread, and are out of context when presented here. The material should be read in that light. How are these posts selected? Click here to find out and nominate a post yourself!

I am posting "The Essential REIT" on this board for the last time. However, for those of you who, for some reason, enjoy reading it, there is good news. Anatole Pevnev, the widely-regarded REIT expert who has created the fine REIT website, REITcafe, and I have agreed that "The Essential REIT" will be regularly and timely posted and available on the REITcafe website, Email service will also be available, and older copies of the newsletter will be archived and available there.

Furthermore, Anatole is setting up a "blog" function on his website, so that anyone can post comments, suggestions and, of course, criticisms of the newsletter -- and is expected to be fully operational in a few days. This arrangement is expected to help me make more efficient use of my time (after all, I am supposed to be "retired)." :-)

Finally, of course I will continue to post regularly on our Motley Fool REIT board, as I have in the past. I very much enjoy the dialogue and the friendship; this has been, and always will be, a very special place for me.


The Essential REIT

March 26, 2007

"Be who you are and say what you feel, because those who mind don't matter and those who matter don't mind." - Dr. Seuss

"An author is a fool who, not content with boring those he lives with, insists on boring future generations." - Charles de Montesquieu

"Writing is like prostitution. First one writes for the love of doing it, then for a few friends, and, in the end, for the money." - Moliere

Preliminary Note: Many, perhaps most, of you are familiar with Anatole Pevnev, a long-time and widely-respected REIT veteran, and proprietor of the excellent website, REITcaf� - I have known Anatole for a number of years, and am delighted to announce that, beginning with the next issue, REITcaf� will distribute and e-mail The Essential REIT to all subscribers. You need not do anything, as I will provide REITcaf� with all of your e-mail addresses.

We will also soon be launching an Essential REIT blog on the REITcaf� website, which will include archived issues of the newsletter; go to The blog will allow for your posting of comments, criticisms and observations on topics covered by the newsletter. Check out the entire REITcaf� website; there are lots of wonderful resources there for the REIT investor.

1. "Sector, Sector, On the Wall..."

....Who's the fairest of them all? One of the greatest challenges in Reitdom is to guess which REIT sectors will perform best over the next several quarters. This may be merely a game to long-term patient REIT investors who are happy with their diversified REIT holdings - but is serious business to certain institutional types and portfolio managers who must, like some well-known sports star, continually prove to others his ability to embarrass his peers with feats of derring-do.

And it's very difficult to win consistently. Yes, it's possible, at times, to shoot the lights out by plowing heavily into, say, hotels, on the eve of an outstanding and spectacular run. But, all too often, the reasons for such outperformance are known only with hindsight, and even superior growth in FFO or same-store NOI doesn't necessarily translate into industry-beating stock returns. Changes in the space and capital markets are often reflected in REIT stock prices well before they come to the surface - and sometimes investors just don't react to them.

In my former life at Bay Isle and Phocas Financial, our REIT portfolios performed quite well over a number of years; but we accomplished this without attempting to place heavy bets on any sector. Humility is usually a virtue and, as asserted in one of Clint Eastwood's "Dirty Harry" movies, "A man's gotta know his limitations." So must investors.

So, with that long-winded rumination out of the way, let's take a quick peak at the performance of a couple of the larger REIT sectors as we near the end of the first quarter. At March 16, 2007, the "average" equity REIT, per NAREIT data, had delivered a total return in 2007 of 3.86%. Let's fix that as our benchmark for purposes of this discussion.

Most sectors, e.g., office/industrial, didn't dazzle us with their outperformance, nor did they embarrass themselves. A few smaller sectors, such as healthcare and self-storage, fell behind, but not by much; if they move as fast as Sammy chasing a tennis ball, they can make up lots of lost ground. But a few large sectors stand out, including retail and lodging, on the upside, and apartments, on the downside.

Retail, as a group, was the clear stand-out, scoring a very impressive total return of 9.8%, while lodging did almost as well, generating an average total return of 7.1%. Apartments, however, had to sit in the corner and eat worms; they were negative by -2.5%. Although I continue to think the hotel REITs are undervalued, and we may see some further buyout activity here, I would like, in the interests of space, to talk about just the retail and apartment sectors.

Retail was led by the mall REITs, with an average total return of 14.0%; their brethren "strip center" REITs (no, these do not own properties at the edge of town, at which exotic dancers lap dance) were up 6.3%. It would seem that, despite the death sentence some have imposed, the indefatigable American consumer remains alive and well. Neither high gasoline prices, nor the end of the housing and refinancing bubbles, nor weak consumer confidence numbers, have stayed these hardy souls from their appointed rounds at the shopping mall.

Retailers (and their balance sheets) are in good shape despite their ubiquitous discounting practices, and they continue to seek to placate the Gods of Earnings Expectations by looking for new space in well-located venues. The mall owners, in particular, continue to enjoy stable and healthy same-store NOI growth (thanks to substantial imbedded revenue growth as old leases expire and are marked to market), and the supply of new centers hasn't, in most markets, created pressures on occupancy or rental rates.

Equally as important, cap rates for quality retail properties haven't compressed to the degree we've enjoyed in the apartment space or, more recently, office properties. Mall cap rates, while difficult to determine due to limited transaction volume, probably average a bit below 6%, while those for strip centers are a tad north of that. Conversely, apartment caps have, on average, been below 5.5% for some time, while office caps, thanks to recent high-profile transactions, have plunged recently, and some believe that they've been shoved down below 5% in major higher-barrier markets (in Manhattan, of course, caps are barely above the rate of inflation).

So, despite having generally outperformed their peers from 2002 through 2006 (malls underperformed only last year, while strip centers fell short only in 2005), retail REITs seem to be at it again. FFO growth, while not spectacular, should remain solid, and valuations are more reasonable here. Despite worries about spreading consumer malaise due to contagion from the sub-prime lending fiasco, retail sales are still growing (albeit a bit more slowly now). Even lowly Mills, thanks to a pending buyout, has brought smiles to the faces of its long-suffering shareholders in '07. Retail will continue to perform reasonably well this year, absent an unexpected trashing of the US economy.

But the performance of apartment REITs has disappointed their champions. We've seen some of the very best same-store NOI growth in this sector in recent quarters, and most markets are strong enough to enable these fellows to continue their leadership in this all-important department. Expect SS NOI growth for this year to come in at something like 6.5%, based upon management guidance, and 2008 may be almost as good. AFFO growth for this year will be above-norm, at something like 8-9%.

So why have these wealthy and privileged pups been driven by market forces to eat Ken-L-Ration and to hang out in dilapidated doghouses? There could be several factors at work here. First, today's stock market is being driven, as never before, by traders and momentum types, who are apt to blow out their shares at the first signs of earnings growth deceleration; the hotel REITs suffered a massive 1200 basis point underperformance last year, perhaps because RevPar growth was perceived to be topping out.

Also, many institutional types are convinced that the busted bubble of Condomania will result in many more units being tossed onto the market over the next several quarters, thus creating a bulge in the supply of units that will compete with existing apartments. Third, others may believe that, due to the fallout from a steadily declining housing market, the economy, later this year, will become weaker than a sub-prime lender's balance sheet, and this, in turn, will result in very anemic job growth (one of the primary drivers of apartment demand).

These worries are overblown, and those barfing their apartment REITs today won't feel better tomorrow morning. While same-store NOI growth will taper off next year, it will remain well above average for another 12-18 months, and then slowly moderate. Despite the decline in home prices, housing affordability remains at low levels, and the bloom is off the rose regarding the home-buying mania. There will be plenty of new units being offered for rent by hapless condo speculators, but that will have only a marginal effect in some markets (Camden put on a powerful case for this in its most recent conference call). And there appears to be no sign of upward pressure on apartment cap rates.

Apartment REIT stocks have dug themselves a pretty deep hole performance-wise, but I think they are, as a group, quite attractively priced at the present time. Now perceived as dogs, these critters will bite their short-sellers in their collective butts. (And Sammy says, "HOO-WAH!").

2. Revisiting an Old Dilemma.

Perhaps a key argument in the bears' case against REIT stocks is that, for some time now, REIT earnings multiples have been higher than those of other equities. Today the average 12-month forward P/AFFO multiple for your average REIT is, depending upon whose estimates one looks at, somewhere around 26x. For the S&P 500 stocks, it's about 15x. While we all understand that comparing S&P 500 companies' P/E ratio to the REITs' P/AFFO ratio is a bit like comparing a T-bone steak to Chilean sea bass, the bears can legitimately ask two questions:

(a) Is it logical that REITs' multiples are higher than that of their bigger brothers', when earnings growth is apt to be higher, over time, for the latter? And (b) How can this large negative gap be justified when, throughout recorded market history, REIT multiples have always been lower than that of other stocks? And it's not just the bears who've been asking these questions. Green Street Advisors, the pre-eminent REIT research house, has, for a substantial period of time, been troubled by this conundrum, and continues to believe that REIT stocks, while probably fairly priced relative to commercial real estate, are expensive relative to S&P stocks.

This contention has been pressed for some time; yet, as in that old Charles Atlas comic book advertisement, the scrawny REITs have continued to kick sand in the faces of their larger S&P brothers. This might just mean, of course, that REIT stocks have been mispriced for a few years - but it may also signify that something has changed with respect to investors' collective perceptions of REIT stocks (and, of course, the commercial real estate whose values drive REIT stock pricing). Why might this be? And is it logical? Should we expect that hoary investment principle, "reversion to the mean," to exert its power upon REIT prices relative to S&P 500 stocks?

My legal background, together with my temperament, have taught me to see all sides of every issue and to seek humility in all prognostication endeavors. Accordingly, I cannot answer these questions with any degree of conviction. However, there may be several (and at least quasi-rational) forces at work that have, collectively, resulted in significantly higher earnings multiples for REIT stocks than for S&P 500 stocks, and these forces may remain in effect for some further period of time (note that I do NOT say "forever").

One might be that we are on the eve of a period of sub-par earnings growth for the companies that dominate Corporate America. A recent (and very thoughtful) missive from JP Morgan strategist and Chief Investment Officer Michael Cembalest includes the following comment: "...we have firmly entered the single digit era for equity and other risky asset returns. Going back to January 2005...the S&P 500 is now up 8.5% on an annualized basis." His forecast for equity returns for this year is just 7%. He suggests, as reasons for these subdued prospective returns, "rising labor costs, flat yield curves and their impact on spread-lending commercial banks, falling top-line revenue growth, less contribution from energy revenues, and other non-wage related expense increases." As if to confirm these cautious thoughts, consensus earnings growth for the S&P 500 companies for Q1 of this year, per Thompson Financial, has fallen to just 4%.

Further, because a good case has been made by Green Street Advisors that, over time, REIT stocks tend to be priced off of prices in the vast commercial real estate markets, and because REIT stocks today bear only modest premiums over estimated NAVs, the earnings-multiple bears must show that investors' expected returns from commercial real estate assets are either unachievable or not competitive with the risk-adjusted returns available on other asset classes. And this may be difficult for them to do. Jacqueline Doherty, in a recent Barron's article panning the valuation of AvalonBay Communities, didn't even try.

Based upon today's (albeit historically low) cap rates and the solid prospective NOI growth that investors reasonably expect (absent a recession), those who crunch numbers on sophisticated spreadsheets have concluded that a buyer of a quality apartment community, office building or shopping mall will be able to generate an unlevered internal rate of return (IRR) in the neighborhood of 6-7%, and with only modest risk. If that's achievable, this type of return is reasonably competitive with the 6% returns on investment grade long bonds, and 7-8% available on stocks. So if investors in commercial real estate remain as happy with these returns as Sammy is in the after-glow of a long walk, there will be little pressure on cap rates or valuations, and REIT stocks can continue to trade, for some further period of time, at current earnings yields and P/AFFO multiples - even if S&P 500 multiples remain mired in the 15-17x range.

And there may be another issue at work these days that is causing REIT earnings to be more highly valued than the earnings of the big non-REIT companies. This has to do with the reinvestment of retained earnings in Corporate America. We all know, of course, that a key issue for investors, certainly with respect to the pricing of common stocks, is the use that is made of retained earnings. The P/E for a company that's able to reinvest retained earnings at a return exceeding its weighted average cost of capital will, all else being equal, be higher than for a company that cannot or will not do so. REITs, of course, have a similar issue, but the parameters (how I hate that word!) of discretion are much more narrow, due to the constraints of REIT laws (requiring that at least 90% of earnings be distributed to the shareholders).

So it may be relevant to ask: Are S&P 500 companies doing a good job of reinvesting the retained earnings that are not being dividended out to their shareholders? Are they using retained earnings in a way that maximize shareholder value? If not, then perhaps their shares deserve to trade at more modest multiples of earnings - perhaps lower than those of REIT organizations who may be doing a better job of deploying retained earnings.

I don't have the tools that I would need to make an assessment of how effective major corporations are in their capital allocation process. However, in one area, at least (and in my opinion), they are sadly deficient: they aren't sharing enough of their retained earnings with their shareholders. I look at this all-important issue in a fairly simple manner: If a company's expected returns on newly-invested capital, determined in a sober manner, are apt to be less than scintillating - perhaps because of difficult industry conditions, substantial competition, uncertain unit selling prices, or whatever - that company ought to be dividending out a substantial portion of its earnings to shareholders (assuming those earnings are real, and not some type of GAAP voodoo).

But that's not what's happening in Corporate America today. Since 1926, dividends have provided over 40% of the S&P's total returns. But do corporate managements care? Despite a current maximum tax rate of 15% on "qualified" dividends (vs. 38.6% previously), most companies outside of REIT world seem to believe that substantially boosting cash dividends is like giving away one's first-born son or daughter. Despite the very low tax rate, record earnings and peaking profit margins, US corporations continue to be stingy with their cash. According to S&P index analyst Howard Silverblatt, "While 2006 produced 12% more in actual dollars paid to shareholders, the number of dividend increases actually dropped 2.3%." And lots of cash is sitting idle on corporate balance sheets (Microsoft is wallowing in $26 billion in cash).

We can observe some very egregious, perhaps even nauseating, examples of stupid dividend policies. Dillard's Inc., which owns and manages middle-market department stores across the US, is expected to earn $2.09 in its current fiscal year, but pays out only 16 cents. Is Dillard's a true growth story? Hardly. Five years ago the stock traded between $25 and $30; today it trades at $33, or a market-type multiple of 15.8x.

And what about the oil and gas E&P companies? These bozos are stingier than Scrooge McDuck when it comes to dividends. Despite the fact that oil and gas is becoming as difficult to find as a mean Golden Retriever, and finding costs have increased significantly (in the case of natural gas, above the price of the commodity ), these companies are using almost all their cash flows to punch new holes in the ground. Take Anadarko (APC) as an example; it will earn $3.67 this year (even more in cash flow), yet it pays out just $.36 to investors (the stock yields less than 1%). I suppose the rest of our return is supposed to come from capital appreciation. If so, APC shareholders may be waiting for Godot.

I don't mean to pick on Dillard's or Anadarko; we can find hundreds of examples of corporations with mediocre track records and lackluster growth prospects paying out less than 20% of their earnings in dividends. My contention is that this, all too often, runs contrary to the creation of shareholder value, and perhaps is one reason why REIT stocks are trading at higher multiples than S&P 500 stocks.

But wait - aren't these companies using much of their retained earnings to buy in stock, rather than boost cash dividends and payout ratios? And isn't this a better use of a company's retained earnings, as it will goose net income per share?

NO! While professorial types and their acolytes may contend that it doesn't matter whether a company buys in stock or pays out dividends, there are some very practical differences that make the former a poor substitute for the latter. Buybacks can be announced but not carried out. They can be terminated at any time, for any or no reason. They may merely offset the dilution from stock options (and, by the way, management option holders normally don't benefit at all from cash dividends). Buybacks are often implemented even when the stock trades at a price that provides the company with a very low return on its investment. Further, the increased earnings per share may not create higher stock prices or capital appreciation for the shareholders. And they suggest nothing regarding the management's belief in long-term earnings stability, and provide no income stream on which the shareholder may reasonably rely.

"If you are a stock investor, do you like to see a big debt-financed share-buyback? I'm not sure. Mathematically, it improves earnings per share, but does it actually help a stockholder? I don't know. Federated, for example, announced a $4 billion stock-buyback today and got downgraded because of it. What's the stock doing? Nothing." - Carol Levenson, "Gimme Credit" (as quoted in Barron's March 12, 2007).

Valero Energy (VLO), another dividend Scrooge, continues to buy in its stock. But investors haven't reacted to these buy-back announcements; the stock levitates only when business prospects appear to be improving, e.g., when the "crack spread" or RBOB futures soar. Conversely, on December 12, US Bancorp (USB) raised its dividend by 21%, creating a dividend yield of 4.65%. The stock spiked 3.5% on the day of the announcement, and was up 6.7% over the next few trading days.

I am certainly not suggesting that corporations ought to distribute most of their income in dividends. However, I do believe that, generally speaking, US corporations aren't generous enough in their dividend policies, and that stock buybacks, while appropriate in some circumstances, are no substitute for a reasonably generous dividend policy. One need not agree entirely with Rob Arnott's study, in which he has tried to show that, both here and in other countries such as Australia, companies with higher dividend payout ratios tend to generate faster earnings growth and deliver stronger total returns to shareholders, to wonder whether today's payout ratios are lower than they ought to be.

And, if that is what investors are thinking, perhaps this, along with the other factors noted above, might explain why S&P 500 stocks are being assigned lower multiples than REIT stocks. Most management teams and Boards of Directors continue to pray at the Altar of Stock Buybacks, and earnings per share growth seems to be the name of the game in the stock market. But the investment world remains a puzzling place, where, as suggested by Lewis Carroll's grinning Cheshire cat, things are becoming curiouser and curiouser, and are not always what they seem.

Best regards,
Ralph (Block)


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