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The REIT Malaise
Board: Real Estate Inv. Trusts: REITs

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By Reitnut
May 22, 2007

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Last Friday, May 11, the RMZ closed at 1115.24, where it was up a modest but respectable 2.3% for the year. This morning, as I write, the RMZ is at 1048.11 and again sinking fast. So, from last Friday's close through the present date and time, less than five trading days, the average REIT stock, represented by the RMZ, has been trashed 6.0%. Meanwhile, from last Friday's close through early this morning, the S&P 500 index was up 1%. The big S&P500 bully is, for the first time in many years, kicking sand in REITs' faces. Year to date, the typical REIT is off 3.9% (price only), seemingly on its way to the first negative year since 1999.

All right, what's the problem? Obviously, there must be a problem; otherwise the RMZ wouldn't be down 6% in less than five trading days. Certainly we know that no asset class is risk-free, other than T-notes, and REIT stock performance has its own set of risks (some of which are shared with the broader market). These include, in no particular order:

(a) a weaker economy and poor job growth, which would pressure rents and occupancy rates; (b) rising interest rates, which would cause investors to reduce valuations and pressure operating margins (REITs are capital intensive and thus major borrowers); (c) over-valuation, which would cause REIT stocks to decline simply by the application of the laws of gravity; (d) rising cap rates and falling prices for commercial real estate, which would negatively impact REIT NAVs; (e) weakness in commercial real estate markets, which would impact growth prospects; and (f) money flowing out of REIT stocks in order to buy "what's working," i.e., asset reallocation away from REIT stocks. Let's look at each of these.

a. Weak economy? Certainly there are issues involving the US economy. Job growth has slowed, GDP was up only 1.3% in Q1, the sub-prime wreck and high gasoline prices threaten consumer spending growth, and inflation remains a concern of the Fed (and investors). But the preponderance of economists, including Fed Chairman Bernanke, don't believe a recession is in our future. Recent data suggest that factory output and utilization rates are increasing; claims for unemployment benefits are at their lowest levels since January; and yesterday JC Penny, Nordstrom's and Kohl's reported better than expected financial results. Perhaps most important, the rise in the S&P 500 this year belies an impending recession that would pinch owners of commercial real estate. So, no, it's not an impending wreck in the US economy that's been killing REIT stocks.

b. Rising interest rates? This issue is a non-starter. The 10-year T-note ended 2006 at 4.71%, and was 4.67% last Friday. This morning the yield is 4.76%. Yawn. Meanwhile, as Pimco's Bill Gross admits with a red face, spreads over T-notes have widened only slightly this year, suggesting that debt obligations of issuers other than governments are not being penalized in the market. As for short-term rates, the Fed has been on hold since last August, and the chances of an interest rate boost are as likely as a cut. A final point here: Historically, interest rates have had very little correlation with REIT stock performance.

c. Overvaluation. Aha! The chickens are coming home to roost! But wait! If REIT stocks have been so overvalued, why haven't they tumbled before now? The issue with REIT stock valuation today relates not to values in the commercial real estate markets, but rather their valuations relative to other asset classes. The average REIT stock today trades at an NAV discount of approximately 6-8%, so overvaluation relative to private market real estate values isn't an issue. Yes, REIT stocks could be overvalued relative to stock and bond markets, certainly when compared with historical norms. But, if this is so, why haven't REIT stocks collapsed until now? This issue has been bandied about for months - in fact, all the way back to the beginning of last year.

I continue to maintain that REIT stocks are not overvalued today, either relative to private commercial real estate (which is why so many REITs have been bought out by private players such as Blackstone) or stocks or bonds - especially when adjusted for risk. I have posted often on this topic, and either I was right then and am still right today, or I am still wrong - but nothing in the past week has changed any of that.

d. Rising cap rates? What about rising cap rates and falling prices in the vast private real estate markets? About all I can say on that point is that this topic was one of the most talked about in REITs' Q1 season of earnings conference calls, and there are no signs of upward movement in cap rates (with the possible exception of self-storage assets). Indeed, there is even evidence that cap rates may have a bit further to fall in the retail sector. This can change, of course, but REIT NAV estimates at Green Street Advisors remain firm and stable, and they spend LOTS of time on this.

e. Real estate market weakness? So perhaps the culprit is weakness in commercial real estate markets? Earnings season only ended about a week ago, so how REIT organizations are faring at the property level is fresh in our minds. The all-important same-store net operating income (NOI) figures let us know how the space markets are faring, and there were no significant negative surprises. Yes, as anticipated, apartment NOI growth is slowing from its torrid pace of last year, due to tough comparisons and somewhat weaker employment growth - exacerbated in a few markets by desperate condo speculators putting units onto the market. But, the worst that's happening here is that growth is slowing to a level that's still above historical averages. Much, of course, depends upon the US economy.

NOI growth is still strong in other sectors as well. Office vacancy rates continue to come down, albeit with somewhat lower rates of space absorption. Market rents are still rising, and owners are offering less concessions. Like offices, industrial space continues to generate better NOI growth than last year, and prospects look as good as ever (helped by increasing flows of goods in global commerce).

Even in the retail space, NOI growth remains very solid, thanks to growing embedded NOI growth from healthy retail sales over the past several years and the long-term leases that defer most of this benefit for property owners over a period of several years. Even in the cyclical hotel space, RevPar growth is coming in at expected levels despite the oft-claimed "consumer woes." And healthcare real estate is in as good a shape as it's been in the past several years. Excessive new supply? There is an uncomfortable amount of it in a few apartment and office markets but, compared with historical levels of supply nationwide, this is not a concern; and certainly nothing has caused it to become one during the past week. No, if we are searching for the reason(s) for a REIT trashing, it must come from somewhere other than deteriorating space markets.

f. Money flows out of REITs. Now here, I think, we may have found our culprit. Ever since what happened in the late 1990s, when money was flowing out of REIT stocks because "we can get much higher returns in techs and dotcoms," I have been aware of the fact that REIT stocks compete for capital with other asset classes. This has been particularly true over the past five years, considering that REITs are now in the S&P 500 and most other benchmarks. Simply put, non-dedicated REIT investors have been looking at, and owning, them - if for no other reason than to avoid getting fired if not owning REITs causes a fund to fall behind its performance bogey.

This phenomenon, of course, is both good and bad. It's good in the sense that most investors are now aware of REIT stocks, and a large portion of broad-based investors own them. This has many benefits, not the least of which is more liquidity and, perhaps, greater market "efficiency." REITs are now in the "Big Show." But it also has distinct disadvantages. Despite the large size of today's REIT market cap relative to historical levels, it remains a relatively small asset class. And, the stocks tend to go up and down together. Furthermore, REIT ETFs permit hedge funds and other traders to short them, which causes the ETF to program-sell them to meet redemptions - and which, in turn, precipitates yet more selling.

My guess is that what has happened over the past week is that traders, asset allocators and perhaps even some investors have realized that the S&P 500 and other broad-based equity indices are likely to outperform REIT stocks this year, for the first time since 1999. Whether such outperformance is "justified" is, of course, irrelevant. Perhaps it's because so many large public companies generate much of their revenues and earnings from export sales, and European and Asian economies are likely to be stronger than in the US this year. Of course, few REITs are able to benefit from strong foreign economies.

I don't know why investors are reducing REIT allocations, and it's not that important. What IS important, at least for short-term oriented investors, is that it seems to be happening, and it may continue for a while longer (although not at the present rate of descent - which, if continued for another three months, would pare REITs' valuations by another 78%).

I would like to bring your attention to one last point in support of my thesis. Take a look at the following chart: http://finance.yahoo.com/q/bc?t=5d&s=HST&l=on&z=m&q=l&c=hot

This chart compares the performance of hotel REIT Host Hotels with hotel non-REIT Starwood Hotels. While there are, of course, differences in what drives their long-term performance (HST is essentially an owner, while HOT is more of a franchisor and manager), the fortunes of both are heavily dependent upon the health of the hotel industry. From last Friday's close, HST is down 6.2%. But HOT is down just 0.8%. We see the very same thing when comparing REIT Host Hotels with non-REIT Hilton: http://finance.yahoo.com/q/bc?t=5d&s=HST&l=on&z=m&q=l&c=hlt Wanna bet that the difference is that HST is a REIT and that HOT and HLT are not?

So, we REIT stock owners should prepare mentally for yet more misery - although where the stocks go in the next week, day or hour is beyond my powers to discern. They may go substantially lower if money continues to pour out of them; fair values are irrelevant at such times. Or, they may snap back right away. But I would argue that it's important for REIT investors to understand that the severe price weakness we've seen over the past five trading days is due to factors other than a basic weakness in commercial real estate or its valuation. I could be wrong, of course, but that's my best guess.

Ralph


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