The Essential REIT
May 19, 2008
"The ultimate result of shielding men from the effects of folly is to fill the world with fools" -
"The market can stay irrational longer than you can stay solvent" -
John Maynard Keynes
"The bitterest joke of all is that the quickest way to grow old lies in the attempt to stay young forever" -
Remembrances of Earnings Season Past.
The REITs' late earnings season, which ended last week, was more anxiety-ridden than usual. Change is always stressful. We Reitsters may have become a bit complacent over the past few years, as both space and capital markets were on a roll. Rents were increasing nicely, occupancy rates were firm to up, same-store NOI growth was splendid, and everybody wanted to own commercial real estate - and were paying rich prices for it. But those halcyon days are gone, and we are having to adjust to new realities. In Sammy's parallel world, it would be as if his local park suddenly closed, spiked with stern "No Admittance" signs.
But adjust we must. Perhaps our new reality was best expressed by Boston Properties' Doug Linde, on the company's recent conference call: "Technically, we may not yet be in a recession, but the housing data is weak, unemployment is up, consumer confidence is weak, and the ISI index is below 50. We are facing tough business conditions. The credit markets are improving, but debt for commercial real estate owners remains difficult to obtain, and is expensive." So, now that we are all appropriately unsettled, I'd like to provide you, dear reader, with a few observations from listening to all those Q1 REIT conference calls.
But first, a caveat. Commercial real estate, while clearly affected by macro economic forces, is always a local business; perhaps even more importantly, each type of commercial real estate is affected differently by those forces, and every cycle is unique. So I will be grossly over-generalizing (an occupational weakness among us "strategists").
1. Lousy Economy = Weaker Space Markets. The recession-slowdown-weakness (call it what you will) is - no surprise - having an impact upon US space markets. Job losses, even though modest by past recession standards, are impacting tenant demand for space in almost all sectors. Apartment revenue growth is slowing; transient travelers are seeking fewer room nights; retail store occupancy rates are beginning to fade a bit as store closures increase; and prospective office and industrial tenants are taking longer to make leasing decisions. Nobody is immune, as this downturn is affecting, to one degree or another, virtually all real estate owners.
2. But Only the Over-levered Will be Falling on Their Swords. The news summarized above is glum, but the key question for investors is, "How bad will it get out there?" So far, at least, it ain't so bad, and the damage is being contained. Same-store NOI growth remains positive in all sectors, albeit moderating. Retailers are, for the most part, healthy, and can withstand a period of weak consumer spending; they are, however, becoming more choosy in signing new leases, and reducing expansion plans. Sure, bankruptcies are increasing, and we know that, in the long run, all retailers are dead anyway - but new ones eventually spring up, Phoenix-like, to replace them.
Apartment owners are benefiting from the fear and loathing of owning a single-family residence, as well as Scrooge-like attitudes among residential mortgage lenders and investors (both factors resulting in falling rates of home ownership). Meanwhile, apartment tenant delinquencies remain low; as Camden's Ric Campo noted, with only a bit of irony, tenants pay their cell phone bills first, their apartment rent second, and then other stuff if there's any money left over. Office occupancy rates seem to be almost as sticky as asphalt on a southern Texas highway in August, thanks to the modest amount of new supply added in this cycle (this is NOT 2001 déjà vu). And, in most markets, office sub-lease space hasn't picked up significantly - at least thus far.
In short, well-capitalized commercial real estate owners, including REIT organizations, are well positioned to ride out this storm unless it becomes a lot more violent - and recent economic data coming out of Washington doesn't suggest that this will occur. In summary, I give the space markets a grade of B, but put them on negative credit watch.
3. Slumbering Capital Markets. The capital markets remain somnolent, with wide bid-ask spreads; thus cap rates are as difficult to determine as John McCain's running mate. There appears to be plenty of demand among numerous categories of buyers for quality assets in superior locations; but buyers are wimps, while sellers remain stubborn. Prospective commercial real estate investors have increased their required rates of return to offset the higher risks of commercial real estate ownership resulting from the lousy economy and to offset higher debt costs. But sellers - except for those, like Mr. Macklowe, who became inebriated on cheap debt - are under no compulsion to give their properties away, as property cash flows remain healthy.
One-off transactions are easier to get done and are priced richer than portfolio deals. Buyers are not underwriting increases in cash flows; they are expecting that their IRRs will be only modestly higher than entry cap rates. This is just another sign that the investment world has done a 180, returning to the conservative expectations of yesteryear. Meanwhile, on the debt side, the CMBS market remains near-moribund (although there are a few signs that the zombies are stirring in their graves). Generally, banks and life insurers are willing to provide financing, albeit at higher spreads and lower loan-to-value (LTV) ratios. I give the capital markets a grade of C-, which is better than it was a month ago.
4. Gimme Liquidity. Liquidity remains a key issue, and today's investors will - or at least should - pay premium pricing for those REITs that have lots of it (and punish those that don't). Fortunately, most REIT management teams were quick to recognize the deterioration in the credit markets, and moved quickly to shore up liquidity. Today only a handful of REITs, e.g., GGP, have worrisome liquidity issues, and almost all REITs will be able to ride out a sustained period of credit tightness.
And credit conditions are improving a bit. Secured mortgage financing is generally available for stabilized properties, especially in the residential sector (thanks to Aunt Fannie and Uncle Freddie), but of course spreads over Libor are higher, and LTV ratios are lower - which plays to REITs' strengths. The solid liquidity enjoyed by most REITs is providing them with ample grave-dancing opportunities, should they arise. Regency Centers has located 26 neighborhood shopping center projects in financing disarray, some of which, according to management, look "promising."
5. Development: "Here There Be Dragons." As even Sammy can tell you, development projects have become more problematical in the current economic environment. Many developments are taking longer to lease, and this, combined with uncertain cap rates, increasing risks, and higher debt and equity costs, make most developments a very questionable endeavor when it comes to all-important value creation. Fortunately, there are a few mitigating factors, e.g., we've heard mixed reports on land costs, but, despite rising material costs, total construction costs have been moderating, especially labor costs.
REITs, fortunately, have reacted appropriately, and management teams are much more selective; a number of projects are, where possible, being deferred or even cancelled. So far - and while it's still too early for any conclusions - moderating construction costs and still reasonable demand for quality space are preventing wholesale reductions in projected stabilized yields. And the silver lining to the development issue is that many merchant developers have been forced to go off and pick daisies due to credit unavailability, thus perhaps setting up a very interesting supply-demand dynamic in 2010-2011, when the US economy might be firing on all cylinders. Some starry-eyed optimists may even be contemplating - gasp! - rent spikes a few years out.
6. Firm Results and Guidance. Another observation from the recent earnings season is that FFO and NOI results in Q1 have generally come in as expected, and in many cases above consensus. And guidance for 2008 has been surprisingly solid, with little or no backtracking except in the hyper-sensitive hotel sector. Generally, modestly lower guidance from some REITs has been offset by upward guidance from others. Most management teams have, appropriately, been cautious about forecasts for this year despite the firm Q1 results. Sugar coating has been in short supply.
Why have the reported numbers, as well as guidance, been so firm despite the economic headwinds? Most management teams have a good handle on their business, and have been playing the guidance game for quite some time. Also, the commercial real estate business, thanks to long-term leases in most sectors, is a lot more predictable than others; occupancy rates, however, are becoming more of a question mark.
Another contributing factor to the stability of REITs' cash flows this year might be the relatively modest impact that this recession is having on US businesses. Unlike the prior recession, this one is hitting consumers, not businesses, hardest. Public companies reported earnings growth in Q1 of close to 14%, if financial services companies are excluded. And, the cut-back in employee payrolls has been modest, certainly by prior recession standards, thanks to the cautious nature with which businesses expanded over the past several years and the increase in exports by US manufacturers. Other than the investment banks and other benighted investors who, using debt leverage, gobbled up all that toxic waste, balance sheets are healthy in Corporate America.
The weakest real estate sectors today are those that serve the consumer or that are particularly sensitive to the economy. The hotel REITs have generally been guiding lower for this year, albeit RevPar should still be positive. But guidance from the retail guys has been firm. This is due, I think, to the leasing momentum built up over the past several years, including high occupancy rates, as well as owners being able to capture large re-leasing spreads attributable to retailers' Golden Years - which ended only very recently. Most retail real estate owners, especially those whose tenant base includes numerous healthy national and regional retailers, should easily be able to withstand the consumer illness for at least another year.
7. Bubble Markets. Real estate markets, over the past few years, have generally been in synch with one another; the health of the US economy has been broad-based. However, it now seems that we are witnessing a greater gap among markets. As is evident from the comments of managements and their operating results, some markets are suffering from a huge hangover following the Great Housing Speculation Party. The "usual suspects" include Florida, much of California, Arizona and Nevada.
In these markets, owners of apartment communities and retail properties, in particular, have some things to worry about. Retailer sales in these locations have been soft, e.g., tenant sales at Macerich's Arizona properties were down 5.4% in Q1. Leasing of new developments has been slow in these locations. Some investors are concerned, for example, about discouraging lease-up progress in some of Weingarten's Florida developments. And occupancy may be declining more quickly, e.g., Equity One, which has over half of its properties in Florida, reported that occupancy fell by 50 bps just since Q4 (fortunately, EQY owns lots of stable supermarket-anchored centers, and thus won't be hurt too badly).
It is also in these post-bubble markets where the residential guys are having the most problems. According to Camden's Ric Campo, "our markets that are at the epicenter of the housing bust, Florida, Arizona, Nevada, suburban Washington D.C. and inland California...are experiencing job loses related to the continued unwinding of housing-related employment and an increased shadow supply of rental condominium and housing. Operating fundamentals remain challenging in these markets." Even the self-storage guys are seeing softness in their Florida assets.
8. Reluctant Dragons. Buyback programs are a great way to create shareholder value by taking advantage of today's negative gap between stock prices and net asset values; this is particularly apparent in the mall, hotel, apartment and office sectors of Reitdom. Avalon Bay bought in 482,100 shares in Q1 alone, at a cost of $42.1MM ($87.42 per share average). However, most REITs have been reluctant dragons, having bought back few shares even when trading at major-league NAV discounts. For example, Diamond Rock Hospitality approved a 4.8MM share buyback program at the end of February, but has yet to buy a single share.
I suspect that the reasons for this shyness are varied, and include: (a) the importance of liquidity today - and building a war-chest for possible fire-sale opportunities (which, however, for most REITs, will be like waiting for Godot); (b) the sale of properties (where the proceeds after debt repayment would be used to fund the buyback program without goosing debt leverage) is taking longer than expected in today's illiquid markets; (c) uncertainty about future cap rates and real estate valuations; and (d) the need to fund committed developments during a capital-constrained environment.
9. "What Recession?" As we expected, two sectors are proving somewhat resistant to the broad economic downturn. The healthcare REITs, which own senior housing and assisted-living properties, skilled nursing homes and medical office buildings, have reported solid, albeit unspectacular, operating results. These properties, of course, are not immune to recessions - demand for senior housing units seems to be softening a bit, as difficulty in selling one's home can slow the pace of decision making, and states that are starved of tax revenue due to a very weak economy are prone to look for ways to reduce Medicaid reimbursement rates for nursing home operators. But, for the most part, healthcare REITs' NOI and FFO growth, while always modest, remains stable and in line with expectations.
Also, the self-storage sector is proving to be somewhat recession-resistant. Demand is driven by life's changes, including marriage (assuming youngsters still get married), divorce (yeah, that still happens), deaths (that too) and - of course - job transfers and lay-offs. For example, Detroit has been a strong market for self-storage owners. However, we can make too much of this phenomenon, as some weak housing markets are proving to be less resilient; Florida continues to be the "weak sister" in most storage REITs' portfolios. Bottom line: Although it's a little early for a victory-cigar celebration, in the way of Red Auerbach, same-store revenue and NOI growth in this REIT sector, as evidenced by Q1 results, remain reasonably solid, and perhaps justifies the stock price outperformance of the sector year-to-date.
10. These Guys Get It. Perhaps the most important impression that remains in this fuzzy head of mine after listening to so many conference calls is that the management teams of quality REIT organizations have a good handle on their business, the existing and probable performance of their real estate assets, capital availability and cost, the risks and rewards of development projects and - certainly - the risks inherent in the current environment.
These management teams have moderated their internal and external growth expectations, they have strengthened their balance sheets and liquidity, they have been culling and using triage on their development pipelines, and they have been, for the most part, looking for ways to cut costs. And they haven't panicked - long-term business strategies remain in place. They are looking for unusually good opportunities that may arise from the weak economy and credit crunch, but seem to be quite patient. Report card: A-.
Conclusion. As many of you know, I am kind of an odd duck - I have the vast majority of my personal assets invested in REIT stocks, but am always looking over my shoulder and ready to reduce my exposure if I think that the risks ahead are excessively (or even uncomfortably) high. I have, for example, pared back my REIT common stocks a bit over the past five months, putting much of the proceeds into REIT preferreds at 8%+ yields.
However, despite a US economy that continues to give me the cold sweats, and after mulling over the results of the first quarter of the year as discussed on the conference calls, I remain sanguine concerning the stability and predictability of REITs' cash flows despite the current economic environment. And the obscene volatility of the shares over the past year or two seems to be abating - certainly another good sign.
Yes, AFFO growth will slow over the next 12-18 months, but will still be respectable. I won't claim that the shares are ridiculously cheap, particularly after their pretty good absolute and relative performance so far this year, but they remain quite attractive for long-term investors, especially when adjusted for risk. Fill those REIT allocations, and concentrate on more important things. Take your dog on a walk, go to the park.
The Essential REIT