REITs 'Extremely Volatile' Under Economic Stress

MBA (8/13/2008 ) Murray, Michael
United States real estate investment trusts continue to experience volatile market trends under current economic stresses, softening commercial real estate conditions and an ongoing credit crisis.

The July U.S. Quarterly report from Prudential Real Estate Investors, Parsippany, N.J., said the U.S. REIT market remains "extremely volatile" and, given the state of the economy and Wall Street jitters, any expectations for a broad-based rally in REIT share prices would be “unduly optimistic.”

"REIT stocks are highly correlated with financials and are often lumped together with other real estate stocks such as homebuilders,” the report said. “These battered sectors are likely to experience a high level of volatility until the capital market crisis works its way through the system."

"I don't know any part of the market that has not been volatile," said Michael Grupe, executive vice president of research and investor outreach at the National Association of Real Estate Investor Trusts. "For most sectors of the investment markets—both bond and stock in real estate—2008 has provided an unsettling experience for alot of people."

Senior real estate executives said problems in the U.S. financial markets and the broad economic downturn have a negative effect on income-producing real estate—office buildings, shopping malls, warehouses, hotels and apartment buildings, based on a survey from Real Estate Roundtable.

Nearly 85 percent of respondents said credit availability is “much worse” than it was one year ago, and equity financing conditions are worse—but not to the extent seen on the debt side. Since April, general real estate expectations by senior real estate executives fell 10 percent and capital market expectations by 6 percent. Nearly all respondents expect no significant improvement for the next 12 months.

“It is a bit of a unique set of circumstances right now,” said Jeffrey DeBoer, president and CEO of the Real Estate Roundtable.

“There is growing concern about where commercial property net operating income might be trending given general economic conditions,” DeBoer said. “Real estate continues to face one of its biggest liquidity challenges in over a decade. Even though loan delinquencies to the sector are very low, the ongoing lack of credit for real estate has led to weaker property values and has stalled transactions.”

"On the stock side, with the economy being the way it is and prospects for possible further payroll reductions in many industries, demand for commercial space could certainly suffer on the office side and probably on the retail side, too," said Mike Magerman, senior vice president at Realpoint LLC, Horsham, Pa.

In retail, the Reading, Pa.-based Boscov’s regional department store chain filed for Chapter 11 bankruptcy protection this month. In July, Mervyn's west coast department store chain filed for Chapter 11 bankruptcy after Starbuck's announced closings of 600 stores across the country.

PREI's report said REIT stocks are "undervalued by historical standards, but it would be rash to predict a rally when investor sentiment is so poor."

PREI forecasts REITS to produce a total return between 5 percent and 8 percent this year. REIT dividends alone "should be a good bet to produce about 2.5 percent in the second half of the year, and after the sharp decline in June, share prices could move higher."

Grupe said the long-term outlook appears favorable, based on historical performance from the past 40 years, and that commercial real estate kept supply and demand in check.

"The most important unknown in the market today—probably for all equities, including real estate equities—is what happens to economic growth," Grupe said. "Economic activity is the primary driver of the demand for space. When employment grows, we need more office space. When trade grows, we need more industrial space. When household spending and income rise, we need more retail space. And, when all of those things begin to weaken, then the demand for space pretty much weakens likewise. That's the big unknown."

Magerman said REITs generally have better properties than the overall stock of commercial real estate, and although REITs will not be immune to economic stresses, those problems may not have the same impact as they will for other owners with more “vulnerable properties."

"They all have to be concerned to some extent or another because they are all affected by this economy," Magerman said. "We know that manufacturing is suffering in this country and is continuing to suffer, but that accounts for only one-quarter or less of all industrial space. Industrial space—in most markets—is warehouse and distribution space. As long as there are goods to be distributed, most of the distribution markets should be okay, especially when REITs have portfolios weighted in major distribution hubs in North America and elsewhere."

Magerman said a weak economy could depress apartment demand for college graduates choosing to live at home rather than rent, but can also help apartments for potential homeowners choosing to rent.

"There are quite a few [condominium] units that are coming back into the stock as apartments," Magerman said.

Luxury and mid-tier hotels, however, become more vulnerable—with nightly room rates as opposed to long-term or short-term leases.

“Obviously, that changes a lot faster and exposes [hotels]—in both good times and bad—to turnarounds more quickly than other commercial types,” Magerman said. “With the economy the way it is right now and people travelling less because of higher fuel prices…it’s still pretty high compared to one or two years ago…it may continue to depress travel somewhat. It would not surprise me at all if we started seeing hotel REITs start to struggle a little bit more—just like the rest of the hotel industry.”

DeBoer said commercial real estate is in “somewhat uncharted waters” because the current situation does not apply to supply and demand economics, as it had in the late 1980s and 2000.

“As we have seen problems in the subprime market roll into the broad housing market, and then roll into the broader credit markets in general, I think it is only natural that we start to see people who are owning, operating and financing large real estate assets to be suffering the same fate as almost all economic participants are facing right now—and that is deteriorating credit conditions,” DeBoer said.