Real estate investment trusts have slid off a cliff, but while some firms deserve to fall hard, others are on better footing.
Real estate sits at the epicenter of the global financial crisis. Although housing was the first area to implode, we're now well into a severe downturn in other types of real estate--a downturn that has crushed equity real estate investment trust stocks the past year. In 2008, the REIT industry shed 62% of its value, according to the Dow Jones Equity REIT Index. I recently spoke with Morningstar senior stock analyst Joel Bloomer, who heads up Morningstar's REIT team. The team covers more than 70 REITs, which gives Morningstar one of the broadest coverage lists out there.
Haywood Kelly: Joel, walk us through a likely scenario for 2009 across some key property types.
Joel Bloomer: While some firms will be hit harder than others, overall we expect cash flow to decline in all property types. Here's roughly how we would rank the relative performance from bad to worst: health care, apartments, public storage, industrial, retail, and hotels.
Health care should remain relatively insulated from turmoil, with the one caveat that some health-care REITs have concentrated tenants with weak balance sheets. Still, it's hard to imagine mass reductions in the number of hospitals, skilled nursing facilities, and other health-care-related facilities. Apartments will see head winds as cash-strapped consumers trade down to more-affordable accommodations and in some cases consolidate with friends or family to save cash. The oversupply of residential properties being converted into apartments won't help matters, either.
We expect demand for public storage to suffer as consumers realize that storing goods used infrequently (if at all) is not worth the monthly expense. Demand for industrial space is obviously tied to general economic activity, which is declining rapidly around the globe. Retail properties should suffer from the growing number of retail bankruptcies. In addition, as retailers reduce store expansion plans or, in more extreme cases, shutter stores, the supply of retail properties will expand sharply.
Lastly, hotel demand is inherently the most discretionary, and consumers and businesses are rapidly reducing expenses to the bare necessities. Plus, the oversupply picture in the hotel space appears to be worse than all other property types--a recipe for trouble, in our opinion.
HK: Despite that negative outlook, REIT stocks are now yielding 8% to 9%, up from 3% to 4% a year ago. The knee-jerk reaction might be to think the group is a bargain. What do you say?
JB: I think investors should second-guess their initial reactions regarding REITs. This sentiment might be surprising given how awful REIT stock performance has been, but the fact is that much of the punishment was justified. Earlier this year, it became clear to us that there was a major disconnect developing between the perceived strength of REITs relative to their tenants. Basically, the question became, How can property owners remain unscathed when consumers, manufacturers, retailers, and various other tenants are very clearly suffering from a rapidly deteriorating global economy?
Well, the answer is that they can't. As a result, REIT stock prices are starting to reflect more realistic outlooks that include falling rents, property value depreciation, and ultimately reduced cash flow. Still, not all REITs are cheap, especially when our concerns about the amount of leverage in this space are taken into account.
HK: Are there REITs on your coverage list that might not make it to the other side of this recession?
JB: Almost definitely. As was common in several industries over the past few years, REITs became drunk on capital. Exceptionally lenient debt markets acted as a bottomless wallet that some REIT management teams tapped aggressively to fund acquisitions, new developments, and redevelopments of existing properties. Unfortunately, profitability projections put in place when new projects were started are proving very optimistic, making current debt loads at several firms appear onerous. Therefore, we think investors who want exposure to REITs are better served picking companies that don't fall into this category, because those who just buy an index are nearly guaranteed to see several of its constituents go bankrupt.
HK: Your team has a handful of 5-star stocks. Which ones offer the best combination of value and financial strength?
JB: The valuations on several REITs have become so compressed that many are undeservedly pricing in a high probability of bankruptcy, in our opinion. While we have a negative outlook, we certainly don't expect all REITs to go to zero. Through research that sometimes resembles that of a credit analyst rather than an equity analyst, we've been able to surface several names that are priced for an outcome much more dire than we think is reasonable. The common theme among these companies is a reasonable amount of debt on the balance sheet, good coverage of interest by cash flow, and at least a decent property portfolio.
HK: Your team does a lot of work stress-testing your fair value estimates and cross-checking against other valuation approaches. Could you walk me through an example--perhaps with one of your team's 5-star stocks?
JB: Sure, let's look at AMB Property Corp.
One of the first places I look in valuing REITs these days is the balance sheet. I'm already comfortable saying that nearly every REIT will see cash flow decline in the near term. What I need to know immediately, though, is whether or not the company has the liquidity to withstand not only falling cash flows, but extremely unreceptive credit markets.
One of the primary metrics we look at in this respect is total debt relative to gross property, plant, and equipment, which is similar to a loan/value ratio commonly quoted in residential real estate. For AMB, this number is below 50%, which tells me that this firm won't have to deleverage at an inopportune time. In contrast, ProLogis is at nearly 70%, when more than 60% is generally deemed unacceptable, especially today. This means that as debt comes due, ProLogis will only be able to refinance a portion of the capital and must pay the rest with cash. Because most REITs have very little cash on their balance sheets, the only way to reduce debt is to sell properties in the currently inhospitable environment. Other important leverage metrics we look at are earnings before interest, taxes, depreciation, and amortization relative to interest (2.5 times for AMB and 1.8 times for PLD) and total debt relative to EBITDA (10 times for AMB and 15 times for PLD). Clearly, AMB is in a much better capital position.
After becoming comfortable with the balance sheet, we turn to our cash-flow forecasts and various valuation triangulation methods to determine what the stock is worth. We then compare this value with the stock and decide if it's over- or undervalued. One triangulation method in particular that I'm fond of is the free-cash-flow yield of a stock at our Consider Buying price (the price at which the stock would be given a 5-star Morningstar Rating for stocks). This method basically tells me the cash the company produces after expenses in relation to the amount of money I invest in the stock.
In today's much-higher-return environment, where preferred equity and debt yields are often in the double digits, I think there is very little reason to accept less than a 10% free-cash-fl ow yield on common equity, and depending on the situation, even higher. So far, this strategy has worked out well for our team: It provides an attractive margin of safety in a highly uncertain world.
Haywood Kelly, CFA, is vice president of equity research at Morningstar.