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A REIT Recovery, With a Catch

Analysts say rosy assumptions are already baked into stock prices. 

Philip Guziec, 08/16/2011

This article first appeared in the August/September 2011 issue of Morningstar Advisor magazine. Get your free subscription here.

Everybody knows about the problems facing residential real estate, but what's going on in commercial real estate? I sat down with real estate analysts Todd Lukasik, Jason Ren, and Philip J. Martin to get the scoop.

Q: How was commercial real estate affected in the recession, and how has it fared in the wake of the recession?

Philip J. Martin: This downturn in real estate wasn't really supply- or oversupply-driven; it was more financial-crisis-driven. This should allow underlying commercial real estate cash flows and valuations to recover more quickly coming out of this downcycle. It's much different than coming out of the late 1980s or early 1990s, when we saw significant oversupply in commercial real estate, largely driven by a lack of lending discipline throughout the 1980s. The result was oversupply and an associated commercial real estate recession. The commercial real estate sector required at least five years to recover, and it wasn't until the mid- to late-1990s that underlying commercial real estate operations, rents, and valuations began to recover. That would compare to residential real estate today, where we arguably have a one- to three-year oversupply of residential real estate.

Q: You said that we don't have the kind of oversupply that we had in the 1980s, but we did have a bit of a banking cycle and some pretty loose lending practices. Did you see some oversupply in commercial real estate?

Martin: We didn't really see significant overdevelopment heading into this. Any oversupply experienced was generally at the local level as opposed to being more widespread or national. However, we did see some aggressive commercial real estate pricing in 2005-2007, which may require some time to digest and justify from a return perspective.

Q: There was no excess square footage that we would see normally when heading into a recession; we had a price spike, collapse, and recovery.

Martin: We had the price spike, but we didn't have oversupply. So, the fundamental underpinnings are a bit better. Coming out of the late 1980s and early 1990s, most commercial real estate was in the hands of private owners and operators. The Resolution Trust Corporation took over a significant portion of real estate owned by the savings and loans, much of which was sold to professional commercial real estate owners and operators. Coinciding with that, we saw the publicly traded equity REIT sector begin to grow significantly. So, all of a sudden, a significant portion of commercial real estate was being owned in a publicly traded structure, where there is more discipline. Who's underwriting and financing a big chunk of the sector from this point forward? It's not just a bank--it's an institutional investor. The broader public equity and debt markets are financing a larger percentage of the commercial real estate business, where there is, arguably, better underwriting discipline, transparency, and corporate governance and structure requirements.

Jason Ren: From the banks' balance-sheet point of view, relatively more of the construction troubles came from residential construction than commercial.

Todd Lukasik: Certain pockets of commercial real estate associated with that residential construction were also hit hard. If you're talking about a shopping center built on the prospect of a new community going up in suburban America that never got off the ground because of the residential real estate crisis, those shopping centers obviously took a hit. But as Philip [Martin] was saying, generally a lot of the loose credit we saw went into acquisition financing, and that drove pricing up to very high levels. What's interesting since then is that we've seen a full cycle on the valuation side. REITs are among the most highly levered investments in the stock market, and when the financial crisis hit, there was concern that there just wouldn't be capital available to repay loans. So, equity values for a lot of REITs got decimated. But with the return of capital market activity, we're again seeing very low cap rates and very high valuations for commercial real estate. It's been pretty stunning how quickly that valuation cycle went from peak to trough and back to a very, very strong recovery.

Ren: At the time, the leverage concerns were compounded by the REITs' liquidity position. Owing to the REITs' business model, they can't really retain much of their organic earnings for growth. They aren't taxed at the corporate level, but they have to pay out 90% of their capital income to shareholders as dividends. So, they have to constantly tap the capital markets in order to grow.

Q: So, the depressed valuations in commercial real estate, as driven by distress at the REITs, were basically a manifestation of financial risk?

Martin: Yes. Affordable and available equity and debt financing is a critical component of successful real estate investing.

Q: The underlying assets were performing reasonably well, fundamentally, but the market was concerned that even with a decent asset, could it get the refinancing done?

Martin: Yes, and I think there was some question as to how deep the crisis was going to be and how well the REIT portfolios would weather the storm. What I think the equity REIT sector generally experienced coming out of 2008 and into 2009 were portfolios maintaining occupancy levels and REIT management teams proactively working with clients to renew and modify leases. So far, and with some benefit of hindsight, equity REIT management teams and portfolios proved successful due to a proactive approach and the overall quality of underlying commercial real estate portfolios.   

Q: In today's landscape, are there different stories to be told by geography or industry, versus commercial real estate as a whole?

Lukasik: I think there are two ways to break it down. One is based on the length of the lease that the landlord is dealing with, and the other is based on the competitive advantage of the property portfolio. Going into the downturn, companies that had very short-term leasing structures--hotels, self-storage facilities, apartment landlords that reprice on a short-term basis--felt the impact of the downturn in the pricing in their markets more immediately that the areas that have longer-term leases, such as office or retail. And they're also recovering relatively faster as their markets recover. The other way to think about it is the way we're analyzing REITs in general, which is in terms of moats.

Landlords that have competitive advantages in their property portfolios have generally done a lot better than those who haven't. We've seen "moaty" landlords able to maintain higher levels of occupancy, higher levels of rent, and oftentimes still being able to achieve positive releasing spreads--where even when leases expire, the rents that they're getting on new leases exceed the rents that were in effect on expiring leases. Really being able to assess a REIT's property portfolio from the competitive-advantage standpoint has proven valuable throughout the downturn and during the initial recovery.

Q: The competitive advantage, as we're looking at it, is the advantages of the individual properties? Or is it something to do with the management team?

Martin: It would be both. Location is important, but the ability to execute a strategy certainly cannot be discounted. If you're defining a moat, it could be a niche. Alexandria Real Estate Equities ARE, for example, leases space to biotech and pharma companies. It's one of the go-to providers when a GlaxoSmithKline GSK, Johnson & Johnson JNJ, or Novartis NVS wants specialized lab or R&D space. Alexandria benefits from a unique expertise, competitively advantaged locations in key lab space/biotech clusters, and strategic relationships and proximity with universities. Alexandria has a business model that is very difficult to replicate, and there are very few competitors.

Other differentiators might be a management team with a full-service real estate skill set, where there is an ability to acquire, develop, redevelop, and manage properties. This ability provides flexibility and growth options throughout an economic, financial, or real estate cycle. We are looking for REIT business models that are not one dimensional and are positioned to better manage risk through the real estate cycle. Certainly, locations can constitute a competitive advantage. I'm thinking of Federal Realty FRT on the retail side; it's been in the business of owning properties for decades, and it has some of the best urban infill locations for retail shopping centers in the country, characterized by high incomes, consistent population growth, lots of traffic, and very few competing land parcels.

Lukasik: When we're talking about moats, we're talking about the sustainability and growth of long-term cash flows. The management teams that have decided upon a strategy that focuses on space-constrained markets or areas with very favorable demographics are the ones that have been able to build moats around their property portfolios.

Ren: Underwriting can also lead to defensibly growing cash flow to shareholders. In health care, they're writing these leases that are cross collateralized. If you're a tenant, and you're locked into a 10- or 15-year lease, you can't readily drop a poorly performing property, or maybe you have a better-performing property that's making up rent on a poorly performing property. There are a lot of protections on these leases that are hard to get out of.

Q: Where are the opportunities now?

Martin: There's real opportunity, even in a slow-growth environment, for dividend growth and for REITs to maintain dividend yields. FFO dividend payout ratios average 69%--the historical low is about 66%, and they've historically averaged 70% to 75%--so REITs are very well positioned from a cash-flowcushion and balance-sheet standpoint to maintain current yields and inflation "plus" dividend growth. That's important because we may see higher interest rates and inflation, and equity REITs are well positioned to meet these headwinds. Generally, our stance right now is to be a bit more defensive, so we're focused on equity REIT portfolios and business models less dependent on the economic cycle. We would also gravitate to longer leases, where there is less cash flow volatility--for example, health-care REITs.

I would also highlight multifamily. Despite there being some valuation concern about share-price multiples, as all of our apartment REITs under coverage trade at least 30% higher than our estimates of their fair values, the multifamily REIT sector benefits from fundamental tailwinds. Supply is healthy, and demand is increasing; a combination that has resulted in strengthening operating performance and cash flows. Driving multifamily demand is a difficult mortgage financing environment and singlefamily home valuation uncertainty. On top of this, home ownership can be expensive. Home ownership attitudes are being reassessed. Helping to fill the void has been multifamily. Many of the equity REITs own high-quality assets that are professionally managed and offer numerous housing options and amenities.

Q: What's mispriced today? What can an investor buy?

Lukasik: We think that the sector in general is 15% to 20% overvalued relative to what our underlying fair value estimates are for the REITs we cover. But we are finding pockets of opportunity for investors that need to have exposure to the space. We were talking earlier about Alexandria--that's one that's trading at a discount to our fair value estimate right now. But in general it's difficult to find undervalued REITs. In retail, for example, Realty Income O is the only stock that trades below our fair value estimate, and its discount is slight. Choosing specific REITs will be very important for investors who want to make money in the space over the long term.

Q: What's driving the overvaluation today? Is it as simple as yield-chasing?

Lukasik: I think it's a combination of a couple of things. One is yield, as you suggested. As traditional yield-type investments, like U.S. Treasuries or corporate debt, have seen yields go down, many investors are looking for sources of yield, and the dividend yields on REIT stocks have looked attractive. The other factor is just a huge amount of capital that has been allocated to commercial real estate. We've seen it both on the transaction side for individual properties and in the public markets as well. There's been a huge sum of money that's been raised to invest in commercial real estate. And as that money flows into the market, it drives down the cap rates and drives up the values that people are able to get for the assets that they sell.

Ren: There are quite a few motivated buyers out there, but not as many motivated sellers as one would expect given refinancing concerns. The banks have still been playing a bit of "extend and pretend" on commercial real estate credits, so the availability of properties on the market--there haven't been the grave-dancing opportunities that people prepared for.

Philip Guziec is co-editor and portfolio manager of the Morningstar OptionInvestor online research service and a derivatives strategist for Morningstar.

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