By Michael Fickes

REITs show their mettle in the first recession of the modern REIT era.

Finally, we have a recession with survivors. For the first time in modern memory, the commercial real estate industry did not crash, burn, turn to dust, or transfer all its wealth to a new group of wild-eyed speculators during a recession. In fact, all things considered, the publicly traded real estate industry has weathered the first economic recession of the modern REIT era.

Since the 2001 recession and throughout the slow multi-year economic recovery, there has been virtually no increase in the default rate on commercial mortgages in the United States. Instead of defaulting, commercial real estate owners have by and large continued to pay down debt, while dealing effectively with levels of surging vacancy rates and plummeting rents that have devastated business in past recessions.

By at least two measures, the industry actually prospered during the recession. First, over the past three years, despite terrible real estate fundamentals, real estate property values increased in every property category. Second, over the same period, the stock prices for publicly traded REITs increased by 40 percent to 50 percent. "REIT shares are relatively high, in part because the asset values of portfolios have risen," says Ray Torto, a principal with Torto Wheaton Research.

The key difference about the current publicly traded real estate industry is financial management. Perhaps for the first time in a generation, real estate owners have built their businesses on a solid equity foundation, instead of excessive leverage. They have also managed with a view toward long-term earnings, instead of speculative short-term windfalls. And they have taken advantage of tools available in the market—in this case, historically low rates of interest.

"We like to say that management matters in real estate," Torto says. "Studies show that management can make a long-term difference in real estate performance, where it doesn't make a difference generally in stocks. In other words, you seldom find stock market managers who beat the market long term. But most of our research shows that well managed real estate portfolios do outperform the market."

Managing The Equity Difference

In past recessions, declining rents and cash flows eventually overwhelmed the ability of property owners to service highly leveraged debt, producing flurries and sometimes avalanches of defaults.

"During the late 1980s, many real estate buyers relied on 100 percent financing at valuations not supported by rents," says David Fick, managing director with Legg Mason Wood Walker, Inc. "Tax incentives and other financial devices bridged the gap."

Instead of building a business designed to produce long-term earnings, owners aimed for speculative returns from appreciating properties. A quick one-two punch wrecked that strategy. Federal tax reform in the late 1980s eliminated tax incentives related to commercial real estate. And the 1991 recession arrived before commercial properties had stabilized their financial structures through anticipated appreciation.

The downturn caused vacancy rates to skyrocket, and owners couldn't service their extraordinarily high debt from remaining cash flow. Loans defaulted and lenders were left with the keys to thousands of properties. It was worse than a recession; it was a depression.

"Then we had a massive re-pricing of commercial real estate and a giant transfer of wealth," Fick says.

Industry Snapshot Total equity market capitalization = $275 billion Equity REIT market capitalization = $248 billion REITs own more than $400 billion of commercial real estate, or 10 to 15 percent of the total institutionally owned commercial real estate market 187 REITs are in the NAREIT Composite Index 154 REITs are traded on the New York Stock Exchange NYSE listed REITs market capitalization = $265 billion Commercial real estate industry represents a significant portion of the U.S. Economy: 6.0 percent of GDP in 2003 6.7 percent of GDP growth over the past 10 years Source: NAREIT. Data as of Sept. 30, 2004

To deal with the crisis, the federal government authorized the Resolution Trust Corporation (RTC) to take over failed properties and find buyers. Private buyers with cash flocked to the RTC auctions. Additionally, a host of property owners formed new REITs, sold stock and used the proceeds to purchase the RTC properties for 50 cents or so on the dollar, far below replacement costs. As the economy rebounded, properties leased up, prices appreciated to reflect new levels of income, and owners looked forward to a new cycle of property development.

This time, however, real estate lenders applied conservative underwriting standards to loan applications by demanding substantial pre-leasing and equity commitments from buyers.

"Underwriting was done in a way that when things headed south again, lenders wouldn't end up with the keys," Fick says.

The new environment suited owners with deep pockets, and REITs, awash in equity, have flourished ever since. In 1991, the REIT universe consisted of 136 companies with a total market capitalization of $13 billion. Today, there are 187 REITs with a total equity market cap of $275 billion. Equity REITs make up the lion's share of modern REITs, with 144 companies and a market cap of $205 billion. By and large, equity REITs have remained extremely conservative in their use of leverage. According to NAREIT, the overall debt ratio of equity REITs at the end of 2003 stood at 41.8 percent.

Since 1991, the strong equity position of REITs has fueled the purchase of sizeable slices of institutional quality commercial real estate in every property category. According to Prudential Real Estate Investors, office REITs now own 7.9 percent of office space; apartment REITs own 7.4 percent of multifamily space; industrial REITs own 8.5 percent of their market; non-mall retail REITs own 13.1 percent of theirs; and mall REITs own a whopping 36.8 percent of the investable universe of malls.

A Different Kind Of Real Estate Recession

Traditionally, real estate recessions begin when competing owners build too many buildings. Oversupply drives down rents and revenues. Less competitive owners cannot service debt from the reduced cash flow and lenders eventually take buildings back.

However, in the run-up to the recession of 2001, commercial real estate did not overbuild, thanks in large measure to REITs.

"REITs led the slowdown in development," says Tim Pire, managing director with Heitman Real Estate Securities, a multi-national real estate investment management firm. "While building did continue in the multifamily sector, it was private developers, not REITs that were doing it."

Capitalization rates (the investment return on property) fall when property prices or values rise. Investors, it seems, have been willing to pay higher prices for properties despite the lagging fundamentals of vacancies and rent.

According to Pire, the multifamily category has added about 300,000 units per year to available stock since the recession began—a lot, but not enough to cripple the industry. Even with continued private development, multifamily vacancies have begun to decline, moving from a high of 6.5 percent at the end of 2003 to 6.2 percent in the middle of 2004, according to Pire.

Pire also notes that retail construction has held relatively steady, along with retail occupancy rates. No cutback was necessary in retail, since, in an unusual development, consumer spending remained solid despite the struggling general economy.

The real threat of overbuilding loomed in the office and warehouse sectors, in which the 2001 recession caused the most damage. But both categories slashed construction before crisis arrived. According to Pire, office development will decline to 40 million square feet in 2004, down from 100 million square feet in 2001. Likewise, industrial and warehouse construction will fall to 90 million square feet in 2004, compared to 240 million square feet in 2001.

By controlling development, REITs and the industry at large stunted rising vacancy rates in both categories.

In 2000, office vacancies bottomed out at 7.5 percent and began to rise. In the middle of 2003, according to Pire, they crested at 17 percent. Over the past year, the rate has fallen back to 16.5 percent.

Industrial vacancies peaked at 12 percent at the end of 2003 and have since fallen back to 11.6 percent. Legg Mason's August 2004 "Market Cycle Monitor" expects a decline to 10 percent by the end of 2004, still 1.5 percent off of the long-term category vacancy average of 8.5 percent.

Recovering Instead Of Rebuilding

Although most agree that an economic recovery is underway, real estate analysts have not yet given the all-clear signal on fundamentals. "While occupancy rates have begun to improve, there is no home run yet because rents have not begun to move up," Torto says.

That's a remarkable observation to make at this point in a real estate recovery. Three years into the recovery following the 1991 recession, lenders and the RTC had repossessed a significant amount of real estate. This time around, the industry is looking forward to incremental improvements in fundamentals and a return to growth in funds from operations (FFO).

Legg Mason's August report predicts that office rental rates will decline by 1 percent to 2 percent in 2004 but should turn positive in 2005. Industrial rents will stop falling by the end of this year and remain flat through next June. Multifamily owners will restrain rent increases for the remainder of this year and hope for a 2 percent rise in 2005. Retail remains the relative bright spot, with rents likely increasing by 2 percent to 3 percent in 2004 and by as much as 4 percent in 2005.

While the bad times left their mark, improving occupancy rates have positioned REITs for renewed growth in FFO.

"As you look out to 2005, FFO trends for all property sectors are positive," Pire says. "Sectors with the shortest lease terms will see the most growth."

According to a Citigroup Smith Barney report, retail REIT FFO is forecast to grow at 10 percent in the mall sector and 7.4 percent in the shopping center category in 2004. Multifamily REITs will deliver an estimated 4 percent increase in FFO this year. Unwilling to set figures for the industrial and office categories, the report calls for some improvement.

"At best, we're talking about a FFO increase of 3 percent this year for the overall real estate industry," says Kenneth T. Rosen, chairman of Rosen Real Estate Securities, LLC. "Fundamentals are turning around, but this hasn't shown up in net operating income yet and probably won't for another six to 10 months."

A Recession That Raised Stock And Property Prices

Despite slow FFO improvement, REIT stocks are generally trading at values 40 percent to 50 percent above 2000 prices. Analysts say that investors have historically paid stock price premiums of 7.5 percent above net asset values (NAV), the total dollar value of the real estate owned by a REIT.

"Today, investors are paying even more significant premiums," Pire says. "For most of 2004, the premium has been around 10 percent, and I think it will go even higher."

Why would an investor pay such a high premium? "Investors believe REITs have passed the test of surviving weak fundamentals," Rosen says. "And now fundamentals are turning positive. In addition, investors have seen REITs as good alternatives to bonds during this period of very low interest rates."

In a related anomaly, capitalization rates for properties in all sectors have fallen steadily since the recession. Capitalization rates (the investment return on property) fall when property prices or values rise. Investors, it seems, have been willing to pay higher prices for properties despite the lagging fundamentals of vacancies and rent.

According to Dan Fasulo, an associate with Real Capital Analytics, multifamily cap rates fell from 8.7 percent in 2001 to 7 percent in 2004; office cap rates dropped from 9.8 percent to 8.2 percent for the same period; retail cap rates moved from 9.7 percent to 8.2 percent; and warehouses dropped 8 percent to 7 percent.

Fasulo explains falling cap rates by pointing to low interest rates, which enable property investors to service higher property debt from rents paid by existing tenants. Moreover, as the recovery causes empty space to lease up with tenants paying higher rents, property values increase, mitigating the risk of higher purchase prices.

The Next Challenge: Higher Interest Rates

If low interest rates have helped drive up property prices, NAVs and REIT stock prices, what happens when interest rates rise? "That's the next test for REITs," Rosen says. "How will REITs function in a normal or even high interest rate environment? We don't know the answer to that question yet."

The market provided some clues earlier this year. At the end of March, improving employment figures caused a large sell-off among REIT investors who feared that interest rates would soon rise and adversely affect REIT performance. "There was a meaningful recovery following the sell-off," says Keith Pauley, chief investment officer with LaSalle Investment Management Securities. "That's as it should be."

…after the sell-off REIT shares soared and approached all-time highs. Subsequent rate increases by the Fed have yet to have a direct impact on REIT performance or share prices.

In fact, after the sell-off REIT shares soared and approached all-time highs. Subsequent rate increases by the Fed have yet to have a direct impact on REIT performance or share prices.

Pauley adds that rising rental revenue will ultimately prove more beneficial to REIT earnings than low interest rates. In other words, the revenue generated by property in a growing economy will raise property performance and stock prices to levels that will more than offset the costs associated with higher interest rates.

Will investors agree? In early September, Citigroup Smith Barney lowered its investment recommendation to "underweight" for the REIT category. An industry note by analyst Jonathan Litt states that REIT shares rose 16.1 percent between January and August 2004, compared to a general 6 percent decline in overall stock market returns.

When job growth accelerates, unemployment falls and corporate earnings grow, the general stock market begins to look better to investors than the REIT market.

Litt also observes that a 100 basis point increase in the 10-year treasury rate from the early September average of 4.21 percent would eliminate the yield advantage of REITs over treasuries, which stood at 93 basis points. If treasury interest rates move higher than that, into the 5.5 percent to 6.5 percent range, REIT share price premiums to net asset values would drop from early September levels of 24 percent to around 5 percent, driving REITs further down the list of investor preferences.

"We believe the group (REITs) is now overvalued and is due for a pause in total returns as earnings catch up with valuations," Litt says. "REITs could suffer a sell off of 10 percent to 15 percent in the next 12 months, but will likely end the period flat, with share prices being down 5 percent or so."

However, REIT fundamentals are improving as occupancy rates increase and rents look forward to recovery. At the same time, FFO has begun to move up. But the emphasis on REIT investing remains on long-term results as opposed to short-term trends.

"In the short run, there are always disconnects between fundamentals and stock prices," Rosen says. "Over the last several years, low interest rates have led investors to buy REIT stocks despite terrible fundamentals. On the other hand, in 1998, REIT fundamentals were good, but NASDAQ was the hot investment.

"The long run is more important, and in the long run, I believe that REITs and real estate fundamentals correlate perfectly. Over time, REITs will perform just as real estate performs."