Amid a climate of market volatility, now is a great opportunity to buy REITs

By Annette Kornblum

Every cloud has a silver lining. After seven years of outperforming the broader markets, REITs struggled in the first seven months of 2007 as investors stepped back and took profits. In the wake of the subprime mortgage market crisis, investor panic also inflicted collateral damage broadly on bond and equity markets, including REIT stocks. Most analysts see REITs rebounding as investors recognize the underlying strength of the industry.

Merrie Frankel, vice president and senior credit officer, Moody's Investors Service, says the volatile market is taking a toll on investors, but the overall industry is sound. "The residential market is coloring the commercial market, and what you're seeing is perception over reality."

Edward Jones analyst Shawn Barnes also sees equity REITs emerging from the subprime crisis as a stable, long-term portfolio asset. "We're seeing a disconnect between the long-term financial strength of some companies and how the market perceives their value," he says.

Lisa Sarajian, managing director at Standard & Poor's ratings agency agrees. "Investor confusion with respect to the credit crisis and the woes of some mortgage REITs have affected all REITs, to some degree," she says.

While short-term credit woes are still a concern in real estate markets, to date the subprime disintegration has been largely restricted to the single family home sector. "When lots of capital is available, borrowers can shop for favorable lending terms and competition among lenders can lead to the potential for loose underwriting," says NAREIT Vice President of Research and Industry Information Brad Case.

Case doesn't expect panic among businesses whose profits are tied to home buying to significantly depress commercial property markets over the longer term. "That would only happen if there was a significant economic slowdown on the commercial side," Case says.

Sarajian says that the disappearance of cheap debt is likely to direct investors' attention back to sound management of commercial properties rather than acquisition of companies and their assets. "Now that debt markets are less certain and have less capital to finance, you are less likely to see a lot of aggressive leveraged buyout (LBO) activity," she says. "Many LBOs negotiated earlier in the year have been stranded and are waiting to be financed. The cost of financing any deal in this environment has gone up."

Consistent Performance

After 21 years with one of the nation's largest owners and developers of commercial properties, Dennis D. Oklak, chairman and CEO of Duke Realty Corporation (NYSE: DRE), takes a long view of the market's ups and downs.

Oklak insists that investors should separate stock prices from the reputations of the businesses in which they invest. "If you look at the history of our industry for the last 10-plus years, we have provided very consistent, solid returns to our investors. We have shown we can grow earnings and dividends," Oklak says.

Ron Donohue, an analyst with Hoyt Advisory Services supports Oklak's view. "A credit rating affects debt but does not affect my opinion of a company," he says. "A credit rating change impacts the cost of capital, but that seldom changes my opinion about a stock." In fact, those opportunities may be a bargain hunter's dream. "The key is that equity REITs have traded down, irrespective of quality, so discriminating REIT buyers have a chance to pick up high-quality stocks at good prices," he says.

Defying the Market

Case also points to advantages in the economic uncertainty. "Some commercial real estate investors on the margins are highly leveraged and aren't going to be in the market looking for more properties," he says. "However, these investors are mainly undercapitalized, short-term speculators who have always been the ones caught short from market cycles."

Frankel agrees. "When financing was easy to come by, it was harder for REITs to compete in the arena because of the requirement to keep lower leverage than private players. These companies can leverage up to the 70 percent range or more, compared to REITs that typically restrict themselves to the 40 percent to 45 percent range," she says. "In a situation where it is now harder to get financing, REITs may do well."

Jane Delfendahl, CFA, an investment officer with the California Public Employees' Retirement System (CalPERS), views this current market as a REIT investment opportunity. She says that CalPERS switched its strategy once prices in private commercial real estate pricing came down, expecting further declines of 15 percent to 20 percent. "We sold some of our REIT stocks in April 2007 when the market appeared more than fully valued," she says. "However, now the pricing is right we are beginning to look for opportunities in the industrial, residential and office sectors."

As pricing adjusts and the dust settles from the credit crunch, more investors will find opportunities when investing in REITs. "We are waiting for REITs to adjust to these values, and we will continue to look for opportunities as pricing becomes more attractive," Delfendahl says.