In the midst of economic uncertainty, what’s in store for REITs?

By Ryan Chittum

The good old days seem like a long time ago.

It's now been more than a year and a half since The Blackstone Group bought Equity Office Properties in February 2007, which in hindsight proved to be the top of the market. The credit crisis that began in earnest in August 2007 has continued unabated with no end in sight. Deal-making has withered, and real estate has begun to deteriorate as the shock of the housing bust and its aftereffects continue to spread through the economy.

The U.S. has shed jobs for nine straight months, bad news for everybody, but particularly for the office market. Inflation has risen at the fastest clip in nearly two decades, hitting hotels, whose customers have been slammed by rising gas prices and airfare. Retail is getting knocked around by inflation and also by the lowest consumer confidence in more than three decades.

However, the sectors have widely varying prospects, as do companies in the same sector who have different geographical footprints and debt loads. "If you're to look at it from a risk perspective, retail has the highest risk profile right now, then hotel, industrial, office and then apartment," says Glenn Mueller, a real estate investment strategist at Dividend Capital Group, a real estate investment management firm.

Some analysts are sanguine on the industry as a whole. "We generally think that the relatively decent fundamentals are certainly balanced with some significant risks that still remain in the overall economy," says Paul Adornato, REIT analyst at BMO Capital Markets. "But given valuations which have corrected significantly since a year ago, we've had a market perform [recommendation] on the REIT sector overall since early this year."

Reduced demand has pushed up capitalization rates, but by how much is hard to tell. Most of the commercial real estate industry—especially in REIT land—is still fundamentally sound, seeing only marginal deterioration so far.

"REITs so far have done a pretty good job collectively of avoiding capital markets problems," says Mike Kirby, chairman of Green Street Advisors. But, "We expect real estate pricing to drop quite a bit, and we don't see how REITs can fare well in that environment," he adds.

While everybody's hurt by the credit crisis, the economy is hitting REIT sectors in different ways.

Office Embedded Rent Growth

Demand for office space is heavily correlated with the health of the job market, and in recent months, companies have been shedding jobs. Employment has fallen in every month since January for a total loss of more than 764,000 jobs, and the unemployment rate has jumped to 6.1 percent in September, from 4.7 percent a year ago.

Those aren't terrible levels for a downturn, especially compared to similar times in the previous two recessions, but they've pushed office vacancy rates up by 50 basis points to 13.6 percent, according to Reis, Inc. "On the office leasing side it's softening, there's just no question about it," says Bob Bach, senior vice president and chief economist at Grubb & Ellis.

This downturn likely will be more moderate than past ones because of the relatively restrained construction in recent years. However, there are still some 100 million square feet of office space in the pipeline, and it seems likely that the economic impact of this crisis will be more severe. Bach says that will push vacancy rates up two percentage points and any significant negative absorption of office space could result in a peak vacancy rate of 17 percent versus 18 percent in the last two down cycles.

But, for now, the market isn't that bad yet. Landlords aren't tripping over themselves to hand tenants concessions just yet, and some companies whose leases are rolling over are deciding to stay put rather than take a gamble one way or another on new space.

William P. Hankowsky, chief executive of Liberty Property Trust (NYSE: LRY), an office and industrial REIT, says he's seen a noticeable increase in renewal rates at his properties, which has reduced transaction costs by $5 million a quarter in recent months.

Additionally, many landlords have a considerable cushion from the rising rents of recent years to help them through a prolonged downturn. "The good news for a lot of office owners in high-barrier office markets like Boston, New York and San Francisco is that they have a lot of embedded rollover rent growth," Kirby says.

Retail Location Cuts through Economic Swings

Retail is another story. It's at the high end of the risk spectrum, according to Mueller, because of concerns about the consumers, who are loaded with debt, feeling much less wealthy and extremely worried about their financial security. Real consumer spending and personal income both fell significantly in July.

Lower spending pushed second-quarter vacancy rates at malls to 6.6 percent, the highest level in seven years, says real-estate research firm Reis Inc. Shopping centers are worse off. Vacancies hit 8.4 percent in the second quarter, the highest in 14 years.

Grocery-anchored strip centers fare much better than power centers in economic downturns, because they tend to have tenants that sell non-discretionary goods and services like food and drugs. Large malls are typically better off than strip malls because they have more chain stores with resources better able to weather the financial storm. That's held true so far in this cycle, but discretionary spending, which malls depend on, is getting hurt by the credit crisis.

"We'd also point out that where you own your centers is important," Adornato says. "In markets that are greatly exposed to single-family housing construction and where you now have lots of laid-off construction workers and plummeting home prices, those are where shopping center operators will have a hard time."

REITs tend to own premier pieces of property—ones that are better-located with higher-quality tenants and better inured to economic trouble. "The bottom line is that good real estate with good people kind of cuts through all the broader economic swings," says David St. Pierre, president of Legacy Capital Partners, a real estate private-equity firm.

For example, Taubman Centers Inc. (NYSE: TCO) has the most productive portfolio of the mall REITs. CEO Robert S. Taubman says high-end shoppers are holding up fairly well, with sales up 3 percent so far this year. "Given what other companies and retailers have reported, we believe [it] suggests the better-income customer is doing much better," he says. "More broadly, more moderate-income assets and centers are experiencing much flatter-to-down sales comps within our industry." He says restaurant sales are up, indicating that shopper traffic has held its own so far.

Taubman says he is comfortable with the outlook for REITs as long as unemployment stays in the 6 percent range, but "not 7 percent." As long as they have jobs, "people will continue to have cash flow to buy goods and services, regardless of the negative impact from housing related net-worth losses," he says.

Kirby notes that the high-end malls that REITs tend to own have embedded rent growth that would take vastly higher vacancy rates—300 to 400 basis points higher—to erode. John Bucksbaum, CEO of General Growth Properties Inc. (NYSE: GGP), says that retailers' balance sheets are in much better shape than they have been in past recessions—something that will help ease pressures on vacancies by mitigating bankruptcies.

But, there are company-specific problems in mall-land, too. General Growth, the Chicago-based mall REIT, is struggling under a heavy debt load. Its shares have underperformed its closest competitor, Simon Property Group (NYSE: SPG), which has much less debt, by nearly 50 percentage points in 2008 through August. "These are two companies whose core businesses doesn't look all that different," Kirby says. "But one company has managed its balance sheet better."

A thaw in the debt markets would ease General Growth's problems considerably. Meanwhile, Bucksbaum says his company is actively looking to lower its debt by selling non-core properties, selling bonds, and entering into joint ventures. "We're in the market working on all of them," he says.

Industrial Remaining in First Gear

Retailers cutting back expansion plans and inventories not only hurts malls and shopping centers, it puts a damper on the industrial market as well. In addition, manufacturing activity has been soft despite the growth in exports. The Institute for Supply Management's measure for August showed the sector contracting ever so slightly.

"All of the stocks except EastGroup Properties (NYSE: EGP) have gotten hit pretty dramatically this year," Adornato says. As of early October, stocks in the sector had shed more than a fifth of their market values. That's despite the weak dollar, which has spurred export activity. "What's important to industrial REITs is not the direction of the goods that are flowing but the overall volume of trade," he says. Even industry leader ProLogis Inc (NYSE: PLD) has seen its share price sliced by about a fifth through August.

Adornato says development yields of companies he covers, including Liberty, East Group and First Industrial Realty Trust (NYSE: FR), are in the 9 percent to 10 percent range, and notes that REITs own just 5 percent of the sector's property and that it's the "cream of the crop."

Green Street projects that industrial REITs will see net operating income of zero in 2009—"and that could prove optimistic," Kirby says. "People talk about 'Gee, things aren't that bad'. And none of these numbers are Armageddon, but they've gotten a lot worse."

Hankowsky says despite the modest downturn, "I think the economy might remain in first gear. I'm not sure it's going to stall out."

MULTIFAMILY
Withstanding the Downturn

The multifamily sector is likely to make it through the downturn—especially one led by the collapse of the home market—with the least amount of trouble. Home loans are much harder to come by these days. Green Street Advisors projects revenue and net operating income in apartments will both rise by approximately 2.5 percent in 2009.

"I think multifamily can continue to do well," St. Pierre says. "Fewer and fewer people can own a home, and that means there are more renters in the rental pool."

While the oversupply of condominiums and single-family houses has introduced some competition for rentals, especially in markets in hard-hit areas like California and Florida, most in the industry see future demand for rentals being relatively solid. Mueller notes that population growth alone adds 2.7 million people a year in the U.S. and the "echo boom" generation is in their 20s—the age that tends to rent the most.

SELF-STORAGE AND HEALTH CARE
Driving Demand

Additionally, self-storage, a sector some thought would be hit by the housing bust, has proven strong this year, with stocks up about a fifth through August. "What we saw is the self-storage tenant is quite sticky and there are many drivers of self-storage demand," Adornato says. "Losing a house can be as much a reason for renting a self storage space as moving to a metro area for a new job."

Health care REITs haven't fared well in the downturn, but have done better that the overall industry because demand is stable and typically a must-have. So far this year, health care REITs are up. On the other end of the spectrum, hotels have been hit particularly hard already by the downturn.

HOTELS
Facing Headwinds

Green Street Advisors is forecasting a decline in hotel net operating income for 2009 of 7 percent. "The fundamentals have really fallen apart in the hotel sector," Kirby says.

Looking ahead to what happens next, it all comes back to capital markets and how long it takes for them to heal. Nobody's terribly optimistic. Kirby says he doesn't see financing easing up for at least a year. St. Pierre is hoping for a turnaround next year, and the consensus on Wall Street seems to be that nothing will happen until the housing market bottoms out. However, most REITs are in pretty good shape to make it through.

"The vast majority of REITs have done a good job during the good times of shoring up their balance sheets and putting in place long-term fixed-rate financing at very attractive rates," Adornato says. "They're well positioned to weather this storm for the next 24 months or longer."

Companies with the strongest balance sheets will be able to sit back and buy property on the cheap at some point, though right now nobody wants to be the first to try to catch the falling knife. So far, cap rates have risen anywhere from 75 to 125 basis points, according to BMO. Vornado Realty Trust (NYSE: VNO) is sitting on a $4 billion "war chest," Kirby says, and Simon swooped in with a big debt offering earlier this year at an opportune time. Also, Simon and The Westfield Group (ASX: WDC) have taken stakes in British mall REIT Liberty International (LSE: Lll.L).

Still, with so much uncertainty about the economy and how bad it might get, this is when good management teams earn their paychecks.

"You are nervous that something is going to turn and get worse, and you want to be able to react to that quickly," Hankowsky says. "This is a more management-intense environment than an upturn where you've got the wind in your sails."