Diamonds in the Reits rough
Depending on which market barometer you read, real estate investment trusts are either a potentially good investment or best left untouched, even by the longest bargepole. The minute one of the sector’s standard bearers attempts to make a rallying call, almost immediately it receives another hammer blow.
Research and analysis of Reits offers vastly conflicting opinion. For instance, Standard & Poor’s third-quarter report into global property suggested Reits offered investors some opportunity. This despite, or perhaps because, in mid-November, US Reits had falled 70% from their February 2007 peak, and 58% since October 1. Picking her words carefully, Beth Piskora of S&P Equity Research wrote: "It’s been a tough real estate market but S&P Equity Research is still enthusiastic about select real estate investment trusts."
S&P still ranks some Reits with four and five stars and believes in the long term larger Reits should be set to perform well. Ernst & Young’s latest research, Global Reits: Riding out the storm, showed that Europe and Asia’s Reit markets were holding up well, posting small gains in market cap during the year, despite the gloomy conditions. Total market capitalization of publicly listed Reits around the world reached nearly $605 billion to June 30 this year, down from $764 billion a year earlier.
"Like every other sector of the real estate market, publicly listed companies have been hit very hard by the global credit freeze. It remains to be seen when Reit markets will stabilize," says Michael Frankel, global director of Reit services for Ernst & Young.
He adds that Reits in Asia have been the best performers, in terms of one-year and three-year returns, for the 12-month period ending June 2008. "With China planning to launch a pilot Reit programme next year, there is likely to be renewed interest in the public Reit sector in Asia," he says.
Other Reits supporters point out that the FTSE EPRA/NAReit Global Reits index has performed relatively well against other equity indices (showing a loss in mid-November of 8.9% year to date against the UK losing 19%).
Index exile
Equally detractors cite strong reasons to be wary of Reits. Most glaringly there was bad news from the US in mid-November as Reits faced further selling pressure after the highly leveraged General Growth Properties, one of the country’s biggest mall operators, was thrown out of the S&P 500 index after it plummeted in value — losing 99% this year (see following feature).
"There are headwinds in every direction for Reits," says Joel Bloomer, an analyst at Morningstar. With consumer spending falling off a cliff, retail tenants are suffering badly and this pain has been passed on to landlords with falling rents hitting Reit cashflows.
In another blow to the sector, ProLogis, a global industrial Reit, lost its chief executive, Jeffrey Schwartz, as it announced a plan to save capital, including a dividend cut. ProLogis shares fell 68% in the first two weeks of November. Other symptoms of sickness are clear from the exchange-traded fund SPDR Dow Jones Reit, which had fallen nearly 50% year-to-date by mid-November.
"Reits are the most volatile publicly traded equity sector, routinely putting up total daily returns equal to what the sector should logically do in an entire year," analysts from Stifel Nicolaus wrote in a November research note. "Increased volatility could be a harbinger of either total capitulation or pending recovery. However, it more probably simply reflects a small, thinly traded group that is being buffeted by external factors."
Nothing has been immune. "Reits with even the most pristine balance sheets have been damaged," says Stifel Nicolaus. "Reits that focus on development have also been singled out for poor performance, especially those with high capital requirements and dependency on construction gains to meet earnings goals."
The National Association of Real Estate Investment Trusts (Nareit) struggles on manfully, banging the drum for its industry. "Reits continue to offer a strong value opportunity for long-term investors," it said in its November briefing. "Some real estate industry analysts are pointing to the likelihood of a 20% drop in direct commercial real estate values from the 2007 peak. Yet Reit stocks are currently down approximately 47% from their peak in February 2007."
Nareit argues that Reits led the private commercial property market on the way into the current downturn as they traditionally have done and are now trading at a deep discount to the level the direct property market is projected to reach.
It adds that Reits have also traditionally led the private commercial property market in recoveries and therefore were offering an exceptional value opportunity. On top of that they provide strong and reliable dividends. "There are very few income investments today delivering yields that even come close to matching the rate of inflation, much less yields that match those of Reits."
Gearing too high
Perhaps the biggest factor counting against Reits is their level of gearing. The order of the day remains deleverage wherever possible, and the typical Reit will have leverage of 40%.
The market is taking against anything with leverage and hitting it hard. Reits commonly rely on short-term leveraging and many may need to refinance by the end of the year. Failure to do so could trigger firesales of properties, and in the current market, that would lead to severe losses.
The UK’s Real Estate Investment Trust Association (Reita) says that, particularly in the UK, leverage levels are covered by regulation so refinancing is not so pressing a problem. However, even Reita remains realistic about prospects. While they have offered some diversification from direct property investment and property open-ended investment companies (Oeics), they are not immune to a weakening economy. A drop in tenant demand will hit Reits as much as any other part of the property industry.
Between September 19 and the end of October, the FTSE Real Estate Index fell by one-third, although there was then a bounce after the UK government’s bank bailout plans were announced.
