Real Estate Investment Trusts

Equity REITs have rebounded nicely over the past few months. So far this quarter, equity REITs have posted total returns of 36% (total return FTSE NAREIT Index). All sectors are up in the 2nd quarter; the best performing sectors were lodging (102%), regional malls (68%), shopping centers (42%), and industrial (37%).

Overall, REITs are still down 7% in 2009, vs. a drop of 3% in the Dow and a gain of 2.8% in the S&P.

OPPORTUNITIES

• Many REITs are still trading at discounts to NAV [net asset value], a good buy signal. Historically, over the past 7 or so years, REITs have traded near or in excess of NAV 

• Even with dividend cuts and share price gains, the average yield for equity REITs is still over 6%. Yields are well in excess (300 bps) of the 10-year Treasury, although the spread has narrowed considerably. 

• Most companies have been shoring up balance sheets by raising cash and paying down debt. 

• The credit freeze will have a positive effect on commercial real estate down the road; new office, apartment, and retail construction has slowed considerably which will benefit owners in a couple of years. Many companies that we cover have ceased all new construction.

• Commercial real estate fundamentals are deteriorating, although not as much as some feared. 

In this environment, we like well-capitalized companies that have adequate liquidity to fund maturing debt at least through 2010. One name we still have Buys on is Avalon Bay Communities, Inc. (AVB - Analyst Report), an apartment REIT with low debt and assets in infill markets where little new supply will be coming on board. Fannie and Freddie are still heavy lenders for apartments, which gives the sector access to relatively cheap capital.

In addition, we like Vornado Realty Trust (VNO - Analyst Report), another company with low comparative debt, lots of cash and class-A office assets in some good long-term, heavily supply-constrained areas.

WEAKNESSES

On the other hand:

• REITs still depend on access to debt to fund growth, and with the credit markets still tight, it will be difficult for companies to raise cheap debt. 

• Going forward, many REITs will raise capital through property level debt, dividend reductions, and equity offerings. Property level debt is harder to obtain and more expensive as commercial real estate prices continue to plummet. Many companies are writing down the value of assets. Share offerings are generally dilutive at low prices, and dividend cuts make the sector less attractive to income-oriented investors.

• A few companies are now paying a large portion of their dividends in new shares, which we view as a negative. This could become more common over the next few quarters if fundamentals decline bank lending does not increase. 

• REITs will be dependent on asset sales to raise cash. Overall commercial sales volumes decreased dramatically in 2008, and going forward it will be difficult to unload assets. There is still a large bid-ask spread between sellers and buyers. Sellers are holding out for pre-recession pricing. In addition, financing is hard to obtain. 

• Commercial real estate delinquencies are ticking up at a fast pace, which makes lenders nervous about exposure to the CRE sector. 

• Expect share prices to be volatile over the next two quarters. Headline risk, notably job growth and consumer spending patterns, which will both be negative in 2009 will continue to weigh on the sector. 

• Specifically, we are negative on suburban office and industrial going forward. Suburban office and industrial vacancies are ticking up at a rapid pace, and absent job growth, filling space will be difficult.