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Real Estate Investment Trusts

The U.S. Real Estate Investment Trust (REIT) industry continued its strong performance in first quarter 2010 that started with the recovery at year-end 2009. The FTSE NAREIT Equity REIT Index reported total returns of 10.02% in first quarter 2010, vs. a 5.39% and 4.11% gain for the S&P 500 and the Dow Jones Industrials, respectively.

The strong performance of the FTSE NAREIT Equity Index was primarily attributed to the stabilization of market fundamentals, which resulted in relatively stable fourth quarter earnings. The quarterly results also benefited from cap-rate compression and tightening credit spreads, as well as from low interest rates and government policies, including subsidized mortgage rates, tax credits, increased FHA (Federal Housing Administration) lending and a government-sponsored slow down in distressed liquidations.

Earlier in 2009, REITs and REOCs (Real Estate Operating Companies) raised nearly $38 billion in an industry-wide push to recapitalize balance sheets, and over 90 secondary equity offerings were issued in addition to 37 unsecured debt offerings. However, now that the economy shows signs of revival, REITs are on the way back up. With gradual stability in the overall industry, sector dynamics and individual companies’ strategies are currently receiving greater attention in order to capitalize on the future growth potential.

The standout performance in the industry during the first quarter was that of the hotel sector (a total return of 22.0% as measured by the FTSE NAREIT Equity REIT Index), followed by shopping-center REITs (14.0%), self-storage sector (11.7%), apartment REITs (9.7%), regional mall sector (9.5%), office sector (8.8%), healthcare REITs (6.8%) and industrial REITs (3.4%).  


Many REITs are still trading at discounts to NAV (net asset value), traditionally a good "buy" signal. Over the past 7 or so years, REITs had traded near or in excess of NAV.

With dividend cuts and share price gains, the average yield for equity REITs during first quarter 2010 was 3.9%, compared to 3.8% for the 10-year Treasury, as most companies have been raising cash through asset sales and equity financing to pay 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 stopped all-new construction.

In this environment, we like well-capitalized companies that have adequate liquidity and manageable near-term debt maturities. Currently, we are bullish on American Capital Agency Corp. ([url=]AGNC[/url]), a mortgage REIT that invests exclusively in agency securities for which the principal and interest payments are guaranteed by U.S. government agencies like Ginnie Mae, Fannie Mae ([url=]FNM[/url]) and Freddie Mac ([url=]FRE[/url]). The company has a conservative balance sheet and maintains adequate liquidity sufficient to continue operations under potentially adverse circumstances. Furthermore, American Capital is one of only a few companies to have increased its dividend during the economic downturn.

Another stock worth mentioning is Vornado Realty Trust ([url=]VNO[/url]), the largest publicly traded office REIT in the New York region, concentrating on Class A office properties. The core properties of Vornado are still performing at a high level, maintaining strong occupancies and increasing rents in most property formats. We believe this puts the company well ahead of many competitors, and warrants upside potential.

We would also like to mention Simon Property Group Inc. ([url=]SPG[/url]), the largest publicly traded retail real estate company in North America, with assets in almost all retail distribution channels. The geographic and product diversity of the company insulates it from market volatility to a great extent and provides a steady source of income. Furthermore, Simon Property’s international presence gives it a more sustainable long-term growth story than its domestically focused peers.


REITs still depend on access to capital to fund growth, and with the credit markets still not fully back to normal, it is difficult to raise money for new developments/acquisitions. In this scenario, most REITs are raising capital through property level debt, dividend reductions and equity offerings.

Although both debt and equity financings provide the much-needed cash infusion, they could potentially burden an already leveraged balance sheet and/or dilute earnings. Property level debt is also harder to obtain and more expensive as commercial real estate prices remain under pressure.

Fundamentals are declining in many suburban office markets as corporate expansion continues to slow. More and more corporations are putting off leasing decisions until the economy recovers. Recent employment trends are also not encouraging as the U.S. economy continues to shed jobs at a rapid pace.

Year-to-date, the U.S. has lost over 8.4 million jobs since the start of recession in December 2007. The national unemployment rate has also remained relatively high at 9.7%. As the U.S. economy struggles with the economic downturn, REITs will have trouble holding tenants and leasing new space.

Given the market uncertainties, we are bearish on Developers Diversified Realty Corporation ([url=]DDR[/url]), which is primarily engaged in owning and leasing shopping centers across the U.S., Puerto Rico, Brazil, Russia and Canada. The current recession has led to increased tenant bankruptcies, which in turn have led to a decline in occupancy and an increase in vacancy rates. The possibility of store closings at many Developers Diversified centers further adds uncertainty to the earnings, and it might have to re-let large "big-box" spaces at significantly lower rents in a very tough leasing environment.

We would also avoid BRE Properties Inc. ([url=]BRE[/url]), a real estate investment trust (REIT) that develops, acquires and manages multi-family apartment communities, primarily in the Western U.S. BRE Properties has exposure to some weakening multifamily markets, notably, The Inland Empire, Los Angeles, and Orange County, which together make up over 40% of the company’s portfolio. Furthermore, stagnant job growth has negatively affected the demand for apartments, and high-end apartment homes such as that of BRE Properties have been hit the hardest as renters move down to less expensive ‘B’ class properties.

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