Management's Appetite for Acquisitions and Investment Opportunities Tempered by Wait For Prices To Hit Bottom
Since the credit crisis put a major scare in the economy in mid-August, Wall Street analysts have been especially keen to hear what executives for publicly traded REITs have to say about their third-quarter results -- and their financial outlook for 2008.
The major REITs have so far reported a mixed bag of third quarter earnings, with solid real estate fundamentals and earnings growth holding sway against higher borrowing costs and the threat of falling property values and associated diminished cash flow yields. REITs have tried to entice investors to stay tuned by saying they hope to use their low-leverage balance sheets to cherry pick opportunistic purchases from private-equity players that paid record prices for assets earlier this year and now find themselves squeezed to cover their debt service due to higher than expected borrowing costs and rents that have not risen as fast as expected.
For now, at least, it appears investors may may to wait a little longer for those expected opportunistic purchases as they have not yet materialized, for the most part.
The earnings season got off to an upbeat start, with most REITs last week reporting fundamentals in line with the Street’s expectations and posting better-than-expected growth in funds from operations (FFO), the measure used by investment trusts to define operating performance.
SL Green Realty (NYSE:
SLG) reported that cap rates are holding up better than expected in the bellwether New York office market -- as did Boston Properties (NYSE:
BXP), which believes distress sales will eventually translate into buying opportunities. ProLogis (NYSE:
PLD), the world’s largest industrial developer and landlord, beat analysts’ estimates and raised guidance as it ramps up development starts through the end of the year.
This week brought more fireworks. Large-cap REITs like Vornado Realty Trust (NYSE:
VNO) and Brookfield Properties (NYSE:
BPO) posted better-than-expected results, while Indianapolis-based Duke Realty Corp. (NYSE:
DRE) late Wednesday reported FFO at $99.9 million, or 68 cents a share, besting the consensus estimate of 67 cents a share.
Large-cap REIT shares got a shot in the arm on Wednesday after the Federal Reserve cut the federal funds rate by a quarter point to 4.50%, addressing some investors' concerns that the housing downturn and credit market turmoil will spill further into the broader economy.
What's your take on the outlook for real estate in 2008? E-mail CoStar Group Senior News Editor Randyl Drummer. Select comments may be added to the article as it is updated during the day, or we may contact you for a future article.
Equity Residential (NYSE:
EQR) jumped 4.8% to close at $41.78. Vornado Realty rose 1.67% to $111.72. Prologis rose more than 1.5% to $71.74, and SL Green Realty edged up 2.7% to $120.66.
The earnings and interest rate picture unfolds against an overall stable credit rating outlook for U.S. REITs, according to a report issued this week by Moody's Investors Service.
"In general, REITs have fared well during the credit crunch because of their typically moderate leverage, unencumbered properties and robust business models," the rating agency said. Average leverage for Moody's-rated REITs has risen only modestly so far in 2007, according to the report.
That flush financial condition will eventually open the door to buyers with ample cash and access to well-placed debt. The question, as always, is when.
Will well-capitalized potential buyers like Boston Properties be swamped with attractive acquisition opportunities in Washington, D.C., New York and San Francisco? Not so fast, said BXP President Doug Linde.
"The quandary is, even if you believe cash flow on the [acquisition target] will double in 10 years, the debt service and other capital costs necessary to get to that higher cap slope nirvana -- coupled with the accrual on the mezzanine financing -- means that any equity probably becomes a zero-coupon buy," Linde said in an investor conference call.
Although numerous buyers may have overpaid for properties over the last couple of years, "to date, no one has been prepared to recognize any losses. We’re just beginning to see these things play out," Linde added.
However, if and when they do play out, and as more equity is required to complete deals, Boston Properties said it is "very well positioned to take advantage of these new opportunities as they arise," Linde said.
"But we’re not going to be in the market for properties that can’t be underwritten rationally, and are still priced with inadequate yields," he added.
Moody’s sees no significant operating or leverage deterioration ahead -- although a widening of cap rates is already under way, especially for properties of lesser quality or in secondary locations, said Moody's analyst Christopher Wimmer.
"We may very well be entering a `Revenge of the REITs' period, where we see a greater premium on financial strength and operational capacity," added John Kriz, head of REIT coverage at Moody's.
The winners in this market will be equity REITs with leadership, good liquidity, operational depth, and established access to diverse financial markets including unsecured debt, Wimmer said.
Adds Kriz: "These characteristics were not highly valued in recent years when the wave of liquidity washed over the commercial real estate market, but they will lend significant strength now."
Standard & Poor’s REIT analyst Royal Shepard said the cyclical upswing in office occupancy levels since 2003 will moderate going into 2008, and tightening conditions in the credit markets may result in higher borrowing costs for REITs considering acquisitions of commercial properties in coming months.
"Also, property values may have weakened somewhat in recent months, although not as much as in the residential sector, in our view. We think REITs positioned in more favorable regions such as New York City, Washington D.C., and Southern California will outperform peers due to a combination of positive labor markets and office supply constraints," Shepard said.
Here are some snapshots of selected REITs that have reported earnings in the last 10 days:
Office/Industrial/Mixed
Boston Properties (NYSE: BXP) reported solid results, with third-quarter FFO of $1.15 in line with analysts’ estimates and revenue for the period rising 3.3% to $371.5 million from $359.5 million for the same period last year. The company said it expects fourth-quarter earnings between $1.12 and $1.13 a share and 2008 earnings between $2.52 and $2.62 a share. The solid FFO sets the stage for ramped-up development and core growth over the next several years for BXP, a REIT with a stable, high-quality office portfolio with above-average rent growth prospects. Citibank expects FFO growth of 7%-8% over the next three years.
"BXP is in an enviable position, with a considerably under-leveraged balance sheet with excess cash which can be used to fund development," Citibank REIT analyst Jonathan Litt said in a note to investors.
SL Green Realty Corp. (NYSE:
SLG), reported a 40% increase in FFO to $77.8 million or $1.25 per share last week. The performance blew past Citibank’s adjusted estimate of $1.06. SLG also raised its forecast for the year a third time, citing strong rent growth in its Manhattan properties. Revenue doubled to $259.2 million due largely to strong leasing activity at two Manhattan buildings, 420 Lexington Ave and 750 Third Ave., and due to its acquisition earlier this year of Reckson.
"While the positive conditions can change and capital will need to be spent, SLG should be able to capture some of the upside through aggressive leasing and renewals over the next few years," Litt said.
Kilroy Realty Corp. (NYSE:
KRC) reported that third-quarter FFO increased 2 cents above consensus to $28.2 million, or 81 cents a share, from $26.5 million, or 76 cents a share a year ago. The El Segundo, CA-based company’s occupancy was stronger than expected at 92.6% and expected to rise 94% by year end. The lack of pre-leasing in the company’s future developments combined with increased vacancy in San Diego could cause some investors concern, analysts said.
Vornado Realty Trust (NYSE:
VNO) reported that third-quarter FFO increased to $221.2 million, or $1.35 per share, compared with $204.5 million, or $1.31 per share a year ago - on target with analysts’predictions. The gains were driven by property sales, which grew to $31.9 million from $10.8 million.
Analysts said VNO continued to benefit from momentum during the quarter in its strong core office and retail portfolio, with key positions in New York and DC. Vornado’s overall growth is enhanced with a large and growing development and redevelopment pipeline that should boost earnings and NAV over time, noted James Feldman of UBS. VNO’s portfolio and balance sheet "are well positioned to profit given uncertain economic conditions, with New York office assets expected to generate strong internal growth of 6-8% as leases roll to market rents," Feldman said.
VNO’s New York retail operations should benefit from international shoppers and a weak dollar, Feldman added. Management maintains its appetite for opportunistic investment but is waiting for signs that market pricing has reached bottom. That said, access to capital - the company has a $2.5 billion credit line, among other financing options -- should put Vornado in a position to act fast, Feldman said.
Brookfield Properties Corp. (NYSE:
BPO), another of Manhattan's biggest office landlords, reported higher third-quarter FFO of $146 million, or 36 cents a share, up from $109 million, or 31 cents a share in the same time last year. BPO attributed the gain mostly to investment by its U.S. office fund, which closed in the fourth quarter of last year, along with improved occupancy and lease rates.
Brookfield's portfolio includes interests in 110 properties, including the World Financial Center in Manhattan, Brookfield Place in Toronto, Bank of America Plaza in Los Angeles and Bankers Hall in Calgary. The company said it expects to have a strong fourth quarter and to meet expectations for the year.
Apartment/Condominium/Mixed
Post Properties Inc. (NYSE:
PPS) announced third-quarter results in line with Wall Street expectations. Rental revenue for mature properties held longer than a year increased 4.7% compared with the third quarter of 2006. Occupancy remained at 95%, and most of the revenue increase came from an average rental rate increase of 4.2%. As in the second quarter, Post’s New York and Houston showed the strongest revenue gains at 9% and 10%, respectively. Rents in Post's largest market, Atlanta, rose by a modest 3.5%, however,
"The good news is that [Post] continues to be a net seller of property in what we think is a frothy market; the firm has sold over $200 million more of property than it has purchased in 2007," wrote Morningstar stock analyst John Coumarianos. "We project that rents will increase by an average of about 4% annually for the next five years. This is a significant improvement from the rent decreases and concessions that marked the start of the decade. We believe that the company's exposure to Atlanta, New York, and Washington, D.C., properties will drive this growth. These markets should offset the lukewarm outlook for the firm's Texas communities."
Equity Residential (NYSE:
EQR) said Tuesday its third-quarter FFO fell 12% to $172.4 million, or 62 cents per share. A consensus of analysts predicted FFO of 56 cents per share.
The company said results were hurt by lower net gains on sales of condominium units and land during the quarter. Higher debt costs, lower interest and other income, and lower property net operating income also hurt the bottom line. EQR’s growth in Orlando and South Florida is feeling the pinch from an excess supply of residential units. Seattle, San Francisco and Portland led the way or EQR with revenue growth of 6.7% to 8.8% year over year. But many of the company’s largest markets, New York metro, Los Angeles and Northern Virginia, showed decelerating year-over-
year revenue growth compared with last quarter.
What's your take on the outlook for real estate in 2008? E-mail CoStar Group Senior News Editor Randyl Drummer. Select comments may be added to the article as it is updated during the day, or we may contact you for a future article.