Accepting Fate: REIT Execs Look Ahead to Market Rebirth

Call it the sound of collective mourning. Throughout more than 60 roundtable discussions between analysts and real estate investment trust executives gathered this week at Citigroup’s three-day Global Property CEO Conference in Naples, FL, REIT management teams representing all U.S. asset types returned again and again to a now-familiar list of themes and concerns.

Stalled transaction activity is inhibiting the market's ability to establish reliable property values, and vice versa. Occupancies, absorption, rents and other property fundamentals are weakening in tandem with the declining job market and shaky consumer confidence. REITs seek to preserve capital by cutting dividends, writing down investments, trimming costs and canceling development projects. And perhaps most urgently, highly leveraged firms are still trying, with limited success, to navigate the frozen flows of capital markets, refinance or retire debt -- and at the same time, try to predict when to make a well-timed re-entry into the acquisitions arena.

Citigroup research analyst Michael Bilerman conjectured that the industry may have entered the last of the "five stages of grief" -- acceptance -- after the REIT sector's initial reactions of denial, anger, bargaining and then depression following the financial crisis that first gripped the industry last fall. "I think we’ve now gotten to the acceptance phase," he said. "There are more people who accept where things are now. Companies are focusing on what needs to get done, on their core business and balance sheet ... there's a little more hope than utter and complete chaos."

Even so, it was challenging to detect hope among the veteran CEOs in attendance. Interest rate spreads are still way too high for the economy to recover quickly and property prices are at a 10-year low, stated Steven Roth, CEO of Vornado Realty Trust (NYSE: VNO), owner of a diverse mix of New York City office buildings and retail properties in the Northeast.

"We’re in a period where asset values are deflated, and that has driven out all normal-course lending because nobody wants to make a loan; nobody knows the value of the collateral of what they’re lending against," he said. "We say frequently, one of the things that makes a bottom is stupid, stupid, stupid low [implied] asset values, and we’re getting to at least the first or second ‘stupid.’"

Still, Roth predicts the "greatest opportunity in our lifetime to buy things extraordinarily cheap" will soon be within sight.

"If people have the liquidity and the smarts and intelligence to navigate, I think there are going to be some incredible buys whether in the public or private markets. There’s going to be more good quality assets available than we all combined have the capital for. There’s going to be three or four years of investing -- there’s that much product available. There’s more product than there is capital now, and that will continue for years."

Office Sector: NYC Hammered by Financial Meltdown

Vornado has $1.7 billion in liquidity in reserve for the future market turnaround. For now, however, all the big REITs that own office buildings in New York City - Vornado, SL Green Realty (NYSE: SLG), Boston Properties (NYSE: BXP) and Brookfield Properties (NYSE: BPO) - were in agreement that midtown and downtown market fundamentals continue to erode, marked by declining rents and midtown vacancies up as much as 4% over last year.

CB Richard Ellis estimated recently that New York banks, securities firms and insurers, led by the bankrupt Lehman Bros. Holdings and other troubled financial titans such as JPMorgan Chase & Co. and Citigroup, may vacate as much as 8 million square feet of office space this year. See related CoStar Advisor story, titled "Financial Services Industry Continues Bleeding Money, Jobs"

However, occupancy in SLG’s Midtown Manhattan portfolio is holding steady and leasing has been healthy in the first quarter of 2009, given the deterioration in financial services and the rising tide of sublease space.

In a bit of news that would dump more space onto the Lower Manhattan if it comes to fruition, SL Green Chief Executive Officer Marc Holliday told the conference this week "it is our understanding that Merrill [Lynch] will be moving much of its banking, sales and trading" later this year from the World Financial Center -- adjacent to the "Ground Zero" site where the World Trade Center buildings stood -- to fill available space in new ML owner Bank of America Corp.'s new $1 billion tower at 1 Bryant Park, among other Midtown locations.

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Boston Properties has turned away from acquisitions and development to focus on shoring up its balance sheet. The REIT is trying to grow occupancy and renegotiate leases but leasing activity has been extremely light, CEO Douglas Linde said.

In the capital markets arena, BXP expects bankers' loan commitments will be smaller -- for example, the company has downsized its loan funding expectations for its Russia Wharf project from the original $300 million to between $250 million and $300 million.

Industrial: Huge Portfolios on the Market

The world’s two largest owners of industrial property, ProLogis (NYSE: PLD) and AMB Property (NYSE: AMB), told investors they are focused on deleveraging and generating liquidity through asset sales, cost savings and stockpiling capital for future opportunities.

AMB has a total of $1.6 billion in assets available for sale or joint venture and expects to sell at least 50% to fund $950 million in debt and development funding coming due through 2013. AMB CEO Hamid Moghadam pointed out that world trade is likely to pick up this year and new industrial supply will probably stay in line with demand. While average vacancies of up to 13% are expected in the broader industrial market, Moghadam said AMB’s portfolio occupancy would remain in the low 90% range.

ProLogis CEO Walter C. Rakowich said his company, which has been hammered by the global financial meltdown, cut the size of its development pipeline from $8 billion to $5.1 billion by the end of 2008, including the postponement or cancellation of more than $550 million in construction projects that had not yet gone vertical.

"Today, we find ourselves in a much stronger position. We’ve made a [lot] of progress but we’ve still got more wood to chop," Rakowich said.

Specifically, the REIT targets up to $1.5 billion in asset sales to help deleverage. More than half to two-thirds of that will come through contributions of assets to already raised international funds. However, ProLogis hopes to raise a substantial sum through the sale of a 30 million-square-foot portfolio of U.S. properties, put on the market in late December for a combined asking price of $1 billion. By the beginning of February, ProLogis had received 87 offers, Rakowich said.

"We didn’t know what the buyer’s universe looked like. We now think we know where the market is," he said, adding that offers for the properties are "all over the map."

ProLogis expects to raise at least $500 million through the sale and has "entered into letters of intent with all the people we need to hit that goal," he said.

Selling the assets and closing the previously announced sale of ProLogis’s China operations for up to $1.4 billion, while backing out $800 million to complete developments in progress, will reduce the company’s leverage by roughly $2 billion by year’s end, Rakowich said.

As for fundamentals, ProLogis predicts that rents will continue to decline and occupancy of its portfolio will go down 150 to 300 basis points this year from the current 93-94%.

"The saving grace on rents is that in a tough market, companies tend to simply renew. I’m cautiously optimistic our renewal rates will be very high this year, but some of the guys in the field are talking about 5% [rent declines], and if that’s all it is, I’ll be one happy camper."

Apartments: Flat Rents and Occupancies

Apartment REIT executives for the most part agreed that weakness in the larger economy is canceling out any advantages enjoyed by apartments due to favorable demographics and declines in home ownership over the last few years. AvalonBay Communities Inc. (NYSE: AVB) CEO Bryce Blair said apartment fundamentals are simply being "overwhelmed by the sheer magnitude of job losses in the weak economy."

AVB made no acquisitions and sold $650 million in assets last year, the most in company history, to build liquidity. However, the REIT also sourced a record $2 billion in the capital markets last year and will continue to pursue more secured debt this year through the Fannie Mae and Freddie Mac agencies to fund future distressed-asset acquisition opportunities.

In the first two months of 2009, AvalonBay has recorded positive revenue growth in its Seattle, Northern California and Washington, DC apartment portfolios, while revenue has declined in its Southern California, New York and New England markets.

The company cut development starts by 50% last year and will start no new projects through at least mid-year of 2009. However, as it did during the downturn earlier in the decade, the development-minded REIT resisted pressure from Wall Street during the current cycle to prematurely shut down its development pipeline, he said.

"Those companies that try to turn [development] on and off are going to be constantly missing the timing and the cycle within development," Blair said. "While the capital markets are certainly different this time around from 2001-‘03, there are many parallels. We were one of the few companies [during the previous cycle] who were able to start construction in the 2003-‘04 time period, delivering very robust volume."

Blair and other apartment REIT execs believe 2009-‘10 will be very weak times for the economy and for apartment fundamentals.

"But as you look forward to 2011 or 2012, one thing is certain: there will be a shortage of new product in this country," Blair said. "There is virtually nothing being permitted or financed today, and little that will be started in ’09 or ’10. For those companies with a capacity from a balance sheet point of view to keep their organization and development in place, I have no doubt there will be rewards for those who can deliver into that time period."