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REIT Industry Hopeful, Analysts Cautious Ahead of Upcoming Industry Conference in Manhattan

Deal Volume, Prices Continue to Fall as Talks For Sale of Macklowe’s GM Building Unfold in NYC
May 21, 2008
Boston Properties, Goldman Sachs and two Persian Gulf investors are reportedly in talks to buy Macklowe's GM Building for $2.8 billion.
Boston Properties, Goldman Sachs and two Persian Gulf investors are reportedly in talks to buy Macklowe's GM Building for $2.8 billion.
Despite the relatively strong market showing of equity REITs this year, Wall Street continues to be cautious about the outlook for the sector.

"We remain concerned about current valuation, slowing fundamentals and the lack of transaction volumes," Goldman Sachs analyst Jonathan Habermann wrote in an investor note last week. Habermann expects a sell off of 15% or more "as investors adjust return expectations in light of higher funding costs and lower leverage, not to mention more modest growth rate assumptions.

"Across all major property sectors, we are now beginning to see early yellow flags, indicating that a slowdown in fundamentals is underway," according to Habermann. "In fact, REIT executives are no longer forecasting increases in the pace of rent growth or occupancy levels. Instead, companies now seek to maintain occupancy at the expense of rent growth."

The focus of investor concerns this past week ahead of NAREIT’s REITWeek investment forum in New York June 4-6, was split between the two coasts. In Los Angeles, the board of directors of Maguire Properties (NYSE:MPG) voted last Saturday to replace its chairman and CEO, Rob Maguire, with former Catellus Development Corp. President/CEO Nelson C. Rising, and elected Walter L. Weisman chairman. The moves capped months of turmoil for the L.A.-based landlord, which developed the U.S. Bank Tower in downtown Los Angeles, the tallest building on the West Coast. Maguire and his team have been under fire from Wall Street for more than a year because the company has underperformed its REIT peers following its decision to load up on Orange County investments just before it became one of the first office markets in the country to be hit by fallout from the subprime residential mortgage meltdown.

Meanwhile in New York City, REIT analysts are closely watching talks that could lead to the purchase of Harry Macklowe’s General Motors building and three other properties by a consortium that includes Mort Zuckerman’s Boston Properties (NYSE: BXP), Goldman Sachs and two Persian Gulf investors for a reported $3.9 billion. The ultimate pricing of that transaction could cast a new light on a real estate market.

This week alone, three reports have pointed to weakening prices and deal activity:

  • According to the National Association of Realtors (NAR), transaction activity fell during the first three months of 2008 and will likely continue to drop in the coming months. The first quarter marked the third straight quarterly decline since mid-2007.


  • Another report by Moody's Investors Service said Monday that property prices fell 2.3% in March -- the steepest one-month decline in commercial real estate prices since the dawn of the decade.


  • Architects, harbingers of future development activity, chimed in Wednesday with evidence that commercial construction may remain flat for at least the next year. The American Institute of Architects (AIA) reported that billings for blueprints of future commercial buildings remained weak in April. The billing index rose slightly to 45.5 -- up from March’s record low of 39.7, but still the third straight month of contraction in design billings for buildings which would be constructed nine to 12 months in the future.


Net absorption and completion of new commercial buildings will be positive but somewhat weaker over the next six to nine months, predicted NAR Chief Economist Lawrence Yun.

"Along with the impact of the credit crunch, a weakening in leasing and building sales activity should come as no surprise because commercial real estate follows changes in overall economic activity," Yun noted.

However, although often overlooked, there is some honey to go with this mostly vinegar-soured outlook. AIA Chief Economist Kermit Baker said the April uptick in the architecture billing index shows the slowdown is beginning to level off after precipitous drops in the index for two months.

"Even though the downturn in design billings has come on very quickly, most areas of the country aren’t showing signs of an oversupply of nonresidential facilities," Baker said. "That provides hope that this weak patch may be relatively short-lived."

Yun said the long-term fundamentals for commercial property remain bright. "The job market is weak, but not recessionary," he said. "There are large regional variations, with job growth in the South, while overall professional business service jobs are in the process of a long-term expansion. The U.S. is the world leader in the knowledge-based industry, and trade exports are solid -- combined, these are solid underlying fundamentals for positive rent growth and net absorption."

The National Association of Real Estate Investment Trusts (NAREIT), gearing up for its annual REITWeek investors conference featuring 130 companies next month, pointed out that its FTSE NAREIT All REIT Index has soundly outperformed other major markets so far in 2008. Through the first four months of 2008, the equity REIT index was up 7.34%, while the Dow Jones Industrial, the S&P 500 and the NASDAQ Composite were all in the red. Self-storage REITs (+23. 83%), apartments (+14.87%) and shopping centers (+10.14%) remained the best of breed so far.

Overall REIT fundamentals, however, are likely to deteriorate in the second half of 2008 and in 2009, Habermann said.

Occupancy could decline 50 to 100 basis points and rents could similarly drop over the next year as demand slows and tenants gain the upper hand with landlords, he said. Moreover, most companies are scaling back development to offset the risk of recession.

Among the select REITs earning a "buy" recommendation from Habermann is Boston Properties, which is heavily invested in the New York City office market and looking to become more so. BXP, Goldman Sachs, the Qatar Investment Authority and the Kuwait Investment Authority are reportedly ready to pay $2.8 billion for the GM building alone, up to 15% below the original asking price. In fact, at least one estimate once pegged the value of the landmark building at $4 billion.

The assets are part of the former EOP New York portfolio Macklowe bought from Blackstone last year for $7 billion, including about $6 billion in short-term financing from Deutsche Bank and a $1.2 billion mezzanine loan from Fortress. The loans have been in default since February, forcing Macklowe to sell.

In the minds of some analysts, the purported deal has mixed -- if not contradictory -- messages about the state of the market.

The sale "would be a positive sign that the credit markets have modestly improved and that investors with equity capital are seeking new opportunities," Habermann noted. That said, the price cut for the GM building is "a clear reflection that investors have altered their return requirements and that cap rates still need to adjust upwards" in light of higher financing costs and weaker fundamentals, he added.

Shares of New York-focused office REITs including BXP, SL Green (NYSE: SLG), Brookfield Properties (NYSE: BPO) and Vornado Realty Trust (NYSE: VNO) could come under pressure if pricing for the GM building continues to fall, or the deal falls apart, Habermann said.

However, the analyst maintains his favorable view of the NY market. The implied $1,400-psf price for the GM building would have an estimated cap rate in the upper 3% or lower 4% range -- below analyst assumptions for the New York market, Habermann notes.

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