Improvement Among the Stronger Rated REITs May Provide a Road Map Towards a Wider Industry Turnaround
Data from the National Association of Real Estate Investment Trusts (NAREIT) clearly show that investors have smiled on REITs so far this year. There were 45 secondary equity offerings in the REIT industry in 2009 through May 31, which raised $14.2 billion. In May alone, 18 secondary equity offerings raised $5.3 billion. By comparison, there were 76 secondary offerings in all of 2008 raising about the same amount.
This was greeted as very good news indeed by commercial real estate observers, as REIT share prices historically lead direct commercial property values by approximately five quarters, and the trough in the current market cycle may have been reached in early March, NAREIT reported. REIT shares fell 75% from the industry's peak in February 2007 through this March 6. But from that point through the end of May equity REITs were up 58%, led by double-digit gains from lodging and commercial financing REITs.
But just to prove there's no pleasing some people, the New York securities ratings agencies this week threw cold water on investor enthusiasm for the REIT sector. In its latest quarterly REIT report entitled "Hold the Applause," Fitch Ratings said it maintains a circumspect view towards REITs because the opportunities are company-specific and have not translated to a sector-wide trend.
Fair enough. Most investments, especially those of the real estate variety, require extensive due diligence on individual companies if not individual properties controlled by those companies.
According to Fitch, maintaining sufficient liquidity remains the primary credit risk to U.S. equity real estate investment trusts in spite of recent opportunistic actions to reduce financial pressures. Many REITs have taken advantage of opportunities to bolster liquidity. However, Fitch Ratings said major challenges lie ahead, including likely reduced revolving credit facility commitments, limited bond issuances, a near-dormant U.S. CMBS market, and uncertainties regarding the recent re-equitization wave in the REIT sector.
Moody's Investor Services chimed in with its own concerns. Many US REITs also face imminent refinancing needs at a time of uncertain credit market access, Moody's said, adding that it expects most rating actions among the REITs to be negative in the coming year.
"Investment-grade REITs in particular entered this period of credit dislocation with sound balance sheets and largely unencumbered portfolios of assets," said Chris Wimmer, a Moody's vice president. "These strengths have allowed some REITs to successfully raise capital in the debt and equity markets, which they have used to lower refinancing risk and augment liquidity."
However, Wimmer added, a number of REITs have seen increases in total leverage and secured debt levels, thinning their cushions for covenant compliance, which has led to negative pressure on ratings and even to downgrades.
In its report, Fitch noted that the activity is coming primarily from REITs with investment-grade issuer default ratings that have liquidity surpluses. Fitch said it anticipates that more REITs will likely have liquidity deficits starting next quarter, when Fitch will begin to include 2011 debt maturities in the liquidity calculations.
Year to date, Fitch's rating actions have included 15 downgrades, 16 affirmations, and two upgrades. Certain downgrades have been driven by weakening liquidity profiles, while further rating downgrades may occur in instances where liquidity shortfalls become a growing concern.
Steven Wechsler, president and CEO of NAREIT, acknowledged to a national conference of real estate writers and editors last week in Washington, DC, that commercial real estate still faces a lot of challenges in coming back from the recession.
"If you think that March of this year was the bottom for publicly traded real estate, which may very well prove to be the case, we will not hit bottom in the non-public part of the commercial real estate market until sometime next year," Wechsler was reported as saying.
"Because real estate tends to lag the economy, there is an expectation that we'll continue to see operating level income from commercial real estate around the country decline for a period of time. That further erodes valuations in the commercial real estate market," Wechsler added.
However, Wechsler noted that the ability of REITs to raise billions in this market is an encouraging sign to investors "because there is less concern about their ability to refinance in 2010, 2011 and 2012."
REITs account for about 10% of the $6 trillion commercial real estate market, Wechsler said, adding that that 10% has found its bottom and historically the public real estate market leads the private real estate market by four to six quarters.
Some REIT analyst this past week have also called the REIT bottom.
"We recently upgraded the REIT sector to outperform in the belief that thawing capital markets and a bottoming economy has made the risk/reward profile of REITs attractive," BMO Capital Markets analyst Paul Adornato wrote in a note. "We are taking advantage of market dips to upgrade those REITs we believe have the potential for multiple expansion as liquidity fears begin to fade."
Adornato this past week raised the stock-investment ratings of DCT Industrial Trust (DCT) and Duke Realty (DRE) to outperform, citing improving balance-sheet prospects for both.
Steven Brown, in house real estate analyst to American Century Investments group of mutual funds, also called a REIT market bottom. In its annual report to mutual fund holders that came out this week, Brown wrote that American Century is confident that low interest rates and gradually improving credit conditions will allow many REITs to refinance their near-term maturing debt. Although he said expect weaker REIT earnings in 2009, he said that this has already been factored into the deeply discounted prices of many REITs.
"Given this more positive outlook, we began shifting away from our defensive positioning in March by expanding our holdings in some of the more beaten-down sectors of the REIT market, such as hotels and retail," Brown wrote. "We are also focusing on REITs whose balance sheets have improved through recent equity issuance."
Other institutional REIT investors appear to be proceeding cautiously since REIT downgrades still appear to be the norm for now and a year and half of unpaved road likely ahead for commercial real estate.
By property sectors, Moody's has a negative rating outlook on industrial and lodging REITs. It has a stable rating outlook for retail, office, multifamily, and health care REITs.
In its annual report to shareholders this month Heitman Real Estate Securities, as advisor to the Old Mutual Heitman REIT Fund, wrote that it is not certain that all of the bad news has been accounted for in real estate stock prices. However, Heitman said REIT stock prices may anticipate an improvement in the economy and real estate fundamentals before an improvement in property cash flows are apparent.
Heitman continues to position the Old Mutual Heitman REIT Fund defensively, investing in those companies that it believes have strong, liquid balance sheets, sustainable earnings and strong management teams. Heitman has been reducing the mutual fund's exposure to those sectors with shorter-lease terms and business models which Heitman said it believes will see more of the negative impacts from slowing economic growth.
Joseph R. Betlej and Lowell R. Bolken, portfolio managers with Advantus Capital Management Inc., are advisors to the Ivy Real Estate Securities Fund. They wrote Ivy fund investors this week in the mutual fund's annual report "that due to the corrections in prices over the last two years, we feel that we are in much closer proximity to a bottom in pricing for REITs… Evidence suggests that REITs are cheap relative to historical valuation parameters, but we believe that the catalyst must come from the broader economy for positive momentum to take hold in real estate stocks."
Betlej and Bolken said three things will change the sentiment for REITs:
- Evidence in the economy that production is reviving and job losses are abating,
- The consumer must emerge from hibernation, and
- Lenders must embrace the liquidity and incentives that the federal government introduced to become a more sustainable form of capital for companies.
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