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Stubborn Buyer/Seller Stalemate Hinders Solid Quarter for REIT Earnings

Credit Spreads Improve, but Lending Continues to be Tight and Costly, Market Fundamentals Remain Cloudy, Will Looming Construction Loan Due Dates Signal "Judgment Day?"
May 7, 2008
Executives for publicly traded REITs are, for the most part, happy about their first-quarter performance as the latest round of quarterly earnings reports winds down and firms turn their attention to two of the biggest industry events of the year: the ICSC’s annual RECon exposition in Las Vegas May 18-21, and NAREIT’s REITWeek Investor Forum June 4-6.

Wall Street analysts, while predictably less sanguine than real estate execs about the outlook, generally applauded the quarter’s results as better than expected, given the disruptions to the economy, credit markets and commercial real estate fundamentals. On paper, the sector is holding up well. REIT indices are up more than 12% year to date. Fitch’s 2008 REIT rating is stable, with only 10% of firms tracked by the agency receiving a negative outlook or negative watch rating.

However, Fitch views the sector with caution. Debt capital markets, specifically unsecured debt and commercial mortgage-backed securities (CMBS), remain gripped by uncertainty and limited activity, which will likely continue to hinder REITs, especially merchant developers, from accessing capital.

"Not a lot’s trading on the CMBS side; it’s very interesting," David Simon, CEO, Simon Property Group Inc., told analysts. "At this point, it’s just very hard to find the paper. We do expect that log jam to loosen up."

And wait until the construction loans come due, Simon says.

"I think the construction loan side -- I was going to be more graphic than I should be, so let’s see how I can word this -- I think we’re going to see the beginning of the recent developments starting to hit the fan. Judgment Day is coming."

"Transaction volume is way down, which indicates that there is greater bid gap than there was in the past among a lot of buyers and sellers," said Scott Wolstein, CEO of Developers Diversified Realty Corp. (NYSE: DDR). "There is a tremendous amount of CMBS paper that's in distress that people think they are going to be able to acquire at a very reasonable prices and very high yields, and there is a lot of vulture activity going around with various plan[s]. ... so people are taking a little bit longer, but there are enough investors out there that are more interested in secured cash flow."

Editor's Note: In an attempt to channel REIT executives’ and analysts’ thinking,CoStar Advisor listened in on dozens of earnings calls over the last couple of weeks. This week, we’ll focus on REITs specializing in multifamily and multiple product types. Next week in part two, we’ll review office and industrial results from the first quarter.

Several equity REITs’ liquidity positions have weakened in the last few months. Others have taken advantage of shorter-term, low-cost bank loans to repay debt on unsecured revolving lines of credit and cleaned up their balance sheets, according to Fitch. However, caution prevails.

"While the equity markets seem to have moved past the credit and economic issues, the real estate transaction market has not," wrote Michael Bilerman, chief REIT analyst with Citigroup. "We believe it is still too early to say that the economy is in the clear and that we will not see continued weakness going forward."

Credit spreads have improved, but lending overall continues to be tight and costly, with the outlook for fundamentals cloudy, most analysts say. During the current round of earnings reportings, executives reported occupancies declined across most sectors during the quarter and leasing velocity slowed.

Moreover, sellers and buyers remain in a stalemated chess match ("It’s your move. No, it’s your move."), with numerous reports of sellers yanking their deals amid irreconcilable differences with buyers over pricing.

Buyers for the most part remain too cautious to sprint from the sidelines into the game -- though it’s clear that equity players - those that are suited up and ready for action -- are patiently planning for the next market upswing.

Apartment REITs Rebound

Standard & Poor’s maintained its neutral outlook on residential REITs, with increased supply, job losses and slower rent growth offsetting generally solid quarterly earnings and stable market conditions. S&P, though, found that shares of many firms have outpaced underlying fundamentals.

The S&P Residential REIT Index rebounded 10.3% during first quarter after declining 27.9% during 2007. This compares favorably to a 9.8% decline for the S&P Composite Index and a 0.8% rise by the S&P REIT Composite Index. On average, residential REITs yielded 4.9% as of March 31, close to the 5% average yield for all equity REITs.

"We think tightening conditions in the credit markets may result in higher borrowing costs for REITs considering acquisitions in coming months," said S&P analyst Royal Shepard in an investment note. "To date, however, we believe government-sponsored entities (GSEs) such as [Fannie Mae] have provided adequate liquidity to owners of multifamily properties."

Some apartment operators have benefited from the single-family housing downturn, with renters staying put longer. However, the so-called "shadow market" of empty single-family homes is providing an alternative for renters in some markets.

For most apartment REITs, first-quarter same-store net operating income growth (NOI) was in line with expectations. But growth in funds from operations (FFO) has been ahead of consensus, according to Citigroup’s Craig Melcher. Most operators did not scale down their guidance during the quarter, saying they’ve thus far felt little impact at the property level from job losses.

Ask Any Broker

"The first observation I’d make is that acquisition activity and just properties on the market is dramatically down," said Skip McKenzie, president/CEO Washington Real Estate Investment Trust (NYSE: WRE), a diversified REIT. "Talk to many of the prominent brokers in the market and they’ll tell you there’s anywhere from 40% to 80% reduction in activity."

Where cap rates are depends on the property type, McKenzie said. "We’re still seeing very aggressive cap rates on some of the more prominent downtown buildings. We made a pretty hard run at some retail properties and we’re disappointed to find the cap rates were still sub-6% range."

"We have seen slightly increased delinquencies, particularly as it relates to the retail sector," added McKenzie. "There (have) been workouts that we have had. And as a general rule, we have incurred higher bad debt expense."

"The good news is that rental rates have generally been holding out with multifamily," McKenzie said.

Following are earnings snapshots and color from select first-quarter earnings reports by multifamily and mixed REITs.

Equity Residential Property Trust (NYSE: EQR) said that FFO fell slightly due in the quarter in part due to lower gains on sales of condominiums. EQR reported first-quarter FFO of $170.7 million, or 59 cents a share, compared with $173 million, or 55 cents per share a year ago. Deutsche Bank downgraded the stock from buy to hold, saying economic headwinds could cause rents and occupanies to fall.

UDR Inc. (NYSE: UDR), one of the best performing REITs of the year with a 29% total return, met Wall Street expectations by reporting first-quarter FFO of $56.1 million. Citigroup expects the shares of the Richmond, VA-based company to take a pause while it absorbs the proceeds from its $1.7 billion portfolio sales in March to a joint venture of Steven D. Bell & Co.

Post Properties Inc., an Atlanta-based diversified REIT, saw first-quarter results fall on a decline on income from property sales. Funds from operations fell to $13.9 million, or 31 cents per share, from $20.7 million, or 46 cents per share, in the first quarter of last year. Analysts had predicted FFO of 46 cents per share.

Apartment Investment and Management Co. (NYSE: AIV), one of the largest U.S. apartment landlords, reported better-than-expected quarterly funds from operations on Friday, helped by increases in average rents and occupancy rates at its properties. Aimco reported FFO of $67.4 million, or 72 cents a share, higher than the 70 cents per share expected by analysts.

Camden Properety Trust (NYSE: CPT) reported FFO of $52.3 million, as compared to $55.9 million for the same period in 2007. S&P downgraded CPT to sell, saying it faces excess housing inventory in several markets, including Florida, Phoenix, and Northern Virginia, along with a slowing economy that will pressure its ability to increase rent.

AvalonBay Communities Inc. (NYSE: AVB) said FFO rose nearly 8%, boosted by higher rent and acquisitions, to $96.1 million, or $1.24 per share, from $89.1 million, or $1.11 per share. Analysts, on average, had expected FFO of $1.22 per share.

Coloniel Properties Trust (NYSE: CLP) reported FFO of $33.1 million, or 58 cents per share, compared with $43.9 million or 78 cents per share in the same period a year ago. Decreases in net income and FFO from the first quarter of last year are mostly related to office and retail joint venture transactions that occurred in 2007, the sale of some non-core retail assets, and a decrease in returns from for-sale residential.

Washington REIT (NYSE: WRE) said FFO totaled $18.2 million, compared to $24.5 million in the first quarter a year ago, within the range expected by Wall Street. The Rockville, MD-based mixed REIT took an 18-cent change to FFO for a refinancing of debt.
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