Summary
The credit rating agencies have not distinguished themselves in this bust.
The problem might have something to do with the fact that credit is only part of the question when it comes to real estate.
This, in turn, may have something to do with the prior success of asset valuation in mortgage risk management.
If Fitch has a negative outlook at this point, there are two likelihoods: much more extreme risk, and possibly some selective opportunities.
Analysis
The credit rating agencies have not distinguished themselves in the bursting real estate bubble. Their ratings of residential mortgages were meaningless. Investment grade seemed to be based on simple analysis, "Safe as houses". The factors mentioned calmly in this article suggest that somebody has learned a little. The calm suggests that they haven't learned enough.
The problem might arise from the fact that credit is not the only factor in accurately assessing real estate risk. There isn't really enough room here to write a book on real estate analysis. I recommend the classics, Ratcliffe, Wendt, Kinnard... Briefly real estate isn't either manufacturing, nor yet commodities. Real estate comes in big lumps. While it is easy to sell when it's easy, it can be virtually impossible to liquidate when conditions are not. And each property suitable for REIT has a mix of tenants. Michael Young argues that this constitutes diversification. Experience suggests that this sort of diversification offers little or no protection. While government was rather high handed with secured creditors in the recent automotive restructurings, its action pales before the eager willingness of tenants to renegotiate rents downward when the opportunity presents itself. And often lessors have little choice but to either cave in, or expensively litigate. Nor is recovery assured in the latter instance. Think Circuit City.
The University of California Management journal had a great article, about ten years ago, "Nobody Gets Credit For Solving Problems That Don't Happen". The gist was that success in managing a problem leads to minimizing resources directed to that effort. Sooner or later the problem emerges again. Perhaps the "golden age" of real estate investment analysis, the 1960's, was so successful that the finance MBAs could claim that property specific factors were insignificant to loan repayment as compared to credit. Certainly for the last couple decades that philosophy, only credit matters, has ruled. It reached its point of ultimate absurdity in the last few years. The house bubble was deflating by 2007. Commercial started the same decompression last year.
In all events, if Fitch expresses a negative outlook for REITs, I expect they have underestimated the problem seriously. REITs, at least in this case, are equity. If the mortgages have or will have problems, almost a certainty, what hope does equity have? The advantage of REITs is, primarily, liquidity. Want to sell? Call your broker and the trade can almost always be executed, at some price, in the course of a business day. There are several disadvantages, roughly speaking, tied to management. A divergence between direct real estate investment and REITs has been identified ("Linkages Between Direct and Securitized Real Estate" Oikarinen, Hoesli and Moreno). Other studies show that countercyclical direct investment in real estate works. Both suggest that institutional management can be outsmarted and outmaneuvered. Any possible number of reasons suggest themselves.
Despite all disclaimers about past performance not necessarily indicating future, analysis is heavily weighted toward extrapolating historic trends. Missing inflection points is normal. We are experiencing one. I'm trying to puzzle out the changed kaleidoscope pieces bit by bit. Fitch got the factors that rotated the instrument, but probably underestimates the effect on the resulting pattern. So, if Fitch says the REIT outlook is "negative", would believe that "catastrophic" might be a better adjective.Whatever the REIT market is doing in the last month, CoStar is suggesting a 70% value hit coming for the underlying properties. Cognitive dissonance, or just the casino effect of Wall Street?
But, for every cloud there is a silver lining. If you're thinking of buying, think about buying real estate directly. Just be patient and careful.
This author consults with leading institutions through GLG
Analyses are solely the work of the authors and have not been edited or endorsed by GLG.
