Summary
The public markets have traditionally been a leading indicator of trends in the private real estate markets, and with the continuing deterioration in property fundamentals across most property types, it is hard to conceive of a broad based REIT rebound this year. Longer term, it is important to remember that the REIT model of the first part of this decade was predicated less on property and market fundamentals and more on creating attractive dividends through cheap debt. That era is over, and the successful companies will be those who can create dividends and stock price increases through back to basics value creation at the property level.
Analysis
This article highlights an interesting divergence of opinion among industry experts; the optimists see a rebound primarily due to technical improvements due to an 'oversold' market and the thawing of the frozen debt markets, while the pessimists focus more on the property fundamentals.
Steven Carroll, one of the interviewees, correctly states that REITS have typically been a leading indicator of trends in the private commercial real estate market. And 2008 was a bear. A combination of concerns about refinancing issues on the debt side and concerns about the economy sent most REIT's into major slides during the year, and correctly so. The prospects for operating fundamentals and debt refinancings are both bleak. But, the fair question is this: is all this information now fully baked in to the stock prices? If so, the stocks may present a good opportunity to buy. If not, then there are better things to invest in these days.
Although there is no clear answer to this question, three things stand out. First, although it is hard to imagine the credit markets getting any worse, as a practical matter even when the debt markets come back we will not see the kind of cheap debt that drove a good deal of the positive operating results of the REIT's in the first part of this decade. As a result, although REIT prospects may improve when the debt markets return, only those companies with the ability to drive value at the property level will prosper, while those who relied on financial engineering will languish.
But, driving value at the property level only occurs when property markets are in balance, and this brings me to my second point: in many property types the markets are far from being in balance and are deteriorating rapidly. Real estate markets for the most part move like supertankers--once they get headed in the wrong direction it takes a while for them to turn around. So, although a lot of the economic downturn--and its impact on property fundamentals--may be baked into the stock prices of many REITs, the practical reality is that it will take a few years at minimum for the fundamentals to turn around, and only then will this start to show up in the REIT pricing. The once exception to this are those REITS--particularly hospitality--that are effectively operating businesses rather than real estate. These have seen some of the hardest and quickest drops in value to date, and will be the quickest to bounce back once the economy hints at recovery.
Third and finally, although many REIT stocks may be oversold, when private real estate investors can buy senior debt at double digit coupons and stock pickers can find blue chip stocks at very attractive dividend yields as they can right now, it is hard to imagine a huge influx of new money into REITs while these opportunities still exist. Moreover, some REITs--particularly those in specialized niche products or markets--have not seen the decline in value that others have seen, leading to the question of not when they recover, but whether they have farther to fall.
Does this mean REITs are devoid of opportunity right now? Far from it, and in fact REIT indexes are up modestly in recent weeks, perhaps in part because some investors view the sector as ripe for private take-overs at higher prices or see a much more rosy outlook for the economy. But over the long term, market fundamentals are what matter most, and when they come back in balance, those REITs with the strongest capacity to capitalize on this at the property level will be terrific long-term buys.
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