San Francisco / Seattle: US real estate investment trusts (Reits) are poised for their biggest decline in almost a decade as higher borrowing costs curb takeovers and reduce the value of properties.
After outperforming the Standard & Poor’s (S&P) 500 index every year from 2000 to 2006, Reit stocks may drop as much as 20% in the next 12 months, according to University of California, Berkeley economist Kenneth Rosen.
Shaky ground: A westward view towards the Hudson River from the Upper West Side neighbourhood of Manhattan, New York. Property trusts that own office buildings, apartments, hotels and mortgages are losing value as banks and investors shun bonds and loans backed by subprime and commercial mortgages.
“Reits are overvalued by 25% to 40% relative to stocks and bonds and cash flow yields are too low,” said Rosen, who also runs a $480 million (Rs1,896 crore) hedge fund from Berkeley that invests in real estate securities.
Property trusts that own office buildings, apartment complexes, hotels, shopping centres and mortgages are losing value as banks and investors shun bonds and loans backed by subprime and commercial mortgages. That’s going to drive down Reit prices, said American Century Investment Investment Services Inc.’s fund manager Jeffrey Tyler.
Morgan Stanley analysts said last month that Reit returns could decline 10%.
The Chicago-based National Association of Realtors said on Wednesday that sales of previously owned US homes fell more than economists forecast in September as higher mortgage rates made it more difficult for potential buyers to get financing.
Sales were down 19% from September 2006 and the median home price dropped.
The 128-member Bloomberg Reit index returned 78% with dividends in the two years prior to its 8 February peak, the day before New York-based Blackstone Group Lp. bought Equity Office Properties Trust for $23 billion, or $39 billion including debt, the real estate industry’s biggest leveraged buyout.
Since then, the index has fallen 16.5% after dividends as commercial mortgage rates climbed as much as 2 percentage points above the 10-year US Treasury note. The last time the Reit index declined more than 10% in total return was in 1998 when investors were diverting funds to high-flying Internet stocks.
Warehouse and industrial Reits are the only group in the Bloomberg index, which hasn’t lost value this year, gaining 11.5% as imports of US raw materials and consumer products increased.
Public storage Reits dropped the most—down 19%. Apartment Reits decreased 13% and office stocks declined 12%. All returns include dividends.
American Century, the Kansas City, Missouri-based money management firm with about $100 billion of assets, sold about 40% of its Reit holdings in May 2006 because prices, driven up by hedge funds and takeovers, “exceeded the underlying fundamentals”, Tyler said. Now, with rents flattening and vacancies rising, “the picture isn’t getting better,” he said.
The US office vacancy rate increased to 9.8% at the end of September from 9.7% in the second quarter, and rents in Manhattan and San Francisco climbed at the slowest pace in more than a year in the third quarter, according to real estate brokers Cushman & Wakefield Inc. and Studley Inc. in New York and Chicago-based Grubb & Ellis Co.
“There is plenty more shakeout to go in the Reit market,” Tyler said. “Property values are going to be under pressure, and by extension that will move to Reits.”
Sam Lieber, who oversees $5.5 billion in real estate stocks as president of Alpine Mutual Funds in Purchase, New York, sold “lesser-quality” Reits as prices climbed.
“They got very expensive and were trading at very high multiples relative to other investments,” Lieber said, declining to identify specific companies.
Lieber recently bought shares of Los Angeles-based Kilroy Realty Corp., an office and industrial Reit, after it fell more than 30% from its February high.
Drag on growth?
Morgan Stanley, the second biggest US securities firm by market value, told clients on 18 October that weak credit markets and a shutdown of the commercial mortgage-backed bond market may mean “downside stock price risks” for Reits and lower property prices.
The New York-based company said in a 21 September report that returns could fall 10% in a “mild recession” and by as much as 32% in “alow-probability stagflation scenario”.
Economists and Federal Reserve officials are predicting the real estate slump will curb economic growth. Fed Chairman Ben Bernanke said last week that housing “is likely to be a significant drag on growth in the current quarter and through early next year”. It’s “too early” to assess whether the drop will slow consumer spending and business investment, Bernanke said.
Wachovia Corp. analysts reduced 2008 earnings estimates for apartment, hotel, retail, office, diversified and speciality Reits in a 17 October report.
“Reit valuations are not factoring in a more significant slowdown of the economy,” said Christopher Haley, an analyst at Charlotte, North Carolina-based Wachovia, which has an overall investment rating for the industry of “underweight”.
Decline in takeovers
Takeovers fell 72% in the third quarter from the prior quarter, data compiled by Bloomberg show.
While the pace of deals slowed, the value of US Reit acquisitions totalled $59 billion in 2007—up from $7 billion in 2005, according to New York-based industry research firm Real Capital Analytics Inc.
This year’s agreements include the buyout of Chicago-based Equity Office Properties Trust; the $22.2 billion purchase of apartment Reit Archstone-Smith Trust of Englewood, Colorado, by Tishman Speyer Properties LP and Lehman Brothers Holdings Inc.; and Morgan Stanley’s $6.5 billion takeover of Crescent Real Estate Equities Co., the Fort Worth, Texas-based office, residential and resort Reit.
The Reit market got its start in 1960 when the US Congress created property trusts.
That led to a wave of initial public offerings (IPOs) beginning in 1991 with Kimco Realty Corp. of New Hyde Park, New York. Kimco is now the largest US owner of community shopping centres, with a market value of $10.5 billion.
Income as dividends
More than 200 Reits went public since 1991. Today, their combined market value is about $357 billion, according to the National Association of Real Estate Investment Trusts Inc. in Washington, DC.
Reits have attracted investors because they are required to pay out at least 90% of their income as dividends, avoiding corporate taxes, and their dividend yields have historically exceeded those of treasury securities.
Assets in real estate mutual funds rose to $82 billion as of 30 September from $12.5 billion a decade ago, accounting for almost 1% of mutual fund assets tracked by Chicago-based Morningstar Inc.
Almost half of the 128 stocks in the Bloomberg Reit Index yield less than the 10-year Treasury note’s 4.34%, making them expensive relative to government bonds, according to Bloomberg data.
Nine of the 10 largest US Reits by market value have dividend yields of less than 4%.
Confidence in Reits will return once banks resume making loans to finance acquisitions, said James Corl, chief investment officer at New York-based Cohen & Steers Inc., which manages more than $25 billion of real estate stocks.
That will show investors that properties have retained their values, Corl added. “Six months from now, a lot of this stuff will have been flushed out.”
Publicly-traded real estate companies that own office assets in markets such as Tokyo, Hong Kong and London offer potentially higher returns than US stocks, said Ted Bigman, a managing director at Morgan Stanley who invests $25 billion in real estate stocks on behalf of pension funds and endowments.
US Reits are trading at a discount to net asset value as investors anticipate declines in property values; historically, these stocks traded at a premium to the value of the underlying real estate, Bigman said.
“Over time, asset values will settle out and the shares are likely to trade at a premium again,” said Bigman.“The process of property prices settling out is not likelyto happen before the end of 2007.”
Daniel Taub contributed to this story.