REITs claim capital

Brad Case, a vice president with the National Association of Real Estate Investment Trusts Whle real estate investment trusts clearly have a lot of challenges right now, they have one key thing going for them that a lot of other investors don’t: access to capital. In this month’s Q&A, experts who track REITs told The Real Deal that the tremendous volatility the sector was experiencing a year ago is largely gone now. They said the biggest challenge REITs face today is finding worthwhile investments and paying down their debt.

Some REITs, including Sam Zell’s Equity Residential, SL Green and Hersha Hospitality (see “Hersha’s New York play”) have already started picking up more property in New York. Others, like Simon Property Group and Westfield Group, are going head-to-head to take over bankrupt megamall operator and South Street Seaport owner General Growth Properties. Sources said they expect more REITs to start going after entire portfolios of properties (though not on the General Growth Properties scale) in the coming months.

“That’s where The Real Deals are right now — up at 10,000 feet, recapitalizing troubled owners,” one source said, adding, “Nobody wants to get into a bidding war on an individual office building in Manhattan or a prime mall in New Jersey because those are the assets where we are seeing values rise [again].”

A recent phenomenon in the REIT sector that may not have staying power is, however, so-called blind pool REITs — those that don’t own assets yet, but are instead trying to raise money based on the reputation of the managers and the offering plan. While several, including Starwood Capital’s blind pool REIT, had early success with this strategy, others have flopped and have had to return their money to investors because they couldn’t find good investments. One source called blind pools a “flash-in-the-pan” trend.

For more on which REIT sectors are faring best and worst and which REITs are most under- and overvalued, we turn to our panel of experts.

Brad Case

vice president for research and industry information, National Association of Real Estate Investment Trusts

What are the biggest challenges for REITs right now and how do those challenges differ from a year ago, six months ago or three months ago? 

A year ago there was such tremendous uncertainty about access to capital markets that volatility among REIT stocks was huge, never seen before. Those concerns have been gone since about last July. So the challenge is entirely different now. They have solved the problem of meeting their debt obligations and, generally speaking, they have solved the problem of restructuring their capital structure to a level of leverage their investors are more comfortable with. And, starting last August, the debt markets opened up again. Now REITs have access to multiple sources of capital. The challenge now is managing properties in a weak market while waiting for the opportunity to buy good properties from distressed sellers.

What are the major trends you are expecting to see among REITs in New York and elsewhere moving forward?

There [will be] a lot of property available in New York and other cities like it over the next few years. The first quarter of this year is the first indication that transaction activity has picked up. It’s not just properties coming out on the market from distressed sellers; there has also been an uptick of activity among healthy sellers. Going forward we will see an increase in both healthy and distressed. I’m talking about good properties from distressed sellers, not distressed properties. There will be those as well, but the story over the next few years will be good properties from distressed sellers. It will likely pick up gradually and crest around 2012.

Despite the fact that REITs raised billions of dollars last year, according to one report, they bought 67 percent less property than they did in 2008. What sort of buying activity are you expecting from REITs this year and next?

The level of REIT buying activity is really only limited by the number of properties available. Even if there are other buyers, generally speaking what we have now is a situation where REITs have access to capital and hardly anybody else does. There are some people who [wrongly believe that] if other people get capital then they will get the good opportunities. A lot of the problems private-sector investors are in right now came from the fact that they bid too high on properties in the 2005-to-2007 bubble. REITs were the ones selling the most properties at the inflated prices. The reason REITs are in a position to do that is they never faced any deadlines on putting capital to work. Even if other sources of capital come into the market, if those other sources of capital have deadlines on putting money to work, we can pretty much expect that they will make a lot of bad deals.

How are REITs faring as an asset class now versus over the past several years?

In the last year REITs are up 95 percent in total returns. REIT returns over the past three-to-five-year period have been negative. Over the last 10 years REIT returns have been nearly 11 percent per year on average. In contrast, stock market returns have been negative over the last 10 years.

Craig Guttenplan

analyst, CreditSights

A number of firms that are seeking to become REITs are so-called blind pool entities, meaning they don’t own assets yet. What do you think of this strategy compared to the traditional REIT strategy of actually owning property?

We think this strategy was largely a flash-in-the-pan phenomenon that was only successful for the early movers who were able to take advantage of market expectations for an upcoming slew of buying opportunities. As more blind pools raised capital, few could put it to work right away and the market cooled to further offerings. We favor those REITs which already have an existing portfolio of properties.

What are the biggest challenges for REITs right now? 

Maintaining solid fundamentals like high occupancy and rental rates in the face of fierce competition and the reduced demand for space, as well as continuing to build solid liquidity positions and deleveraging. Three to six months ago, our concerns primarily revolved around refinancing and maintaining adequate liquidity to pay off un-refinanceable mortgages and unsecured debt. As the credit markets seem to have thawed a bit and more REITs have been able to tap the debt markets, our focus is beginning to shift.

What are the major trends you are expecting to see with REITs in the coming months in New York and elsewhere?

The New York market is notable since there was a lot of buying activity near peak values and rental rates have come down significantly over the past two to three years, meaning that many properties may be underwater and many may be coming close to tripping debt service coverage covenants, which could mean these assets may come to market. We are also seeing some REITs, such as SL Green, buy mortgages on New York buildings as part of a “loan to own” strategy whereby the mortgage holder would try to take control of a property from equity holders following a mortgage default.

Which REITs do you think have the best long-term outlooks?

Among those that are based in or have significant operations in New York, we favor Vornado and Boston Properties. In our opinion, both companies have very strong portfolios that insulate them somewhat, as well as arguably the best liquidity profiles and capitalization in the whole sector. Also, SL Green, Equity Residential, AvalonBay Communities and Mack-Cali Realty.

What REIT sectors are faring best and worst? 

REITs [that own properties] with shorter lease terms are seeing the most immediate [negative] impact. Hotels have the shortest lease terms, followed by apartments, whereas industrial, office and retail have longer lease durations. Since leases roll over more frequently for hotels and apartments, [REITs that focus on these kinds of] properties are experiencing more abrupt declines in revenues. On the flip side, hotels and apartments are likely to see their results rebound more quickly once there is a meaningful recovery, while the longer lease duration property types will continue to see results dwindle gradually.

What sort of buying activity are you expecting REITs to engage in this year and next? 

Some REITs have started to make acquisitions, notably Equity Residential’s recent purchases in Manhattan as well as Simon Property’s pending acquisition of Prime Outlets and Kimco Realty’s acquisition of its joint venture partner’s interest in a managed portfolio late last year. We expect these types of acquisitions to be somewhat prevalent in 2010. While none of the sellers were distressed per se, they were all non-REIT owners who wanted to monetize certain investments and free up capital. We also believe we may see the beginning of the true distressed opportunities.

How are REITs faring as an asset class now versus over the past several years? 

The publicly held REIT sector proved its greatest competitive advantage over the past year: access to public capital. With the industry seemingly in a death spiral following the Lehman bankruptcy, many companies were able to tap the equity markets for much-needed deleveraging beginning in March 2009. In the second half of the year, some REITs began to tap the public unsecured debt markets, which further enhanced liquidity. The same cannot be said for the private market. Absent an influx of new capital to deleverage, many private owners may have to relinquish some of their properties, and in many cases these assets could find their way into the hands of the freshly recapitalized REITs.

We know that some blind-pool REITs have returned money they’ve raised to investors. Do you expect more of that in the coming months? 

It is possible that some blind-pool REITs will return capital to investors, as the acquisition opportunities will probably not be as abundant as once contemplated.

Which REIT is taking the most aggressive approach today in terms of acquisitions?

Simon Property’s recent offer for General Growth Properties is probably the most aggressive action we have seen on the acquisition front. We do believe it’s a special case for Simon to dramatically increase its dominance in the regional mall industry in one fell swoop and is not reflective of an overly aggressive approach to acquisitions.

Dan Fasulo

managing director, Real Capital Analytics

What are the biggest challenges for REITs right now?

To be able to take advantage of all the opportunities that exist, maybe not on the property level, but being able to use their capital to do things like what SL Green is doing in Manhattan — trying to acquire debt positions, foreclose on certain assets, foreclose on loans to get access to underlying collateral at a lower price than they could actually buy the property for. SL Green took over 100 Church Street. They would like to take over Macklowe’s new building on Madison.

What are the major trends you’re expecting to see with REITs in New York and elsewhere?

I think we’ll see more REITs merge. Some will try to acquire large portfolios as we’re seeing in the General Growth situation, where REITs like Vornado and other public companies like Simon and Westfield are trying to buy GGP in its entirety. That’s where The Real Deals are right now — up at 10,000 feet, recapitalizing troubled owners. Nobody wants to get into a bidding war on an individual office building in Manhattan or a prime mall in New Jersey because those are the assets where we are seeing values rise [again]. Also, I see more private investors in the near future using the REIT structure as a way to recapitalize portfolios. It’s a way for a distressed owner to dilute their equity stake and at the same time retain control over a portfolio of properties. Some of these big groups of portfolios acquired at the top of the market that may be overleveraged may wind up being pooled and pushed into the public market through a REIT offering.
We’ve already seen big players like Equity Residential buy buildings in Manhattan. Do you expect other REITs to follow suit?

Sure, it’s always great when Sam Zell starts buying near your market. Everything hit a pause after the economic collapse, but I do expect REITs to be major players in New York going forward. Equity and [REITs like] AvalonBay have established development teams so they can not only buy, but they can also build if they get the opportunity. Equity just bought land in Chelsea. AvalonBay is building in Brooklyn and Manhattan and aggregating additional sites.

What sectors of the REIT world are faring best and worst?

I like the REITs that have a majority of their exposure in the supply-constrained markets on the coasts, specifically some of the multifamily REITs active in places like Manhattan. For all the talk of a downturn, the vacancy rate for apartments is still 1 percent. Of the core sectors, multifamily is doing the best. That said, I think some of the niche sectors focused more on medical and senior housing are always considered the most recessionproof. Doctors still need office buildings and older people need nursing homes and assisted living facilities.

How are REITs faring as an asset class? 

What’s keeping me a little bullish is that not many investors have given up on commercial property. That’s different from what we saw in the recession in the early ’90s. There will be demand going forward from investors to own REIT stock, especially because many institutional investors are reevaluating and understanding the importance of liquidity in their portfolio. Many are going to continue to be attracted to the liquidity REITs provide versus direct property, which is not easy to move in and out of. In addition, there are proposed changes to the Foreign Investment in Real Property Tax Act that have the ability to make REITs more attractive to foreign investors, which could lead to additional capital flowing into the REIT sector over the next couple of years.

Which REIT is taking the most aggressive approach today in terms of acquisitions?

Hersha Hospitality has been very aggressive in the hotel sector, acquiring assets in prime locations that are arguably at values below replacement costs. So it might be viewed as aggressive right now. There is not much competition in the hotel sector but it may ultimately turn out to be a brilliant strategy of buying assets at the bottom of the market.

Yaacov Gross

partner/head of real estate securities practice group, Morrison & Foerster

What do you think of the strategy blind-pool REITs are using?

The earlier blind-pool mortgage REITs, like Starwood’s, had some success, but only a few of the imitators succeeded. The blind-pool REITs assumed that there would be a lot of distressed real estate assets available at deeply discounted prices. That hasn’t happened yet; there’s actually been a shortage of assets to buy.

What are the biggest challenges for REITs right now? 

There is a lot of capital looking for deals, so if REITs want capital, they can get it. [But] the big challenge for many of them is, ‘Should we take it?’ Without a lot of assets to buy, capital would essentially be deployed to pay down debt. For many REITs, that’s a painful decision.

What sectors of the REIT world are faring best and worst? 

The multifamily sector has continued to be relatively strong. I think the mall sector will get a short-term valuation pop from the contest over General Growth Properties. Hotels are trading at high cap rates and this, applied to low net operating income, makes for some attractive pricing, but that assumes that travel will increase again.

Craig Leupold

president, Green Street Advisors

What are the major trends you’re seeing with REITs in New York and elsewhere?

An increase in asset prices. Our commercial property price index shows that prices bottomed in the middle of 2009, but are up about 10 percent since then. That is the good news; the bad news is that prices are still off about 30 percent from their peak.

Which NYC-based REIT do you think has the weakest long-term outlook?

Brookfield arguably faces the greatest challenge given its exposure to the pending maturity of a sizable lease with Merrill Lynch in Lower Manhattan. Generally speaking, Downtown is weaker than Midtown, which means that the outcome of the Merrill situation could create some drag for Brookfield.

Which sectors do you think are the most over- and undervalued?

Our view is that the office sector is the most overvalued in both the public and private market and that the industrial property sector is the most significantly undervalued. Also, if the economy is indeed on the road to recovery, that bodes well for hotel demand. If we get job growth, the next sector to benefit will be apartments.

Hans Nordby

global strategist, Property & Portfolio Research

What are the major trends you’re seeing with REITs in New York and elsewhere?

REITs are becoming aggressive buyers. SL Green bought the mortgage on a newly developed Midtown office building [510 Madison Avenue]. What was remarkable about the trade was the building’s status — vacant — and the price per square foot, which was reasonable for a new building but a very big number for an empty one.

We know that some blind-pool REITs have returned money they’ve raised to investors. Do you expect more of that in the coming months? 

That depends on how fast banks are required or otherwise motivated to sell nonperforming loans. These assets are some of the primary investment targets for blind-pool REITs. We expect approximately 280 banks to fail in 2010, up from about 150 in 2009. As more of these distressed assets hit the market, just as the economy stabilizes, more blind-pool REITs are likely to deploy, instead of return, capital.