REITs' rise sets off alarms
Analysts say sector due for a pullback

By TOM WALKER
The Atlanta Journal-Constitution
Published on: 03/24/04

For investors, the safest of safe havens over the last four years has been the real estate investment trust, or REIT.
As a group, these companies that own, develop, manage and/or invest in income-producing real estate have advanced 95 percent in share price since 1999.
Even in the worst year of the bear market — 2002 — the Morgan Stanley REIT index gained 3.4 percent, vs. the 24.2 percent decline in the S&P 500.

Now, just as residential developers are beginning to wonder how much longer the single-family housing boom — or bubble — can last, the REIT industry is asking the same question about the outlook for commercial property.

To be sure, nobody is prepared to use the word "bubble" in the REIT industry.
The general outlook is that portions of the real estate market are "due for a landing," according to Michael Grupe, senior vice president for research and investment for the National Association of Real Estate Investment Trusts, or NAREIT.

"The outlook for this year seems to be pretty much the outlook we had last year," he said. "The point being, it's very hard to be able to predict what these sectors are going to do."
That outlook is important to investors, who are attracted to REITs as a source of income as well as share price appreciation. By law, REITs must pay out more than 90 percent of their earnings as dividends.
That makes them especially attractive to the 50-plus age group, where 20 percent REIT allocations in portfolios are not unusual.

There's little mystery here: Real estate is frequently used as a hedge against fluctuations in the stock market.
Regarded as a common alternative to stocks and bonds, REITs can specialize in office buildings, hotels, shopping centers, industrial facilities, apartments or a mix of property types.
REITs usually have high dividend yields. Among public companies in Georgia, the highest dividend yields are offered by REITs: Roberts Realty Investors, 6.9 percent; Post Properties, 6.2 percent; and Cousins Properties, about 5 percent.
As for why REIT returns are expected to slow this year, Morgan Stanley analyst Greg Whyte said it's because they "are poorly positioned to benefit quickly from an economic recovery" — with the emphasis on "quickly."
For one thing, a REIT's cash flow generally comes from multi-year property leases. Thus only a portion of the REITs will be able to benefit from an improving economy via the normal rollover of leases.

Jobs a key factor

In addition, said Whyte, while market rents depend on changes in U.S. gross domestic product, they depend "even more so on job growth, which typically lags a recovery."
That has certainly been the case this time, as recent employment figures showed less-than-average job growth for this stage of the economy's recovery.

Then there is supply and demand, which has become especially important in the multifamily, or apartment, sector.
Tom Bell, president and chief executive of Cousins Properties, said most observers believe "we will see good GDP growth in 2004," with consumer spending "at a respectable rate" and an increase in business investment.
"In this environment we expect our residential, land and retail businesses to see more good development opportunities which meet our investment criteria, which will be nice for a change," Bell said in Cousins' fourth-quarter earnings report.

Despite the market's recent correction, outsized REIT share gains have continued so far in 2004.
The Morgan Stanley REIT index is up by 10 percent this year, compared with a decline of 1.1 percent for the S&P 500.
That's probably why investors have remained loyal to REITs even after the stock market rallied over the past year, industry analysts say.
The NAREIT index posted its biggest growth in 25 years in 2003, a 38.5 percent gain.

Slowdown in growth

This growth was somewhat surprising on Wall Street, where analysts expected 2003 to be a year of only modest REIT growth — especially after three straight years of strong returns.
They were partly correct — real estate fundamentals turned relatively weak, especially in the apartment and office markets.
Apartments were hurt by a weak labor market and by the loss of tenants who took advantage of low mortgage rates to become homeowners.
This has hurt apartment developers such as Post Properties, which cut its dividend last year.

Supply, demand factors

Standard & Poor's analyst Raymond Mathis said the apartment market is not likely to improve this year due to "oversupply and slack demand."
The lodging sector, which was in the doldrums since the Sept. 11, 2001, terrorist attacks, gained almost 32 percent in 2003.
Overall, REIT dividend yields fell to 5.8 percent in 2003 from 7.3 percent in 2002, due in part to lower earnings. But the industry's total market value — share price times number of shares — increased to $224 billion at the end of 2003, up from $162 billion a year earlier.
By all accounts, low borrowing costs sparked the real estate boom in recent years. Real estate companies were able to restructure debt and expand.
But strong demand has boosted property values at a time when low inflation rates also put a lid on property income.

"A great irony exists in the real estate industry right now," said analyst Whyte.
"Landlords have little to no pricing power in setting the price of their space — rents — but are able to command some of the highest valuations ever when it comes to selling decent quality, well-leased assets."
While questions remain about the strength of U.S. job growth — office job growth in particular — Bell at Cousins Properties sees an improvement this year.

"I personally do not buy into the no-job-growth theory," he said.
"There are limits to productivity improvements, and at some point companies have to hire to sustain improvement and growth in their business."
Looking ahead, NAREIT research indicates that investors will have to accept lower returns than they did in 2003.

REIT share prices are likely to peak over the next six months, especially if interest rates go up, a NAREIT survey shows.
Even so, REIT analysts remain confident because the alternatives are not all that attractive.
Bond yields are low, and common stocks are expected to generate average annual returns no better than the 10 percent historical average over the next five years.
According to industry executives attending a REIT conclave in Cannes, France, recently, the real challenge for REIT managers is finding attractive investment opportunities in a highly competitive environment.