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No. of Recommendations: 21
Barry, thanks for your excellent post on the prospects for the office REITs and their dividend paying abilities. I agree with most of what you say in your post, but would like to clear up a couple of points.

First, when I mentioned that there would still appear to be a "cushion" for the dividend (meaning that occupancy could decline further and the dividend still be less than AFFO), this assumes that projected AFFOs will, indeed, be what the REITs eventually report. No one knows whether these projections will, indeed, be accurate, i.e., occupancy could fall a lot more than what management and the analysts presently forecast. That's, of course, the basic problem with projections: They rest upon assumptions that may, with hindsight, turn out to have been too optimistic.

Second, I don't believe I suggested that looking at occupancy was the only thing the investor needs to do with respect to dividend coverage. Obviously, we need to look at a REIT's free cash flow out of which dividends can be paid, and it is certainly necessary to look not only at occupancy rates, rental rates, rolldown risk, etc, but also, of course, at tenant improvements, leasing commissions and such, which are excluded when calculating FFO. But the difficulty here is whether we use ACTUAL capital expenditures or a RESERVE for regular recurring capital expenditures.

It seems to me that the latter might be more appropriate when determining a REIT's dividend paying ability over a long period of time, recognizing that there will be some years where the actual cap ex is higher than the amount reserved, and in some years lower. In other words, if in one particularly difficult year, these deductions from FFO amount to $.30 a share, while in most normal years they are $.15, do we deduct the $.30 from FFO and then, perhaps, conclude that the REIT is "not earning its dividend," or do we use the $.15? It could make a difference if capital expenditures and leasing commission payments for office owners go sky high for a year or even two, and then abate substantially. Of course, the investor will have to make the decision whether the higher level of cap ex that Barry is suggesting is a temporary or permanent situation. If permanent, then we shouldn't be kidding ourselves, and should shift into a permanently higher cap ex projection mode.

Finally, on the subject of cap rates, with all due respect to Barry, I don't believe that I forecasted that cap rates would remain constant, nor continue to drift lower, and apologize if I created that impression. I went out on a limb some time ago, and suggested that cap rates would come down for commercial real estate this year. While most of these "macro" predictions of mine are a game -- and no more than 50% accurate -- I got lucky on this one, and it turned out to be true. We have, indeed, seen a drop in cap rates for many commercial properties that are in demand by institutions -- in the office sector, those where occupancy levels are high, lease terms are long and tenant quality is good. But, when I predicted lower cap rates, I also stated that real estate markets would have to stabilize, which would enable buyers to have a pretty good level of confidence in what kinds of cash flows they were buying. So far, at least in the office and apartment sectors, real estate has not yet stabilized and, if they do not, it is certainly possible -- maybe probable -- that they will again rise in order to account for the extra risk the buyer faces.

Accordingly, I have made no projection of future cap rates, and right now I don't know whether they are heading back up, will remain stable, or even drift down a bit more. There are just too many variables to make that call with any confidence; it is like predicting the direction of the stock market or of interest rates. I will say, however, that many REIT executives are anticipating that cap rates will rise as pension funds and other buyers realize they're paying "too much," or because of rising interest rates, or perhaps more property comes onto the market, thus affecting the supply/demand balance. They've been saying that for some time, but perhaps this time they may be right. That would, of course, reduce REIT NAVs significantly, but would open the door just a bit wider to potentially solid acquisitions (if the REIT has a strong enough cash flow and balance sheet to take advantage of them).

Perhaps the market, by discounting REIT stock prices to levels substantially below today's estimated NAVs in recent weeks, at least in the apartment and office sectors, is anticipating a downward revision in NAVs. It wouldn't be the first time that "the market" was ahead of the so-called pundits. As the average REIT NAV premium/discount during the past 10 years has been about zero (albeit with some very high peaks and low valleys), perhaps one of two things must happen: (a) REIT stock prices in the office and apartment markets snap back and again trade at prices closer to existing estimated NAVs, or (b) estimated NAVs get chopped. I don't know which it'll be. Maybe neither.


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